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Thursday, May 25, 2017

Financial Statement Analysis Notes: Financial Statements and its Analysis

Unit – 1: Financial Statement Analysis

Meaning of Financial Statements
Financial statements are the summarized statements of accounting data produced at the end of accounting process by an enterprise through which accounting information are communicated to the internal and external users. A set of financial statements includes (Types):
a)      Balance sheet
b)      Profit and loss account
c)       Schedules and notes to accounts.
The American Institute of Certified Public Accountants states the nature of financial statements as “Financial Statements are prepared for the purpose of presenting a periodical review of report on progress by the management and deal with the status of investment in the business and the results achieved during the period under review. They reflect a combination of recorded facts, accounting principles and personal judgments.”
In the words of Myer,” The financial statements provide a summary of accounts of a business enterprise, the balance sheet reflecting the assets, liabilities and capital as on a certain date and income statement showing the result of operations during a certain period”.

Nature of Financial Statements:
a)      Recording facts of a business transactions;
b)      Accounting Conventions;
c)       Accounting Concepts;
d)      Personal judgments used in the application of conventions and postulates.

a)      Recorded Facts: The Financial statements are statements prepared on the basis of recorded facts; they do not depict the unrecorded facts. Recorded facts means recording of transactions based on evidence in the accounting books.
b)      Accounting Conventions: Certain accounting conventions are followed while preparing financial statements such as convention of ‘Conservatism’, convention of ‘Materiality’, convention of ‘Full disclosure’, convention of ‘Consistency’. According to convention of ‘Conservatism’, provisions are made of expected losses but expected profits are ignored. This means that the real financial position of the business may be better than what has been shown by the financial statements. The use of accounting conventions makes financial statements simple, comparable, and realistic.
c)       Accounting Concepts: While preparing financial statements the accountants make a number of assumptions known as accounting concepts such as going concern concept, money measurement concept, realisation concept, etc. According to the going concern concept, it is assumed that the business of the concern shall be continued indefinitely. The assets are shown in the balance sheet at their book value rather than their market value.
d)      Personal Judgement: Personal judgement also has an important bearing on financial statements. For example, selection of one method out of various methods of charging depreciation, inventory valuation etc., depends on the personal judgement of the accountant.

Characteristics/Essentials of Financial Statements
Financial statements are regarded as indices of an enterprise‘s performance and position. As such, extreme care and caution should be exercised while preparing these statements. Financial statements generally reflect the following observable characteristics:
a) Internal Audience: financial statements are intended for those who have an interest in a given business enterprise. They have to be prepared on the assumption that the user is generally familiar with business practices as well as the meaning and implication of the terms used in that business.
b) Articulation: The basic financial statements are interrelated and therefore are said to be articulated‘. Example: Profit and Loss account shows the financial results of operations and represents an increase or decrease in resources that is reflected in the various balances in the balance sheet.
c) Historical Nature: Financial statements generally report what has happened in the past. Though they are used increasingly as the basis for the future by prospective investors and creditors, they are not intended to provide estimates of future economic activities and their effect on income and equity.
d) Legal and economic consequences: Financial statements reflect elements of both economics and law. They are conceptually oriented towards economics, but many of the concepts and conventions have their origin in law. Example: Conventions of disclosure and materiality
e) Technical Terminology: Since financial statements are products of a technical process called accounting‖, they involve the use of technical terms. It is, therefore, important that the users of these statements should be familiar with the different terms used therein and conversant with their interpretations and meanings.
f) Summarization and Classification: The volume of business transaction affecting the business operations are so vast that summarization and classification of business events and items alone will enable the reader to draw out useful conclusions.
g) Money Terms: All business transactions are quantified, measured and related in monetary terms. In the absence of this monetary unit of measurement, financial statements will be meaningless.
h) Various Valuation Methods: The valuation methods are not uniform for all items found in a Balance Sheet. Example: Cash is stated at current exchange value; Accounts receivable at net realizable value; inventories at cost or market price whichever is lower; fixed assets at cost less depreciation. 7
i) Accrual Basis: Most financial statements are prepared on accrual basis rather than on cash basis i.e., taking into account all incomes due but not received and all expenses due but not paid.
j) Need for Estimates and judgement: Under more than one circumstance, the facts and figures to be presented through financial statements are to be based on estimates, personal opinions and judgements. Example: Rate of depreciation, the useful economic life of a fixed asset, provision for doubtful debts are all instances where estimates and personal judgements are involved.
k) Verifiability: it is essential that the facts presented through financial statements are susceptible to objective verification, so that the reliability of these statements can be improved.
i) Conservatism: Wherever and whenever estimates and personal judgements become essential during the course of preparation of financial statements, such estimates, should be based moderately on a conservative basis to avoid any possibility of overstating the assets and incomes.
j) Understandability: Financial statements should be prepared following the accepted accounting principles for better understanding of the users.
k) Comparable: Financial statements should disclose the information in such a manner that they are conformable for inter-firm and intra-firm comparison.

Users of Financial Statements
Users of accounting information may be categorised into (1) Internal Users; and (2) External Users.
(1) Internal Users:
(i) Owners: Owners contribute capital in the business and they are always exposed to risk. In view of risk involved, the owners are always interested in knowing the profitability and financial strength of the company.
(ii) Management: Managers has the responsibility to not only safeguard the owner’s investment but also to increase the value of business. Financial statements help the management to find out the overall as well as segment-wise efficiency of the business. It helps them in decision making as well as in controlling and self evaluation.
(iii) Employees and Workers: Employees and workers are entitled to bonus at the year end besides the salary and wages which is directly linked with the profits of the enterprise. Therefore, the employees and workers are interested in financial statements.

(2) External Users:
(i) Banks and Financial Institutions: Banks and Financial Institutions provide loans to the businesses. They watch the performance of the business to ensure the safety and recovery of the loan advanced.
(ii) Investors and Potential Investors: Investors uses financial statements to assess the earning capacity of the enterprise and ensure the safety of their investment.
(iii) Creditors: Creditors supply goods and services on credit. Before granting credit, Creditors satisfy themselves about the creditworthiness of the business. The financial statement helps them in making such assessment.
(iv) Government authorities: The government makes use of financial statements to compile national income accounts and other information. The information so available to it enables them to take policy decisions.
(v) Consumers: Customers have an interest in information about the continuance of an enterprise, especially whey they have a long-term with the enterprise. Sometime, prices of some products are fixed by the government, so it needs accounting information to fix fair prices so that consumers and producers are not exploited.

Financial statements are very useful as they serve varied affected group having a economic interest in the activities in the business entity. Let us analyse the purpose served by financial statement:
a) The basic purpose of financial statement is communicated to their interested users, quantitative and objective information are useful in making economic decisions.
b) Secondly, financial statements are intended to meet the specialized needs of conscious creditors and investors.
c) Thirdly, financial statements are prepared to provide reliable information about the earning of a business enterprise and it ability to operate of profit in future. The users who are interested in this information are generally the investors, creditors, suppliers and employees.
d) Fourthly, financial statements are intended to provide the base for tax assessments.
e) Fifthly, financial statement are prepare in a way a provide information that is useful in predicting the future earning power of the enterprise.
f) Sixthly, financial statements are prepares to provide reliable information about the changes in economic resources.
g) Seventhly, financial statements are prepares to provide information about the changes in net resources of the organization that result from profit directed activities.
Thus, financial statement satisfy the information requirements of a wide cross-section of the society representing corporate managers, executives, bankers, creditors, shareholders investors, labourers, consumers, and government institution.

Limitations of financial statements
Financial Statements suffers from various limitations which are given below:
(i) Historical Records: Persons like shareholders, investors etc., are mainly interested in knowing the likely position in future. The financial statements are not of much help as the information given in these statements is historic in nature and does not reflect the future.
(ii) Ignores Price Level Changes: Price level change and purchasing power of money are inversely related. Different assets are shown at the historical cost in financial statements. It, therefore, ignore the price level change or present value of the assets.
(iii) Qualitative aspect Ignored: Financial statements considered only those items which can be expressed in terms of money. Financial Statements ignores the qualitative aspect such as quality of management, quality of labour force, Public relations.
(iv) Suffers from the Limitations of financial statements: Since analysis of financial statements is based on the information given in the financial statements, it suffers from all such limitations from which the financial statements suffer.
(v) Not free from Bias: Financial statements are largely affected by the personal judgement of the accountant in selecting accounting policies. Therefore, financial are not free from bias.
(vi) Variation is accounting practices: Different firms follow different accounting practices. For example, depreciation can be provided either on SLM basis or WDV basis. Profits earned or loss suffered will be different when different practices are followed. Therefore, a meaningful comparison of their financial statements is not possible.

Financial Statement Analysis
We know business is mainly concerned with the financial activities. In order to ascertain the financial status of the business every enterprise prepares certain statements, known as financial statements. 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 and interpretation of financial statements is required.
Financial Statement Analysis is the process of identifying the financial strength and weakness of a firm from the available accounting and financial statements. The analysis is done by properly establishing the relationship between the items of balance sheet and profit and loss account.
In the words of Myer “Financial Statement analysis is largely a study of relationship among the various financial factors in a business, as disclosed by a single set of statements, and a study of trends of these factors, as shown in a series of statements.”
In simple words, analysis of financial statement is a process of division, establishing relationship between various items of financial statements and interpreting the result thereof to understand the working and financial position of a business.
Objectives (Purposes) and significance of Financial Statement analysis:
Financial analysis serves the following purposes and that brings out the significance of such analysis:
a)      To judge the financial health of the company: The main objective of the financial analysis is to determine the financial health of the company. It is done by properly establishing the relationship between the items of balance sheet and profit and loss account.
b)      To judge the earnings performance of the company: Potential investors are primarily interested in earning efficiency of the company and its dividend paying capacity. The analysis and interpretation is done with a view to ascertain the company’s position in this regard.
c)       To judge the Managerial efficiency: The financial analysis helps to pinpoint the areas wherein the managers have shown better efficiency and the areas of inefficiency. Any favourable and unfavourable variations can be identified and reasons thereof can be ascertained to pinpoint weak areas.
d)      To judge the Short-term and Long-term solvency of the undertaking:  On the basis of financial analysis, Long-term as well as short-term solvency of the concern can be judged. Trade creditors or suppliers are mainly interested in assessing the liquidity position for which they look into the following:
Ø  Whether the current assets are sufficient to pay off the current liabilities.
Ø  The proportion of liquid assets to current assets.
e)      Indicating the trend of Achievements: Financial statements of the previous years can be compared and the trend regarding various expenses, purchases, sales, gross profits and net profit etc. can be ascertained. Value of assets and liabilities can be compared and the future prospects of the business can be envisaged.
f)       Inter-firm Comparison: Inter-firm comparison becomes easy with the help of financial analysis. It helps in assessing own performance as well as that of others.
g)      Understandable:  Financial analysis helps the users of the financial statement to understand the complicated matter in simplified manner.
h)      Assessing the growth potential of the business: The trend and other analysis of the business provide sufficient information indicating the growth potential of the business.
Types of financial Statement analysis:
The main objective of financial analysis to determine the financial health of a business enterprise. The analysis may be of the following types:
a)      External analysis: This analysis is performed by outside parties such as trade creditors, investors, suppliers of long term debt etc.
b)      Internal analysis: This analysis is performed by the corporate finance and accounting department and is more detailed than external analysis.
c)       Horizontal analysis: This analysis compares the financial statements viz., profit and loss accounts and balance sheet of previous year along with the current year.
d)      Vertical analysis: This analysis converts each element of the information into a percentage of the total amount of statement so as to establish relationship with other components of the same statement.
e)      Trend analysis: This analysis compares ratios of different components of the financial statements related to different period to those of a base year.
f)       Ratio analysis: This analysis establishes the numerical relationship between two items of financial statement so that the strength and weakness of a firm can be determined.
g)      Funds flow statement: This statement provides a comprehensive idea about the movement of finance in a business unit during a particular period of time.
h)      Break-even analysis: This type of analysis refers to the interpretation of financial data that represent operating activities.
Tools of Analysis of Financial Statements
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’.
Merits of Comparative Financial Statements:
(i)     Comparison of financial statements helps to identify the size and direction of changes in financial position of an enterprise.
(ii)   These statements help to ascertain the weakness and soundness about liquidity, profitability and solvency of an enterprise.
(iii) These statements help the management in making forecasts for the future.
Demerits of Comparative Financial Statements:
(i)     Inter-firm comparison may be misleading if the firms are not of the same age and size, follow different accounting policies.
(ii)   Inter-period comparison will also be misleading if there is frequent changes in accounting policies.
2. 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. 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 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’.
Merits of Common Size Statements:
(i)        A common size statement facilitates both types of analysis, horizontal as well as vertical. It allows both comparisons across the years and also each individual item as shown in financial statements.
(ii)      Comparison of the performance and financial condition in respect of different units of the same industry can also be done.
(iii)    These statements help the management in making forecasts for the future.
Demerits of Common Size Statements:
(i)        If there is no identical head of accounts, then inter-firm comparison will be difficult.
(ii)      Inter-firm comparison may be misleading if the firms are not of the same age and size, follow different accounting policies.
(iii)    Inter-period comparison will also be misleading if there is frequent changes in accounting policies.
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, in 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.
Merits of Trend analysis:
(i)        Trend percentages can be presented in the form of Index Numbers showing relative change in the financial statements during a certain period.
(ii)      Trend analysis will exhibit the direction to which the concern is proceeding.
(iii)    The trend ratio may be compared with the industry, in order to know the strong or weak points of a concern.
Demerits of Common Size Statements:
(i)     These are calculated only for major items instead of calculating for all items in the financial statements.
(ii)   Trend values will also be misleading if there is frequent changes in accounting policies.
4. Ratio Analysis: It describes the significant relationship which exists between various items of a balance sheet and a statement of profit and loss 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. Funds flow statement: The statement of sources and application of funds also called were got were gone statement provides the missing link in the complement of final account statement It demonstrates the manner by which periods activities call upon and generate the financial resources of the business unit and the resultant ebb and flow of these resources through the temporary reservoirs of firm assets. In the process, it high lights the changes in the financial structure of an undertaking funds flow analysis is a valuable aid to the financial executive and creditor For evaluating the use of funds by the firm and determining how these uses were financed A Funds flow statement indicates where fund come from and the here it was used during the period under review These statement can be prepared separately also The are important tool of communication and are very helpful for financial executives in planning the intermediate and long – term financing of the firm.
6. 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.
Parties interested in Financial Analysis
Analysis of financial statements has become very significant due to widespread interest of various parties in the financial results of a business unit. The various parties interested in the analysis of financial statements are:
(i) Investors: Shareholders or proprietors of the business are interested in the well being of the business. They like to know the earning capacity of the business and its prospects of future growth.
(ii) Management: The management is interested in the financial position and performance of the enterprise as a whole and of its various divisions. It helps them in preparing budgets and assessing the performance of various departmental heads.
(iii) Trade unions: They are interested in financial statements for negotiating the wages or salaries or bonus agreement with the management.
(iv) Lenders: Lenders to the business like debenture holders, suppliers of loans and lease are interested to know short term as well as long term solvency position of the entity.
(v) Suppliers and trade creditors: The suppliers and other creditors are interested to know about the solvency of the business i.e. the ability of the company to meet the debts as and when they fall due.
 (vi) Tax authorities: Tax authorities are interested in financial statements for determining the tax liability.
(vii) Researchers: They are interested in financial statements in undertaking research work in business affairs and practices.
(viii) Employees: They are interested to know the growth of profit. As a result of which they can demand better remuneration and congenial working environment.
(ix) Government and their agencies: Government and their agencies need financial information to regulate the activities of the enterprises/ industries and determine taxation policy. They suggest measures to formulate policies and regulations.
(x) Stock exchange: The stock exchange members take interest in financial statements for the purpose of analysis because they provide useful financial information about companies.
Thus, we find that different parties have interest in financial statements for different reasons.
Limitations of financial analysis
Financial analysis suffers from various limitations which are given below:
a)      Historical Analysis: Financial analysis analysed what has happened till date but it does not reflect the future. Persons like shareholders, investors etc., are mainly interested in knowing the likely position in future.

b)      Ignores Price Level Changes: Price level change and purchasing power of money are inversely related. A change in the price level makes the financial analysis of different accounting years invalid because accounting records ignores change in value of money.

c)       Qualitative aspect Ignored: Since the financial statements are based on quantitative aspects only, the quality aspect such as quality of management, quality of labour force etc., are ignored while carrying out the analysis of financial statements.

d)      Suffers from the Limitations of financial statements: Since analysis of financial statements is based on the information given in the financial statements, it suffers from all such limitations from which the financial statements suffer.

e)      Not free from Bias: Financial statements are largely affected by the personal judgment of the accountant in selecting accounting policies. Therefore, financial are not free from bias.

f)       Variation is accounting practices: Different firms follow different accounting practices. Therefore, a meaningful comparison of their financial statements is not possible.
Value Added Statements
Value Added Statement is a financial statement that depicts wealth created by an organization and how is that wealth distributed among various stakeholders. The various stakeholders comprise of the employees, shareholders, government, creditors and the wealth that is retained in the business. As per the concept of Enterprise Theory, profit is calculated for various stakeholders by an organization. Value Added is this profit generated by the collective efforts of management, employees, capital and the utilization of its capacity that is distributed amongst its various stakeholders. Consider a manufacturing firm. A typical firm would buy raw materials from the market. Process the raw materials and assemble them to produce the finished goods. The finished goods are then sold in the market. The additional work that the firm does to the raw materials in order for it to be sold in the market is the value added by that firm. Value added can also be defined as the difference between the value that the customers are willing to pay for the finished goods and the cost of materials.
Advantages of a Value Added Statement
a)      It is easy to calculate.
b)      Helps a company to apportion the value to various stakeholders. The company can use this to analyze what proportion of value added is allocated to which stakeholder.
c)       Useful for doing a direct comparison with your competitors.
d)      Useful for internal comparison purposes and to devise employee incentive schemes.

Economic Value-Added (EVA)
Economic Value-Added is the surplus generated by an entity after meeting an equitable charge towards providers of capital. It is the post-tax return on capital employed (adjusted for the tax shield on debt) less the cost of capital employed. Companies which earn higher returns than cost of capital create value, and companies which earn lower returns than cost of capital are deemed harmful for shareholder value.
EVA Calculation: EVA = (r-c) x Capital
where: r = rate of return, and

c = cost of capital, or the weighted average cost of capital.