Financial Statement Analysis

What is Financial Statement?

A financial statement is an official document of the firm, which explores the entire financial information of the firm. The main aim of the financial statement is to provide information and understand the financial aspects of the firm.

To put it simply. Financial statements are mainly prepared for decision-making purposes. In order to ascertain the financial status of the business, every enterprise prepares certain statements, known as financial statements.

It may show a position at a moment of time as in the case of a balance sheet or may reveal a service of activities over a given period of time, as in the case of an income statement.

Financial statements generally consist of two important statements:

  • The income statement or profit and loss account.
  • Balance sheet or the position statement.

Definition of Financial Statement

According to Hamptons John, the financial statement is an organized collection of data according to logical and consistent accounting procedures.

John N. Nyer also defines it “Financial statements provide a summary of the accounting of a business enterprise, the balance-sheet reflecting the assets, liabilities and capital as on a certain data and the income statement showing the results of operations during a certain period”.

Types of Financial Statement Analysis

Analysis of financial statement may be broadly classified into two types:

  1. Based on Material Used
  2. Based on Method of Operation

Based on Material Used

Based on the material used, financial statement analysis may be classified into two major types as External analysis and internal analysis.

  1. External Analysis
  2. Internal Analysis

External Analysis

Outsiders of the business concern do normally external analyses but they are indirectly involved in the business concern such as investors, creditors, government organizations and other credit agencies. External analysis is very much useful to understand the financial and operational position of the business concern.

The external analysis mainly depends on the published financial statement of the concern. This analysis provides only limited information about the business concern.

Internal Analysis

The company itself does disclose some of the valuable information to the business concerned in this type of analysis. This analysis is used to understand the operational performances of each and every department and unit of the business concern. Internal analysis helps to take decisions regarding achieving the goals of the business concern.

Based on Method of Operation

Based on the methods of operation, financial statement analysis may be classified into two major types such as horizontal analysis and vertical analysis.

  1. Horizontal Analysis
  2. Vertical Analysis

Horizontal Analysis

Under the horizontal analysis, financial statements are compared with several years and based on that, a firm may take decisions. Normally, the current year’s figures are compared with the base year (base year is considered as 100) and how the financial information is changed from one year to another. This analysis is also called dynamic analysis.

Vertical Analysis

Under the vertical analysis, financial statements measure the quantities relationship of the various items in the financial statement on a particular period. It is also called static analysis, because, this analysis helps to determine the relationship with various items that appeared in the financial statement. For example, a sale is assumed as 100 and other items are converted into sales figures.

Techniques of Financial Statement Analysis

The following are the common methods or techniques of financial statement analysis, which are widely used by the business concern.

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

Comparative Statement Analysis

Comparative statement analysis is an analysis of financial statements at different periods of time. This statement helps to understand the comparative position of financial and operational performance at different periods of time.

Comparative financial statements are again classified into two major parts such as comparative balance sheet analysis and comparative profit and loss account analysis.

Trend Analysis

The financial statements may be analysed by computing trends of a series of information. It may be upward or downward directions that involve the percentage relationship of each and every item of the statement with the common value of 100%.

Trend analysis helps to understand the trend relationship with various items, which appear in the financial statements. These percentages may also be taken as index numbers showing relative changes in the financial information resulting from various periods of time. In this analysis, only major items are considered for calculating the trend percentage.

Common Size Analysis

Another important financial statement analysis techniques are common size analysis in which figures reported are converted into a percentage to some common base. In the balance sheet, the total assets figures are assumed to be 100 and all figures are expressed as a percentage of this total.

It is one of the simplest methods of financial statement analysis, which reflects the relationship of each and every item with a base value of 100%.

Funds Flow Statement

Funds flow statement is one of the important tools, which is used in many ways. It helps to understand the changes in the financial position of a business enterprise between the beginning and ending financial statement dates. It is also called a statement of sources and uses of funds.

Institute of Cost and Works Accounts of India, funds flow statement is defined as “a statement prospective or retrospective, setting out the sources and application of the funds of an enterprise. The purpose of the statement is to indicate clearly the requirement of funds and how they are proposed to be raised and the efficient utilization and application of the same”.

Cash Flow Statement

A cash flow statement is a statement that shows the sources of cash inflow and uses of cash out-flow of the business concern during a particular period of time. It is the statement, which involves only the short-term financial position of the business concern.

The cash flow statement provides a summary of operating, investment and financing cash flows and reconciles them with changes in its cash and cash equivalents such as marketable securities. Institute of Chartered Accountants of India issued the Accounting Standard (AS-3) related to the preparation of cash flow statements in 1998.

Ratio Analysis

Ratio analysis is a commonly used tool of financial statement analysis. The ratio is a mathematical relationship between one number to another number. The ratio is used as an index for evaluating the financial performance of the business concern.

An accounting ratio shows the mathematical relationship between two figures, which have a meaningful relationship with each other. The ratio can be classified into various types. Classification from the point of view of financial management is as follows:

  • Liquidity Ratio
  • Activity Ratio
  • Solvency Ratio
  • Profitability Ratio

Purposes of Financial Statement Analysis

Followings are the purposes of financial statement analysis:

  1. Measuring the Profitability
  2. Indicating the Trend of Achievements
  3. Assessing the Growth Potential of the Business
  4. Comparative Position in Relation to Other Firms
  5. Assess Overall Financial Strength
  6. Assess solvency of the Firm

Measuring the Profitability

The main objective of a business is to earn a satisfactory return on the funds invested in it. Financial analysis 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.

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.

Assessing the Growth Potential of the Business

The trend and other analyses of the business provide sufficient information indicating the growth potential of the business.

Comparative Position in Relation to Other Firms

The purpose of financial statements analysis is to help the management to make a comparative study of the profitability of various firms engaged in similar businesses. Such comparison also helps the management to study the position of their firm in respect of sales, expenses, profitability and utilising capital, etc.

Assess Overall Financial Strength

The purpose of financial analysis is to assess the financial strength of the business. The analysis also helps in taking decisions, whether funds required for the purchase of new machines and equipment are provided from internal sources of the business or not if yes, how much? And also to assess how much funds have been received from external sources.

Assess solvency of the Firm

The different tools of analysis tell us whether the firm has sufficient funds to meet its short term and long term liabilities or not.

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