Analysis of Financial Statements - Analysis and Interpretation of Financial Statements, Cost Account | Cost Accounting - B Com PDF Download

Analysis of Financial Statements

Published financial statements are the only source of information about the activities and affairs of a business entity available to the public, shareholders, investors and creditors, and the governments. These various groups are interested in the progress, position and prospects of such entity in various ways. But these statements howsoever, correctly and objectively prepared, by themselves do not reveal the significance, meaning and relationship of the information contained therein. For this purpose, financial statements have to be carefully studied, dispassionately analysed and intelligently interpreted. This enables a forecasting of the prospects for future earnings, ability to pay interest, debt maturities both current as well as long-term, and probability of sound financial and dividend policies. According to Myers, “financial statement analysis is largely a study of relationship among the various financial factors in business as disclosed by a single set of statements and a study of the trend of these factors as shown in a series of statements”.

Thus, analysis of financial statements refers to the treatment of information contained in the financial statement in a way so as to afford a full diagnosis of the profitability and financial position of the firm concerned.

The process of analysing financial statements involves the rearranging, comparing and measuring the significance of financial and operating data. Such a step helps to reveal the relative significance and effect of items of the data in relation to the time period and/or between two organisations.

Interpretation, which follows analysis of financial statements, is an attempt to reach to logical conclusion regarding the position and progress of the business on the basis of analysis. Thus, analysis and interpretation of financial statements are regarded as complimentary to each other.

Objectives of Financial Statement Analysis

Financial statement analysis is very much helpful in assessing the financial position and profitability of a concern. The main objectives of analysing the financial statements are as follows:

1. The analysis would enable the present and the future earning capacity and the profitability of the concern.
2. The operational efficiency of the concern as a whole as well as department wise can be assessed. Hence the management can easily locate the areas of efficiency and inefficiency.
3. The solvency of the firm, both short-term and long-term, can be determined with the help of financial statement analysis which is beneficial to trade creditors and debenture holders.
4. The comparative study in regard to one firm with another firm or one department with another department is possible by the analysis of financial statements.
5. Analysis of past results in respects of earning and financial position of the enterprise is of great help in forecasting the future results. Hence it helps in preparing budgets.
6. It facilitates the assessments of financial stability of the concern.
7. The long-term liquidity position of funds can be assessed by the analysis of financial statements.

Limitations of Financial Statement Analysis 

1. Owing to the fact that financial statements are compiled on the basis of historical costs, while there is a market decline in the value of the monetary unit and resultant rise in prices, the figures in the financial statement loses its functions as an index on current economic realities. Again the financial statements contain both items. So an analysis of financial statements can not be taken as an indicator for future forecasting and planning.
2. Analysis of financial statements is a tool which can be used profitably by an expert analyst but may lead to faulty conclusions if used by unskilled analyst. So the result can not be taken as judgements or conclusions.
3. Financial statements are interim reports and therefore can not be final because the final gain or loss can be computed only at the termination of the business. Financial statement reflects the progress of the position of the business so analysis of these statements will not be a conclusive evidence of the performance of the business.
4. Financial statements though expressed in exact monetary terms are not absolutely final and accurate and it depends upon the judgement of the management in respect of various accounting methods. If there is change in accounting methods, the analysis may have no comparable basis and the result will be biased.
5. The reliability of analysis depends on the accuracy of the figures used in the financial statements. The analysis will be vitiated by manipulations in the income statement or balance sheet and accounting procedure adopted by the accountant for recording.
6. The results for indications derived from analysis of financial statements may be differently interpreted by different users.
7. The analysis of financial statement relating to a single year only will have limited use. Hence the analysis may be extended over a number of years so that results may be compared to arrive at a meaningful conclusion.
8. When different firms are adopting different accounting procedures, records, policies and different items under similar headings in the financial statements, the comparison will be more difficult. It will not provide reliable basis to access the performance, efficiency, profitability and financial condition of the firm as compared to industry as a whole.
9. There are different tool of analysis available for the analyst. However, which tool is to be used in a particular situation depends on the skill, training, and expertise of the analyst and the result will vary accordingly.

Types of Financial Statement Analysis

A distinction may be drawn between various types of financial analysis either on the basis of material used for the same or according to the modus operandi or according to the objective of the analysis.

1. According to Nature of the Analyst

1.1. External Analysis: It is made by those who do not have access to the detailed records of the company. This group, which has to depend almost entirely on published financial statements, includes investors, credit agencies and governmental agencies regulating a business in nominal way. The position of the external analyst has been improved in recent times owing to the governmental regulations requiring business undertaking to make available detailed information to the public through audited accounts.

1.2. Internal Analysis: The internal analysis is accomplished by those who have access to the books of accounts and all other information related to business. While conducting this analysis, the analyst is a part of the enterprise he is analysing. Analysis for managerial purposes is an internal type of analysis and is conducted by executives and employees of the enterprise as well as governmental and court agencies which may have regulatory and other jurisdiction over the business.

2. According to Modus Operandi of Analysis

2.1. Horizontal Analysis: When financial statements for a number of years are reviewed and analysed, the analysis is called ‘horizontal analysis’. As it is based on data from year to year rather than on one date or period of time as a whole, this is also known as ‘dynamic analysis’. This is very useful for long term trend analysis and planning.

2.2. Vertical Analysis: It is frequently used for referring to ratios developed for one date or for one accounting period. Vertical analysis is also called ‘Static Analysis’. This is not very conducive to proper analysis of the firm’s financial position and its interpretation as it does not enable to study data in perspective. This can only be provided by a study conducted over a number of years so that comparisons can be effected. Therefore, vertical analysis is not very useful.

3. According to the Objective of the Analysis

On this basis the analysis can be long-term and short-term analysis:

3.1. Long-term Analysis: This analysis is made in order to study the long-term financial stability, solvency and liquidity as well as profitability and earning capacity of a business. The objective of making such an analysts is to know whether in the long-term the concern will be able to earn a minimum amount which will be sufficient to maintain a reasonable rate of return on the investment so as to provide the funds required for modernisation, growth and development of the business.

3.2. Short-term Analysis: This analysis is made to determine the short-term solvency, stability, liquidity and earning capacity of the business. The objective is to know whether in the short-run a business enterprise will have adequate funds readily available to meet its short-term requirements and sufficient borrowing capacity to meet contingencies in the near future.