ANALYSIS OF FINANCIAL STATEMENTS

Prof. M .B. Thakoor

SYNOPSIS
1) MEANING OF FINANCIAL STATEMENT 2) NATURE OF FINANCIAL STATEMENT 3) ESSENTIAL QUALITIES OF FINANCIAL 4)

5) 6) 7) 8) STATEMENT LIMITATION OF FINANCIAL STATEMENT FINANCIAL STATEMENT ANALYSIS TOOLS & TECHNIQUES OF ANALYSIS TYPES OF COMPARISON INTERPRETATION

NATURE OF FINANCIAL STATEMENT

The data exhibited by financial statements

are affected by a) Recorded facts b) Accounting Concepts, Conventions & Principles c) Personal Judgment

Accounting Principles

Accounting concepts Accounting Conventions a) Entity Concept a) Disclosure b) Going Concern Concept b) Materiality c) Accounting period concept c) Consistency d) Money Measurement Concept d) Conservatism e) Cost Concept f) Cost Attach Concept g) Dual Aspect Concept h) Accrual concept i) Periodic Matching of cost and Revenue Concept j) Realisation Concept k) Verifiable Objective Evidence Concept

ESSENTIAL QUALITIES OF FINANCIAL STATMENTS

1. 2. 3. 4. 5. 6.
Relevance Understandability : Reliability and Accuracy Comparability Completeness Timeliness

LIMITATIONS OF FINANCIAL STATEMENTS

1. 2. 3. 4. 5. 6. 7. Lack of Precision Lack of Exactness Incomplete Information Interim Reports Hiding of Real Position or Window Dressing Lack of Comparability Historical Costs

Analysis
Analysis To Analyse to cut into pieces But only analyse No It means also
Interpretation.

Thus Financial Statement Analysis means

Analysis, comparisons and interpretation of Financial data to achieve the desired result

TOOLS OF FINANCIAL STATEMENT ANALYSIS

1. 2. 3. 4. 5. 6. Comparative Statements Common Size Statements Trend Analysis Ratio Analysis Fund Flow Statement Cash Flow Statement

Types of Financial Analysis

1. Intra-Firm Comparison 2. Inter-firm Comparison 3. Industry Average or Standard
Analysis: 4. Horizontal Analysis 5. Vertical Analysis

Interpretation
The Analysis is of no use without interpretation
The Company has to interpret the financial statement which it has analysed.

The Analysis is made to serve the following

1. Profitability Analysis 2. Liquidity Analysis 3. Solvency Analysis (To know the financial structure)
purpose

Interested Parties in Analysis of Financial Statements

1. 2. Management Investors (In the form of Shareholders or Debentureholders) 3. Banks and Financial Institution 4. Trade Creditors 5. Government and their Agencies 6. Employees 7. Customers 8. Public 9. Trade Association 10. Stock Exchange

1. Comparative Financial Statements

Comparative Financial Statements is a
statement of Financial Position of a business designed in such a way where a comparative study is undertaken of different accounting items, to measure the performance of a Business Activity.

Types of Comparison
There are 3 types of Comparison 1) Inter Firm Comparison 2) Intra Firm Comparison 3) Inter Period Comparison

Merits:
1) Indicate the Direction of Financial
Position 2) Reveal Nature & Trend: 3) Identifying Trouble Spots:

Disadvantages:
1) Misleading picture, if consistency in accounting principle
not followed. 2) Constant change in price level tender accounting statement useless for comparison. 3) Inter firm comparison is useless, unless all the firms are of the same age, size and follow the same principles. 4) If there exists any Abnormal Period between 2 successive accounting period then it will prove to be a pointless analysis.

2. Common Size Statements

It is a Statement in Vertical Form in which
every item of the Financial Statement is reduced to a common base. This was introduced with a view to overcome the limitation of Comparative Statement.

Types of common size statements.

(1)Common Size Balance Sheet
(2)Common Size Income Statement:

Advantages of Common Size Statement

1) It reveals Sources and Application of Funds

in a nutshell which help in taking decision. (2) If common size statements of 2 or more years are compared it indicate the changing proportion of various components of Assets, Liabilities, Cost, Net Sale & Profit. (3) When Inter Firm Comparison is made with the help of Common size statement it helps in doing corporate evaluation and Ranking.

Disadvantages of Common Size Statement

(1) No Established Standard Proportion: Common Size Statements are regarded as useless as
there is no established standard proportion of an asset to the total asset or an item of expense to the net sales.

(2) Consistency Required: If Financial Statement of a Particular business

organization are not prepared year after year on a consistent basis comparative study of common size statement will be misleading

3. Trend Analysis
Trend Analysis is a statement in vertical
form where the earliest year is taken as base year and the value of all the items in the financial statements will be related to the base year in terms of % where value of each item in base year will be considered as 100. Trend % analysis move in one directions either upward or downward progression or regression.

Advantages:
(1) Trend % indicate the increase or decrease

with the magnitude of change in % which is more effective than absolute data. Ex. If we say profit increases by Rs. 50,000/- it will be meaningless unless we find by what % the profit has increased.

(2) Facilitate efficient comparative study of

financial performance

Limitations:
(1) It will give a misleading picture if consistency in

accounting principle is not followed. (2) Constant change in price level render accounting statement useless for comparison. (3) During inflationary period the data over a period of time become incomparable, unless the absolute rupee data is adjusted. (4) There is always the danger of selecting the base year which may not be representative, normal & typical. (5) Trend % should be studied in relation with Absolute figure otherwise it give misleading picture. For ex. No. of student where 2, the next year they increased to 4. Now trend % show 100% increase but absolutely we get clear picture than trend %.

4. Ratio Analysis


TRADITIONAL CLASSIFICATION BALANCE SHEET RATIOS (1) Current Ratio (2) Quick Ratio / Liquid Ratio / Acid Test Ratio. (3) Super Quick Ratio (4) Stock to work Capital Ratio (5) Capital Gearing Ratio (6) Debt Equity Ratio (7) Proprietary Ratio (8) Long Term Borrowing : Total Asset (9) Fixed Assets : Net Worth.

REVENUE STATEMENT RATIOS

Gross Profit Ratio Net Profit Ratio Operating Net Profit Ratio Operating Ratio Operating Expenses Ratio Stock Turnover Ratio Stock Holding Period

COMBINED RATIOS
Return on Investment (ROI) or

Return on Capital Employed (ROCE) Return on Proprietor / Shareholder fund Return on Equity shareholder fund Earning per share Dividend per share Dividend Payout Ratio Price Earning Ratio Interest Coverage Ratio

COMBINED RATIOS
Debt : Service Coverage Ratio Debit Collection period Debtor Turnover Ratio Creditor Payment Period Creditor Turnover Ratio Preference Dividend Cover Equity Dividend Cover

BASED ON FUNCTIONS

SOLVENCY RATIOS Short Term Solvency Current Ratio Quick Ratio / Liquid Ratio / Acid Test Ratio Super Quick Ratio Stock : Working Capital Ratio.

Long Term Solvency / Leverage Ratio /

Capital Gearing Debt : Equity Ratio Proprietary Ratio Long Term Borrowing: Total Assets ( 1 Net Worth )/ Total
Assets Fixed Asset : Net worth

ACTIVITY RATIO / TURNOVER RATIOS

Stock Turn Over Ratio
Stock Holding Period Debt Collection Period Debtor Turnover Ratio Creditor Payment Period Creditor Turnover Ratio

PROFITABILITY RATIO

In relation to sales Gross Profit Ratio Net Profit Ratio Operating Net Profit Ratio Operating Ratio Operating Expenses Ratio.

In relation to capital employed

Return on Interest (ROI) or Return on Capital

Employed (ROLE) Return on Proprietor / Shareholder funds Return on Equity Shareholder Fund Earning per Share Dividend per Share Dividend Payout Ratio Price Earning Ratio

COVERAGE RATIOS

Interest Coverage Ratio Preference Dividend Cover Equity Dividend Cover Debt Service Coverage Ratio

USER BASED CLASSIFICATION

FOR SHORT TERM CREDITORS (1) Current Ratio (2) Quick / Liquid Ratio / Acid Test Ratio (3) Super Quick Ratio (4) Stock : Working Capital Ratio (5) Stock Turnover Ratio (6) Stock Holding Period (7) Creditor Payment Period (8) Creditor Turnover Ratio

FOR LONG TERM CREDITORS

Capital Gearing Ratio Debit : Equity Ratio Proprietary Ratio Long Term Borrowing : Total Asset Ratio Fixed Asset : Net worth Interest Coverage Ratio Debt Service Coverage Ratio

FOR SHARE HOLDERS

Return on Investment (ROI) or Return on Capital Employed (ROCE) Return on Proprietary / Shareholder fund Return on Equity Shareholder fund Earning per share Dividend per share Dividend payout Ratio Price Earning Ratio Preference Dividend Cover Equity Dividend Cover

FOR MANAGEMENT
Return on Investment (ROI) or Return on

Capital Employed (ROCE) Debtor Turnover Ratio Debtor Collection Period Creditor Payment period Creditor Turnover Ratio Stock Turnover Ratio Stock Holding Period

FOR MANAGEMENT
Gross Profit Ratio Net Profit Ratio Operating Net Profit Ratio Operating Ratio Proprietary Ratio Fixed Asset : Net Worth Long Term Borrowing : Total Assets