Analysis of Financial Statements Chapter Notes | Accountancy Class 12 - Commerce PDF Download

Meaning of Analysis of Financial Statements

• Financial Statement Analysis involves critically evaluating the financial information in a company's financial statements to make informed decisions about its operations.
• This process examines the relationships between various financial figures to gain insights into the firm's profitability, operational efficiency, financial health, and future prospects.

Key components of financial analysis include:

• Analysis: Simplifying financial data through systematic classification as presented in the financial statements.
• Interpretation: Explaining the meaning and significance of the data. Analysis and interpretation are complementary; analysis without interpretation is ineffective, and interpretation without analysis is challenging.

In essence, financial statement analysis helps stakeholders assess a company's performance and make informed decisions about its operations and future potential.

Significance of Financial Statement Analysis

• Financial analysis helps identify a firm's financial strengths and weaknesses by examining relationships between balance sheets and profit and loss statement items.
• It can be conducted by internal management or external parties such as owners, creditors, investors, and analysts, with varying focus based on their interests.

Financial analysis is valuable to different users in the following ways:

• Finance Manager: Financial analysis provides insights into managerial performance, corporate efficiency, and creditworthiness. It aids in decision-making, financial control, and corrective actions by examining accounting data and operational policies.
• Top Management: Financial analysis supports top management in evaluating resource efficiency, financial health, and operational success. It helps in performance appraisal and assessing internal control systems.
• Trade Payables: Trade payables use financial analysis to assess a company's ability to meet short-term obligations and future financial commitments, focusing on the firm's liquidity position.
• Lenders: Lenders analyze financial statements to evaluate a firm's long-term solvency, profitability, and cash generation capacity for interest and principal repayment. They assess capital structure relationships for future solvency.
• Investors: Investors are concerned with a firm's earnings, profitability, capital structure, and management efficiency. They analyze present and future profitability to make investment decisions.
• Labour Unions: Labour unions analyze financial statements to determine a firm's capacity for wage increases and productivity improvements.
• Others: Economists, researchers, and government agencies analyze financial statements for economic conditions, price regulation, taxation, and similar purposes.

Objectives of Analysis of Financial Statements

• Analysis of financial statements helps in understanding managerial performance and the efficiency of a firm.
• The main objectives include:
  1. Assessing current profitability and operational efficiency to judge the firm's financial health.
  2. Determining the relative importance of different components of the firm's financial position.
  3. Identifying reasons for changes in profitability or financial position.
  4. Evaluating the firm's ability to repay debts and assessing short-term and long-term liquidity.
• Through financial statement analysis, economists can evaluate the concentration of economic power and identify issues in financial policies.
• This analysis also supports governmental actions related to licensing, controls, price fixing, profit ceilings, dividend freezes, tax subsidies, and other concessions for the corporate sector.

Tools of Analysis of Financial Statements

• Comparative Statements: These statements compare the profitability and financial position of a firm over different periods. They are typically applied to the balance sheet and statement of profit and loss, showing trends and directions of financial position and operating results. This method is also referred to as 'horizontal analysis.'

• Common Size Statements: These statements express each item in a financial statement as a percentage of a common item, allowing for easy comparisons over time or between different firms. This method is known as 'vertical analysis.' Common size statements are useful for both intra-firm and inter-firm comparisons.
• Trend Analysis: This technique examines operational results and financial positions over a series of years, observing percentage changes over time. Trend analysis helps identify basic changes in the nature of the business and assess management performance based on the trends in specific ratios.
• Ratio Analysis: Ratio analysis measures the significant relationships between various items in the balance sheet and the statement of profit and loss. It helps assess the profitability, solvency, and efficiency of an enterprise by comparing individual items' significance through ratios.
• Cash Flow Analysis: Cash flow analysis examines the actual movement of cash into and out of an organization. Cash inflow (positive cash flow) and cash outflow (negative cash flow) are tracked, with the net cash flow being the difference between the two. A cash flow statement summarizes the sources of cash receipts and the purposes for cash payments, reflecting changes in the cash position of a business between two balance sheet dates.

Comparative Statements

Definition: Comparative statements involve the preparation of the statement of profit and loss and the balance sheet with columns for figures from both the current year and the previous year, along with changes during the year in absolute and relative terms.

• These statements allow for the comparison of account balances on different dates, summaries of various operational activities over distinct periods, and the extent of increases or decreases between these dates.
• The figures in comparative statements help in identifying the direction of changes and trends in different performance indicators of an organization.

Steps to Prepare Comparative Statements:

• Step 1: List absolute figures in rupees for two points in time, as shown in the columns of the comparative statement.
• Step 2: Calculate the change in absolute figures by subtracting the first year’s figures from the second year’s figures. Indicate the change as an increase (+) or decrease (–) and record it in the designated column.
• Step 3: Optionally, calculate the percentage change using the formula and include it in the appropriate column.

Example: Convert the following statement of profit and loss of BCR Co. Ltd. into the comparative statement of profit and loss of BCR Co. Ltd.:

Ans:
Comparative statement of profit and loss of BCR Co. Ltd. for the year ended March 31, 2016 and 2017:

Common Size Statement

Also known as the component percentage statement, the common size statement is a financial tool used to analyze key changes and trends in a company's financial position and operational results. In this statement, each item is expressed as a percentage of the total, such as revenue from operations.

• Common Size Balance Sheet: Shows the percentage of each asset to total assets and each liability to total liabilities.
• Common Size Statement of Profit and Loss: Displays expenditure items as a percentage of revenue from operations.

When prepared for successive periods, common size statements reveal changes in these percentages over time.

Common size analysis is particularly useful for comparing enterprises of different sizes, as it provides insight into the structure of financial statements. It enables inter-firm comparison and assessment of a company's position relative to the industry as a whole.

Procedure for Preparing Common Size Statements:

1. List absolute figures in rupees for two points in time, such as year 1 and year 2.
2. Choose a common base (100), such as revenue from operations for the statement of profit and loss, or total assets or total liabilities for the balance sheet.
3. Calculate the percentage of each item relative to the chosen base for the absolute figures.

Common size statements are valuable for understanding financial structures and facilitating comparisons across different organizations and industry standards.

Example: From the following information, prepare a Common size Income Statement for the year ended March 31, 2016 and March 31, 2017:

Ans: 

Limitations of Financial Analysis

• Financial analysis, while useful for assessing a firm's financial strengths and weaknesses, is reliant on the information presented in financial statements.
• It is subject to the limitations inherent in these statements, necessitating awareness of factors such as price level changes, window dressing, alterations in accounting policies, accounting concepts and conventions, and personal judgment.
• Some key limitations include:
  1. Financial analysis does not account for price level changes.
  2. It can be misleading without understanding changes in accounting procedures.
  3. Financial analysis merely examines the company's reports.
  4. It focuses solely on monetary information, disregarding non-monetary aspects.
  5. Financial statements, based on accounting concepts, may not accurately reflect the current situation.