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rahulkarya commerce
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Analysis of Financial Statements

CHAPTER 4

09/09/21 KRISHNAN PB GGHSS PAYYANNUR 1


Analysis of Financial Statements
The term ‘financial statement analysis’ refers to the process of
determining financial strengths and weaknesses of the firm by
establishing strategic relationship between the items of the balance
sheet, profit and loss account and other operative data.

The term ‘financial analysis’ includes both analysis and


interpretation’. The term analysis means simplification of financial
data by methodical classification given in the financial statements.
Interpretation means explaining the meaning and significance of
the data.

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Significance of Analysis of Financial Statements

Financial analysis is useful and significant to different users in the


following ways:

(a) Finance manager: The tools for analysis helps the finance manager
in studying accounting data so as to determine the continuity of the
operating policies, investment value of the business, credit ratings
and testing the efficiency of operations.

(b) Top management: Financial analysis helps the management in


measuring the success of the company’s operations, appraising
the individual’s performance and evaluating the system of internal
control.
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(c) Trade payables: Trade payables are interested in the firm’s
ability to meet their claims over a very short period of time
by evaluating the liquidity position.

(d) Lenders: Long-term lenders analyse the historical financial


statements to assess firms future solvency and Profitability.

(e) Investors: Investors, who have invested their money


in the firm’s shares, are interested about the firm’s
earnings to decide whether to buy, sell or hold the
shares.
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(f) Labour unions: Labour unions analyse the financial
statements to asses whether it can presently afford
Wages.

(g) Others: The economists, researchers, etc., analyse the


financial statements to study the present business and
economic conditions.

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Objectives of Analysis of Financial Statements
1. To estimate the earning capacity of the business
concern.
2. To find out the operating performance of a
company.
3. To examine efficiency of various business
activities.
4. To find out the financial performance of a
company.
5. To judge the managerial ability.
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6. To compare the performance of a company for different
periods.

7. To assess the borrowing capacity of the business concern.

8. To determine the long term liquidity and solvency of the


business concern.

9. To decide about the future prospects of the business


concern.

10. To know the profitability and collection policy of the


business concern.
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Tools of Analysis of Financial Statements
Commonly used tools of financial analysis are:

●
Common size statement
●
Trend analysis
●
Comparative statements
●
Ratio analysis
●
Cash flow analysis
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1. Comparative Statement
Comparative statement shows changes in all items
of financial statements in absolute and percentage terms
over a period of time for a firm or between two firms.
The figures in the comparative statements can be used
for identifying the direction of changes and also the
trends in different indicators of performance of an
organisation. This analysis is also known as Horizontal
Analysis
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2. Common Size Statement
Common size statement expresses all items of a financial
statement as a percentage of some common base such as
revenue from operations for statement of profit and loss and total
assets for balance sheet. It is a statements in which individual
items of financial statements of two or more year are placed side
by side and there after converted into percentage taking a
common base. It provides an insight into the structure of financial
statements. This statement is also known as component
percentage statement.

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3.Trend Analysis
Trend analysis is an analysis of the trend of the company by
comparing its financial statements to analyse the trend of market or
analysis of the future on the basis of results of past performance.

Trend analysis can be done to observe the percentage changes


over time in the selected data. From trend observations financial
problems can be detect or sign of good or poor performance can
also be detect.

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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. Ratio analysis helps to assess the
profitability, solvency and efficiency of an enterprise.

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5. Cash Flow Analysis

It refers to the analysis of actual movement of cash in to


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

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PROBLEMS

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Test your Understanding – III
(a) True
(b) True
(c) True
(g) True
(h) True
(i) True
(d) True
(j) True
(f) False

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LIMITATIONS OF FINANCIAL ANALYSIS
1. Financial analysis does not consider price level changes.
2. Financial analysis may be misleading without the
knowledge of the changes in accounting procedure
followed by a firm.
3. Financial analysis is just a study of reports of the
company.
4. Monetary information alone is considered in financial
analysis while non-monetary aspects are ignored.
5. The financial statements are prepared on the basis of
accounting concept, as such, it does not reflect the current
position.

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THANKS

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