Financial statements are mainly prepared for decision making purposes. But the information as is provided in the financial statements is not adequately helpful in drawing a meaningful conclusion. Thus, an effective analysis of financial statements is required. This 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’.
Benefits of analysis of Financial Statements
- Measuring Profitability: Analysis of financial statement helps in ascertaining whether adequate profits are being earned on the capital invested in the business or not. It also helps in knowing the capacity to pay the interest and dividend.
- Estimate Growth Potential: The trend and other analysis of the business provides sufficient information indicating the growth potential of the business.
- Comparison: The purpose of financial statements analysis is to help the management to make a comparative study of their firm in respect of sales, expenses, profitability and utilising capital, etc with the competition.
- Assess Financial Strength: The purpose of financial analysis is to assess the financial strength of the business.
- Anticipate Solvency: The different tools of an analysis reveal information whether the firm has sufficient funds to meet its short term and long term liabilities or not.
Tools of Analysis of Financial Statements
The most commonly used techniques for analysis of financial statements are as follows:
- Comparative Statements
- Common Size Statements
- Trend Analysis
- Ratio Analysis
- Cash Flow Analysis
Comparative Statements 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. Comparative figures indicate the trend and direction of financial position and operating results. This analysis is also known as ‘horizontal analysis’.
Practically, two financial statements (balance sheet and income statement) are prepared in comparative form for analysis purposes.
Common Size Statements
These are the statements which indicate the relationship of different items of a financial statement with a 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. This analysis is also known as ‘Vertical analysis’.
One advantage of common size statement method analysis is that it allows an analyst to compare the operating and financing characteristics of two companies of different sizes in the same industry. Thus, common size 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.
Common size balance sheet
A statement where balance sheet items are expressed in the ratio of each asset to total assets and the ratio of each liability is expressed in the ratio of total liabilities is called common size balance sheet.
The common size statement may be prepared in the following way. –
- The total assets or liabilities are taken as 100
- The individual assets are expressed as a percentage of total assets i.e. 100 and different liabilities are calculated in relation to total liabilities.
The trend analysis 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.
In this analysis the trend percentages are calculated for each item by taking the figure of that item for the base year taken as 100. Generally the first year is taken as a base year. The analyst is able to see the trend of figures, whether moving upward or downward. From this observation, a problem is detected or the sign of good or poor management is detected.
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. A Cash flow statement is prepared to project the movement of cash.
Cash Flow Statement:
Cash Flow Statement deals with flow of cash which includes cash equivalents as well as cash. This statement is an additional information to the users of Financial Statements by classifying cash flows into operating, investing and financing activities.
Classification of Activities for the Preparation of Cash Flow Statement
Activities are to be classified into three categories:
- Operating activities are the principal revenue generating activities of the enterprise.
- Investing activities include the acquisition and disposal of longterm assets and other investments not included in cash equivalents.
- Financing activities are activities that result in change in the size and composition of the owner’s capital (including Preference share capital in the case of a company) and borrowings of the enterprise
Limitations of analysis of Financial Statements
- Analysis of financial statements is based on the information available in financial statements. Consequently, the financial analysis also suffers from various limitations of financial statements.
- Financial analysis does not consider price level changes.
- Financial analysis may be misleading without the knowledge of the changes in accounting procedure followed by a firm.
- Financial analysis is just a study of reports of the company.
- Monetary information alone is considered in financial analysis while non-monetary aspects are ignored.
- The financial statements are prepared on the basis of accounting concept, as such, it does not reflect the current position.