NCERT Textbook - Analysis of Financial Statements Commerce Notes | EduRev

Accountancy Class 12

Created by: Nipun Tuteja

Commerce : NCERT Textbook - Analysis of Financial Statements Commerce Notes | EduRev

 Page 1


Y
ou have learnt about the  financial statements
of companies. Basically, these are summarised
financial reports which provide the operating results
and financial position of companies, and the detailed
information contained therein is useful for assessing
the operational efficiency and financial soundness
of a company. This requires proper analysis and
interpretation of such information for which a
number of techniques (tools) have been developed
by financial experts. In this chapter we will have an
overview of these techniques.
4.1  4.1  4.1  4.1  4.1  Meaning of Analysis of Financial Statements Meaning of Analysis of Financial Statements Meaning of Analysis of Financial Statements Meaning of Analysis of Financial Statements Meaning of Analysis of Financial Statements
The process of critical evaluation of the financial
information contained in the financial statements in
order to understand and make decisions regarding
the operations of the firm is called ‘Financial
Statement Analysis’. It is basically a study of
relationship among various financial facts and
figures as given in a set of financial statements, and
the interpretation thereof to gain an insight into the
profitability and operational efficiency of the firm to
assess its financial health and future prospects.
The term ‘financial analysis’ includes both
‘analysis and interpretation’. The term analysis
means simplification of financial data by methodical
classification given in the financial statements.
Interpretation means explaining the meaning and
significance of the data. These two are
complimentary to each other. Analysis is useless
L L L L LEARNING EARNING EARNING EARNING EARNING O O O O OBJECTIVES BJECTIVES BJECTIVES BJECTIVES BJECTIVES
After studying this chapter,
you will be able to :
• explain the nature and
significance of financial
analysis;
• identify the objectives of
financial analysis;
• describe the various tools
of financial analysis;
• state the limitations of
financial analysis;
• prepare comparative and
commonsize statements
and interpret the data
given therein; and
• calculate the trend
percentages and interpret
them.
Analysis of Financial Statements Analysis of Financial Statements Analysis of Financial Statements Analysis of Financial Statements Analysis of Financial Statements 4 4 4 4 4
Page 2


Y
ou have learnt about the  financial statements
of companies. Basically, these are summarised
financial reports which provide the operating results
and financial position of companies, and the detailed
information contained therein is useful for assessing
the operational efficiency and financial soundness
of a company. This requires proper analysis and
interpretation of such information for which a
number of techniques (tools) have been developed
by financial experts. In this chapter we will have an
overview of these techniques.
4.1  4.1  4.1  4.1  4.1  Meaning of Analysis of Financial Statements Meaning of Analysis of Financial Statements Meaning of Analysis of Financial Statements Meaning of Analysis of Financial Statements Meaning of Analysis of Financial Statements
The process of critical evaluation of the financial
information contained in the financial statements in
order to understand and make decisions regarding
the operations of the firm is called ‘Financial
Statement Analysis’. It is basically a study of
relationship among various financial facts and
figures as given in a set of financial statements, and
the interpretation thereof to gain an insight into the
profitability and operational efficiency of the firm to
assess its financial health and future prospects.
The term ‘financial analysis’ includes both
‘analysis and interpretation’. The term analysis
means simplification of financial data by methodical
classification given in the financial statements.
Interpretation means explaining the meaning and
significance of the data. These two are
complimentary to each other. Analysis is useless
L L L L LEARNING EARNING EARNING EARNING EARNING O O O O OBJECTIVES BJECTIVES BJECTIVES BJECTIVES BJECTIVES
After studying this chapter,
you will be able to :
• explain the nature and
significance of financial
analysis;
• identify the objectives of
financial analysis;
• describe the various tools
of financial analysis;
• state the limitations of
financial analysis;
• prepare comparative and
commonsize statements
and interpret the data
given therein; and
• calculate the trend
percentages and interpret
them.
Analysis of Financial Statements Analysis of Financial Statements Analysis of Financial Statements Analysis of Financial Statements Analysis of Financial Statements 4 4 4 4 4
without interpretation, and interpretation without analysis is difficult or even
impossible.
Box Box Box Box Box
Financial statement analysis is a judgemental process which aims to estimate
current and past financial positions and the results of the operation of an
enterprise, with primary objective of determining the best possible estimates
and predictions about the future conditions. It essentially involves regrouping
and analysis of information provided by financial statements to establish
relationships and throw light on the points of strengths and weaknesses of a
business enterprise, which can be useful in decision-making involving comparison
with other firms (cross sectional analysis) and with firms’ own performance,
over a time period (time series analysis).
4.2 4.2 4.2 4.2 4.2 Significance of Financial Analysis Significance of Financial Analysis Significance of Financial Analysis Significance of Financial Analysis Significance of Financial Analysis
Financial analysis is the process of identifying the financial strengths and
weaknesses of the firm by properly establishing relationships between the various
items of the balance sheet and the statement of profit and loss. Financial analysis
can be undertaken by management of the firm, or by parties outside the firm,
viz. owners, trade creditors, lenders, investors, labour unions, analysts and
others. The nature of analysis will differ depending on the purpose of the analyst.
A technique frequently used by an analyst need not necessarily serve the purpose
of other analyst because of the difference in the interests of the analysts. Financial
analysis is useful and significant to different users in the following ways:
(a) Finance manager: Financial analysis focusses on the facts and
relationships related to managerial performance, corporate efficiency,
financial strengths and weaknesses and creditworthiness of the company.
A finance manager must be well-equipped with the different tools of
analysis to make rational decisions for the firm. The tools for analysis
help in studying accounting data so as to determine the continuity of the
operating policies, investment value of the business, credit ratings and
testing the efficiency of operations. The techniques are equally important
in the area of financial control, enabling the finance manager to make
constant reviews of the actual financial operations of the firm to analyse
the causes of major deviations, which may help in corrective action
wherever indicated.
(b) Top management: The importance of financial analysis is not limited to
the finance manager alone. Its scope of importance is quite broad which
includes top management in general and other functional managers.
Management of the firm would be interested in every aspect of the financial
177 Analysis of Financial Statements
Page 3


Y
ou have learnt about the  financial statements
of companies. Basically, these are summarised
financial reports which provide the operating results
and financial position of companies, and the detailed
information contained therein is useful for assessing
the operational efficiency and financial soundness
of a company. This requires proper analysis and
interpretation of such information for which a
number of techniques (tools) have been developed
by financial experts. In this chapter we will have an
overview of these techniques.
4.1  4.1  4.1  4.1  4.1  Meaning of Analysis of Financial Statements Meaning of Analysis of Financial Statements Meaning of Analysis of Financial Statements Meaning of Analysis of Financial Statements Meaning of Analysis of Financial Statements
The process of critical evaluation of the financial
information contained in the financial statements in
order to understand and make decisions regarding
the operations of the firm is called ‘Financial
Statement Analysis’. It is basically a study of
relationship among various financial facts and
figures as given in a set of financial statements, and
the interpretation thereof to gain an insight into the
profitability and operational efficiency of the firm to
assess its financial health and future prospects.
The term ‘financial analysis’ includes both
‘analysis and interpretation’. The term analysis
means simplification of financial data by methodical
classification given in the financial statements.
Interpretation means explaining the meaning and
significance of the data. These two are
complimentary to each other. Analysis is useless
L L L L LEARNING EARNING EARNING EARNING EARNING O O O O OBJECTIVES BJECTIVES BJECTIVES BJECTIVES BJECTIVES
After studying this chapter,
you will be able to :
• explain the nature and
significance of financial
analysis;
• identify the objectives of
financial analysis;
• describe the various tools
of financial analysis;
• state the limitations of
financial analysis;
• prepare comparative and
commonsize statements
and interpret the data
given therein; and
• calculate the trend
percentages and interpret
them.
Analysis of Financial Statements Analysis of Financial Statements Analysis of Financial Statements Analysis of Financial Statements Analysis of Financial Statements 4 4 4 4 4
without interpretation, and interpretation without analysis is difficult or even
impossible.
Box Box Box Box Box
Financial statement analysis is a judgemental process which aims to estimate
current and past financial positions and the results of the operation of an
enterprise, with primary objective of determining the best possible estimates
and predictions about the future conditions. It essentially involves regrouping
and analysis of information provided by financial statements to establish
relationships and throw light on the points of strengths and weaknesses of a
business enterprise, which can be useful in decision-making involving comparison
with other firms (cross sectional analysis) and with firms’ own performance,
over a time period (time series analysis).
4.2 4.2 4.2 4.2 4.2 Significance of Financial Analysis Significance of Financial Analysis Significance of Financial Analysis Significance of Financial Analysis Significance of Financial Analysis
Financial analysis is the process of identifying the financial strengths and
weaknesses of the firm by properly establishing relationships between the various
items of the balance sheet and the statement of profit and loss. Financial analysis
can be undertaken by management of the firm, or by parties outside the firm,
viz. owners, trade creditors, lenders, investors, labour unions, analysts and
others. The nature of analysis will differ depending on the purpose of the analyst.
A technique frequently used by an analyst need not necessarily serve the purpose
of other analyst because of the difference in the interests of the analysts. Financial
analysis is useful and significant to different users in the following ways:
(a) Finance manager: Financial analysis focusses on the facts and
relationships related to managerial performance, corporate efficiency,
financial strengths and weaknesses and creditworthiness of the company.
A finance manager must be well-equipped with the different tools of
analysis to make rational decisions for the firm. The tools for analysis
help in studying accounting data so as to determine the continuity of the
operating policies, investment value of the business, credit ratings and
testing the efficiency of operations. The techniques are equally important
in the area of financial control, enabling the finance manager to make
constant reviews of the actual financial operations of the firm to analyse
the causes of major deviations, which may help in corrective action
wherever indicated.
(b) Top management: The importance of financial analysis is not limited to
the finance manager alone. Its scope of importance is quite broad which
includes top management in general and other functional managers.
Management of the firm would be interested in every aspect of the financial
177 Analysis of Financial Statements 178 Accountancy : Company Accounts and Analysis of Financial Statements
analysis. It is their overall responsibility to see that the resources of the
firm are used most efficiently and that the firm’s financial condition is
sound. Financial analysis helps the management in measuring the
success or otherwise of the company’s operations, appraising the
individual’s performance and evaluating the system of internal control.
(c) Trade payables:     Trade payables, through an analysis of financial
statements, appraises not only the urgent ability of the company to meet
its obligations, but also judges the probability of its continued ability to
meet all its financial obligations in future. Trade payables are particularly
interested in the firm’s ability to meet their claims over a very short period
of time. Their analysis will, therefore, confine to the evaluation of the
firm’s liquidity position.
(d) Lenders: Suppliers of long-term debt are concerned with the firm’s long-
term solvency and survival. They analyse the firm’s profitability overtime,
its ability to generate cash to be able to pay interest and repay the principal
and the relationship between various sources of funds (capital structure
relationships). Long-term tenders do analyse the historical financial
statements. But they place more emphasis on the firm’s projected financial
statements to make analysis about its future solvency and profitability.
(e) Investors: Investors, who have invested their money in the firm’s shares,
are interested about the firm’s earnings. As such, they concentrate on
the analysis of the firm’s present and future profitability. They are also
interested in the firm’s capital structure to ascertain its influences on
firm’s earning and risk. They also evaluate the efficiency of the
management and determine whether a change is needed or not. However,
in some large companies, the shareholders’ interest is limited to decide
whether to buy, sell or hold the shares.
(f) Labour unions: Labour unions analyse the financial statements to assess
whether it can presently afford a wage increase and whether it can absorb
a wage increase through increased productivity or by raising the prices.
(g) Others: The economists, researchers, etc. analyse the financial statements
to study the present business and economic conditions. The government
agencies need it for price regulations, taxation and other similar purposes.
4.3 4.3 4.3 4.3 4.3 Objectives of Financial Analysis Objectives of Financial Analysis Objectives of Financial Analysis Objectives of Financial Analysis Objectives of Financial Analysis
Analysis of financial statements reveals important facts concerning managerial
performance and the efficiency of the firm. Broadly speaking, the objectives of
the analysis are to apprehend the information contained in financial statements
with a view to know the weaknesses and strengths of the firm and to make a
Page 4


Y
ou have learnt about the  financial statements
of companies. Basically, these are summarised
financial reports which provide the operating results
and financial position of companies, and the detailed
information contained therein is useful for assessing
the operational efficiency and financial soundness
of a company. This requires proper analysis and
interpretation of such information for which a
number of techniques (tools) have been developed
by financial experts. In this chapter we will have an
overview of these techniques.
4.1  4.1  4.1  4.1  4.1  Meaning of Analysis of Financial Statements Meaning of Analysis of Financial Statements Meaning of Analysis of Financial Statements Meaning of Analysis of Financial Statements Meaning of Analysis of Financial Statements
The process of critical evaluation of the financial
information contained in the financial statements in
order to understand and make decisions regarding
the operations of the firm is called ‘Financial
Statement Analysis’. It is basically a study of
relationship among various financial facts and
figures as given in a set of financial statements, and
the interpretation thereof to gain an insight into the
profitability and operational efficiency of the firm to
assess its financial health and future prospects.
The term ‘financial analysis’ includes both
‘analysis and interpretation’. The term analysis
means simplification of financial data by methodical
classification given in the financial statements.
Interpretation means explaining the meaning and
significance of the data. These two are
complimentary to each other. Analysis is useless
L L L L LEARNING EARNING EARNING EARNING EARNING O O O O OBJECTIVES BJECTIVES BJECTIVES BJECTIVES BJECTIVES
After studying this chapter,
you will be able to :
• explain the nature and
significance of financial
analysis;
• identify the objectives of
financial analysis;
• describe the various tools
of financial analysis;
• state the limitations of
financial analysis;
• prepare comparative and
commonsize statements
and interpret the data
given therein; and
• calculate the trend
percentages and interpret
them.
Analysis of Financial Statements Analysis of Financial Statements Analysis of Financial Statements Analysis of Financial Statements Analysis of Financial Statements 4 4 4 4 4
without interpretation, and interpretation without analysis is difficult or even
impossible.
Box Box Box Box Box
Financial statement analysis is a judgemental process which aims to estimate
current and past financial positions and the results of the operation of an
enterprise, with primary objective of determining the best possible estimates
and predictions about the future conditions. It essentially involves regrouping
and analysis of information provided by financial statements to establish
relationships and throw light on the points of strengths and weaknesses of a
business enterprise, which can be useful in decision-making involving comparison
with other firms (cross sectional analysis) and with firms’ own performance,
over a time period (time series analysis).
4.2 4.2 4.2 4.2 4.2 Significance of Financial Analysis Significance of Financial Analysis Significance of Financial Analysis Significance of Financial Analysis Significance of Financial Analysis
Financial analysis is the process of identifying the financial strengths and
weaknesses of the firm by properly establishing relationships between the various
items of the balance sheet and the statement of profit and loss. Financial analysis
can be undertaken by management of the firm, or by parties outside the firm,
viz. owners, trade creditors, lenders, investors, labour unions, analysts and
others. The nature of analysis will differ depending on the purpose of the analyst.
A technique frequently used by an analyst need not necessarily serve the purpose
of other analyst because of the difference in the interests of the analysts. Financial
analysis is useful and significant to different users in the following ways:
(a) Finance manager: Financial analysis focusses on the facts and
relationships related to managerial performance, corporate efficiency,
financial strengths and weaknesses and creditworthiness of the company.
A finance manager must be well-equipped with the different tools of
analysis to make rational decisions for the firm. The tools for analysis
help in studying accounting data so as to determine the continuity of the
operating policies, investment value of the business, credit ratings and
testing the efficiency of operations. The techniques are equally important
in the area of financial control, enabling the finance manager to make
constant reviews of the actual financial operations of the firm to analyse
the causes of major deviations, which may help in corrective action
wherever indicated.
(b) Top management: The importance of financial analysis is not limited to
the finance manager alone. Its scope of importance is quite broad which
includes top management in general and other functional managers.
Management of the firm would be interested in every aspect of the financial
177 Analysis of Financial Statements 178 Accountancy : Company Accounts and Analysis of Financial Statements
analysis. It is their overall responsibility to see that the resources of the
firm are used most efficiently and that the firm’s financial condition is
sound. Financial analysis helps the management in measuring the
success or otherwise of the company’s operations, appraising the
individual’s performance and evaluating the system of internal control.
(c) Trade payables:     Trade payables, through an analysis of financial
statements, appraises not only the urgent ability of the company to meet
its obligations, but also judges the probability of its continued ability to
meet all its financial obligations in future. Trade payables are particularly
interested in the firm’s ability to meet their claims over a very short period
of time. Their analysis will, therefore, confine to the evaluation of the
firm’s liquidity position.
(d) Lenders: Suppliers of long-term debt are concerned with the firm’s long-
term solvency and survival. They analyse the firm’s profitability overtime,
its ability to generate cash to be able to pay interest and repay the principal
and the relationship between various sources of funds (capital structure
relationships). Long-term tenders do analyse the historical financial
statements. But they place more emphasis on the firm’s projected financial
statements to make analysis about its future solvency and profitability.
(e) Investors: Investors, who have invested their money in the firm’s shares,
are interested about the firm’s earnings. As such, they concentrate on
the analysis of the firm’s present and future profitability. They are also
interested in the firm’s capital structure to ascertain its influences on
firm’s earning and risk. They also evaluate the efficiency of the
management and determine whether a change is needed or not. However,
in some large companies, the shareholders’ interest is limited to decide
whether to buy, sell or hold the shares.
(f) Labour unions: Labour unions analyse the financial statements to assess
whether it can presently afford a wage increase and whether it can absorb
a wage increase through increased productivity or by raising the prices.
(g) Others: The economists, researchers, etc. analyse the financial statements
to study the present business and economic conditions. The government
agencies need it for price regulations, taxation and other similar purposes.
4.3 4.3 4.3 4.3 4.3 Objectives of Financial Analysis Objectives of Financial Analysis Objectives of Financial Analysis Objectives of Financial Analysis Objectives of Financial Analysis
Analysis of financial statements reveals important facts concerning managerial
performance and the efficiency of the firm. Broadly speaking, the objectives of
the analysis are to apprehend the information contained in financial statements
with a view to know the weaknesses and strengths of the firm and to make a
179 Analysis of Financial Statements
forecast about the future prospects of the firm thereby, enabling the analysts to
take decisions regarding the operation of, and further investment in the firm. To
be more specific, the analysis is undertaken to serve the following purposes
(objectives):
• to assess the current profitability and operational efficiency of the firm
as a whole as well as its different departments so as to judge the financial
health of the firm.
• to ascertain the relative importance of different components of the
financial position of the firm.
• to identify the reasons for change in the profitability/financial position
of the firm.
• to judge the ability of the firm to repay its debt and assessing the
short-term as well as the long-term liquidity position of the firm.
Through the analysis of financial statements of various firms, an economist can
judge the extent of concentration of economic power and pitfalls in the financial
policies pursued. The analysis also provides the basis for many governmental
actions relating to licensing, controls, fixing of prices, ceiling on profits, dividend
freeze, tax subsidy and other concessions to the corporate sector.
4.4 4.4 4.4 4.4 4.4 Tools of Financial Analysis Tools of Financial Analysis Tools of Financial Analysis Tools of Financial Analysis Tools of Financial Analysis
The most commonly used techniques of financial analysis are as follows:
1. Comparative Statements: These are the statements showing the
profitability and financial position of a firm for different periods of time in
a comparative form to give an idea about the position of two or more periods.
It usually applies to the two important financial statements, namely,
Balance Sheet and Statement of Profit and Loss prepared in a comparative
form. The financial data will be comparative only when same accounting
principles are used in preparing these statements. If this is not the case,
the deviation in the use of accounting principles should be mentioned as
a footnote. Comparative figures indicate the trend and direction of financial
position and operating results. This analysis is also known as ‘horizontal
analysis’.
2. Common Size Statements: These are the statements which indicate the
relationship of different items of a financial statement with some common
item by expressing each item as a percentage of that common item. The
percentage thus calculated can be easily compared with the results of
corresponding percentages of the previous year or of some other firms, as
the numbers are brought to common base. Such statements also allow an
analyst to compare the operating and financing characteristics of two
companies of different sizes in the same industry. Thus, common-size
Page 5


Y
ou have learnt about the  financial statements
of companies. Basically, these are summarised
financial reports which provide the operating results
and financial position of companies, and the detailed
information contained therein is useful for assessing
the operational efficiency and financial soundness
of a company. This requires proper analysis and
interpretation of such information for which a
number of techniques (tools) have been developed
by financial experts. In this chapter we will have an
overview of these techniques.
4.1  4.1  4.1  4.1  4.1  Meaning of Analysis of Financial Statements Meaning of Analysis of Financial Statements Meaning of Analysis of Financial Statements Meaning of Analysis of Financial Statements Meaning of Analysis of Financial Statements
The process of critical evaluation of the financial
information contained in the financial statements in
order to understand and make decisions regarding
the operations of the firm is called ‘Financial
Statement Analysis’. It is basically a study of
relationship among various financial facts and
figures as given in a set of financial statements, and
the interpretation thereof to gain an insight into the
profitability and operational efficiency of the firm to
assess its financial health and future prospects.
The term ‘financial analysis’ includes both
‘analysis and interpretation’. The term analysis
means simplification of financial data by methodical
classification given in the financial statements.
Interpretation means explaining the meaning and
significance of the data. These two are
complimentary to each other. Analysis is useless
L L L L LEARNING EARNING EARNING EARNING EARNING O O O O OBJECTIVES BJECTIVES BJECTIVES BJECTIVES BJECTIVES
After studying this chapter,
you will be able to :
• explain the nature and
significance of financial
analysis;
• identify the objectives of
financial analysis;
• describe the various tools
of financial analysis;
• state the limitations of
financial analysis;
• prepare comparative and
commonsize statements
and interpret the data
given therein; and
• calculate the trend
percentages and interpret
them.
Analysis of Financial Statements Analysis of Financial Statements Analysis of Financial Statements Analysis of Financial Statements Analysis of Financial Statements 4 4 4 4 4
without interpretation, and interpretation without analysis is difficult or even
impossible.
Box Box Box Box Box
Financial statement analysis is a judgemental process which aims to estimate
current and past financial positions and the results of the operation of an
enterprise, with primary objective of determining the best possible estimates
and predictions about the future conditions. It essentially involves regrouping
and analysis of information provided by financial statements to establish
relationships and throw light on the points of strengths and weaknesses of a
business enterprise, which can be useful in decision-making involving comparison
with other firms (cross sectional analysis) and with firms’ own performance,
over a time period (time series analysis).
4.2 4.2 4.2 4.2 4.2 Significance of Financial Analysis Significance of Financial Analysis Significance of Financial Analysis Significance of Financial Analysis Significance of Financial Analysis
Financial analysis is the process of identifying the financial strengths and
weaknesses of the firm by properly establishing relationships between the various
items of the balance sheet and the statement of profit and loss. Financial analysis
can be undertaken by management of the firm, or by parties outside the firm,
viz. owners, trade creditors, lenders, investors, labour unions, analysts and
others. The nature of analysis will differ depending on the purpose of the analyst.
A technique frequently used by an analyst need not necessarily serve the purpose
of other analyst because of the difference in the interests of the analysts. Financial
analysis is useful and significant to different users in the following ways:
(a) Finance manager: Financial analysis focusses on the facts and
relationships related to managerial performance, corporate efficiency,
financial strengths and weaknesses and creditworthiness of the company.
A finance manager must be well-equipped with the different tools of
analysis to make rational decisions for the firm. The tools for analysis
help in studying accounting data so as to determine the continuity of the
operating policies, investment value of the business, credit ratings and
testing the efficiency of operations. The techniques are equally important
in the area of financial control, enabling the finance manager to make
constant reviews of the actual financial operations of the firm to analyse
the causes of major deviations, which may help in corrective action
wherever indicated.
(b) Top management: The importance of financial analysis is not limited to
the finance manager alone. Its scope of importance is quite broad which
includes top management in general and other functional managers.
Management of the firm would be interested in every aspect of the financial
177 Analysis of Financial Statements 178 Accountancy : Company Accounts and Analysis of Financial Statements
analysis. It is their overall responsibility to see that the resources of the
firm are used most efficiently and that the firm’s financial condition is
sound. Financial analysis helps the management in measuring the
success or otherwise of the company’s operations, appraising the
individual’s performance and evaluating the system of internal control.
(c) Trade payables:     Trade payables, through an analysis of financial
statements, appraises not only the urgent ability of the company to meet
its obligations, but also judges the probability of its continued ability to
meet all its financial obligations in future. Trade payables are particularly
interested in the firm’s ability to meet their claims over a very short period
of time. Their analysis will, therefore, confine to the evaluation of the
firm’s liquidity position.
(d) Lenders: Suppliers of long-term debt are concerned with the firm’s long-
term solvency and survival. They analyse the firm’s profitability overtime,
its ability to generate cash to be able to pay interest and repay the principal
and the relationship between various sources of funds (capital structure
relationships). Long-term tenders do analyse the historical financial
statements. But they place more emphasis on the firm’s projected financial
statements to make analysis about its future solvency and profitability.
(e) Investors: Investors, who have invested their money in the firm’s shares,
are interested about the firm’s earnings. As such, they concentrate on
the analysis of the firm’s present and future profitability. They are also
interested in the firm’s capital structure to ascertain its influences on
firm’s earning and risk. They also evaluate the efficiency of the
management and determine whether a change is needed or not. However,
in some large companies, the shareholders’ interest is limited to decide
whether to buy, sell or hold the shares.
(f) Labour unions: Labour unions analyse the financial statements to assess
whether it can presently afford a wage increase and whether it can absorb
a wage increase through increased productivity or by raising the prices.
(g) Others: The economists, researchers, etc. analyse the financial statements
to study the present business and economic conditions. The government
agencies need it for price regulations, taxation and other similar purposes.
4.3 4.3 4.3 4.3 4.3 Objectives of Financial Analysis Objectives of Financial Analysis Objectives of Financial Analysis Objectives of Financial Analysis Objectives of Financial Analysis
Analysis of financial statements reveals important facts concerning managerial
performance and the efficiency of the firm. Broadly speaking, the objectives of
the analysis are to apprehend the information contained in financial statements
with a view to know the weaknesses and strengths of the firm and to make a
179 Analysis of Financial Statements
forecast about the future prospects of the firm thereby, enabling the analysts to
take decisions regarding the operation of, and further investment in the firm. To
be more specific, the analysis is undertaken to serve the following purposes
(objectives):
• to assess the current profitability and operational efficiency of the firm
as a whole as well as its different departments so as to judge the financial
health of the firm.
• to ascertain the relative importance of different components of the
financial position of the firm.
• to identify the reasons for change in the profitability/financial position
of the firm.
• to judge the ability of the firm to repay its debt and assessing the
short-term as well as the long-term liquidity position of the firm.
Through the analysis of financial statements of various firms, an economist can
judge the extent of concentration of economic power and pitfalls in the financial
policies pursued. The analysis also provides the basis for many governmental
actions relating to licensing, controls, fixing of prices, ceiling on profits, dividend
freeze, tax subsidy and other concessions to the corporate sector.
4.4 4.4 4.4 4.4 4.4 Tools of Financial Analysis Tools of Financial Analysis Tools of Financial Analysis Tools of Financial Analysis Tools of Financial Analysis
The most commonly used techniques of financial analysis are as follows:
1. Comparative Statements: These are the statements showing the
profitability and financial position of a firm for different periods of time in
a comparative form to give an idea about the position of two or more periods.
It usually applies to the two important financial statements, namely,
Balance Sheet and Statement of Profit and Loss prepared in a comparative
form. The financial data will be comparative only when same accounting
principles are used in preparing these statements. If this is not the case,
the deviation in the use of accounting principles should be mentioned as
a footnote. Comparative figures indicate the trend and direction of financial
position and operating results. This analysis is also known as ‘horizontal
analysis’.
2. Common Size Statements: These are the statements which indicate the
relationship of different items of a financial statement with some common
item by expressing each item as a percentage of that common item. The
percentage thus calculated can be easily compared with the results of
corresponding percentages of the previous year or of some other firms, as
the numbers are brought to common base. Such statements also allow an
analyst to compare the operating and financing characteristics of two
companies of different sizes in the same industry. Thus, common-size
180 Accountancy : Company Accounts and Analysis of Financial Statements
statements are useful, both, in intra-firm comparisons over different years
and also in making inter-firm comparisons for the same year or for several
years. This analysis is also known as ‘Vertical analysis’.
3. Trend Analysis: It is a technique of studying the operational results and
financial position over a series of years. Using the previous years’ data of a
business enterprise, trend analysis can be done to observe the percentage
changes over time in the selected data. The trend percentage is the
percentage relationship, which each item of different years bear to the
same item in the base year. Trend analysis is important because, with its
long run view, it may point to basic changes in the nature of the business.
By looking at a trend in a particular ratio, one may find whether the ratio
is falling, rising or remaining relatively constant. From this observation, a
problem is detected or the sign of good or poor management is detected.
4. Ratio Analysis: It describes the significant relationship which exists
between various items of a balance sheet and a profit and loss account of
a firm. As a technique of financial analysis, accounting ratios measure the
comparative significance of the individual items of the income and position
statements. It is possible to assess the profitability, solvency and efficiency
of an enterprise through the technique of ratio analysis.
5. Cash Flow Analysis: It refers to the analysis of actual movement of cash
into and out of an organisation. The flow of cash into the business is called
as cash inflow or positive cash flow and the flow of cash out of the firm is
called as cash outflow or a negative cash flow. The difference between the
inflow and outflow of cash is the net cash flow. Cash flow statement is
prepared to project the manner in which the cash has been received and
has been utilised during an accounting year as it shows the sources of
cash receipts and also the purposes for which payments are made. Thus,
it summarises the causes for the changes in cash position of a business
enterprise between dates of two balance sheets.
In this chapter, we shall have a brief idea about the first three techniques,
viz. comparative statements common size statements and trend analysis. The
ratio analysis and cash flow analysis is covered in detail in chapters 5 and 6
respectively.
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