Nature Of Financial Analysis

The focus of financial analysis is on the key figures contained in the financial statements and the
significant relationship that exists between them. “analyzing financial statements is a process of
evaluating the relationship between the component parts of the financial statements to obtain a better
understanding of a firm’s position and performance”.
The type of relationship to be investigated depends upon the objective and purpose of evaluation.
The purpose of evaluation of financial statements differs among various groups: creditors,
shareholders, potential investors, management and so on. For example, short-term creditors are
primarily interested in judging the firm’s ability to pay its currently-maturing obligations. The
relevant information for them is the composition of the short-term (current) liabilities. The
debenture-holders or financial institutions granting long-term loans would be concerned with
examining the capital structures, past and projected earnings and changes in the financial position.
The shareholders as well as potential investors would 105
naturally be interested in the earnings per share and dividends per share as these factors are likely to
have a significant bearing on the market price of shares. The management of the firms, in contrast,
analyses the financial statements for self-evaluation and decision making.
The first task of the financial analyst is to select the information relevant to the decision under
consideration from the total information contained in the financial statements. The second step
involved in financial analysis is to arrange the information in such a way as to highlight significant
relationships. The final step is the interpretation and drawing of inferences and conclusions. In brief,
financial analysis is the process of selection, relation and evaluation.
2.1.3.2 Types Of Financial Analysis
Financial analysis may be classified on the basis of parties who are undertaking the analysis and on
the basis of methodology of analysis. On the basis of the parties who are doing the analysis, financial
analysis is classified into external analysis and internal analysis.
External Analysis:
When the parties external to the business like creditors, investors, etc. Do the analysis, the analysis is
known as external analysis. This analysis is done by them to know the credit-worthiness of the
concern, its financial viability, its profitability, etc.
Internal Analysis:
This analysis is done by persons who have control over the books of accounts and other information
of the concern. Normally this analysis is done by management people to enable them to get relevant
information to take vital business decision.
On the basis of methodology adopted for analysis, financial analysis may be either horizontal
analysis or vertical analysis.106
Horizontal Analysis:
When financial statements of a number of years are analysed, then the analysis is known as
horizontal analysis. In this type of analysis, figures of the current year are compared with the
standard or base year. This type of analysis will give an insight into the concern’s performance over a
period of years. This analysis is otherwise called as dynamic analysis as it extends over a number of
years.
Vertical Analysis:
This type of analysis establishes a quantitative relationship of the various items in the financial
statements on a particular date. For e.g. The ratios of various expenditure items in terms of sales for a
particular year can be calculated. The other name for this analysis is `static analysis’ as it relies upon
one year figures only.
2.1.3.3 Tools Of Financial Analysis
The following are the important tools of financial analysis which can be appropriately used by the
financial analysts:
1. Common-size financial statements
2. Comparative financial statements
3. Trend percentages
4. Ratio analysis
5. Funds flow analysis
6. Cash flow analysis
Common-Size Financial Statements:
In this type of statements, figures in the original financial statements are converted into percentages
in relation to a common base. The common base may be sales in the case of income statements
(profit and loss account) and total of assets or liabilities in the case of balance sheet. For e.g. In the
case of common-size income statement, sales of the traditional financial statement are taken as 100
and every other item in the income statement is converted into percentages with reference to sales.
Similarly, in the case of common-size balance sheet, the total of asset/liability side will be taken as
100 and each individual asset/liability is converted into relevant percentages.107
Comparative Financial Statements:
This type of financial statements are ideal for carrying out horizontal analysis. Comparative financial
statements are so designed to give them perspective to the review and analysis of the various
elements of profitability and financial position displayed in such statements. In these statements,
figures for two or more periods are compared to find out the changes both in absolute figures and in
percentages that have taken place in the latest year as compared to the previous year(s). Comparative
financial statements can be prepared both for income statement and balance sheet.
Trend Percentages:
Analysis of one year figures or analysis of even two years figures will not reveal the real trend of
profitability or financial stability or otherwise of any concern. To get an idea about how consistent is
the performance of a concern, figures of a number of years must be analysed and compared. Here
comes the role of trend percentages and the analysis which is done with the help of these percentages
is called as trend analysis.
Trend analysis:
Is a useful tool for the management since it reduces the large amount of absolute data into a simple
and easily readable form. The trend analysis is studied by various methods. The most popular forms
of trend analysis are year to year trend change percentage and index-number trend series. The year to
year trend change percentage would be meaningful and manageable where the trend for a few years,
say a five year or six year period is to be analysed.
Generally trend percentage are calculated only for some important items which can be logically
related with each other. For e.g. Trend ratio for sales, though shows a clear-cut increasing tendency,
becomes meaningful in the real sense when it is compared with cost of goods sold which might have
increased at a lower level.108
Ratio Analysis:
Of all the tools of financial analysis available with a financial analyst the most important and the
most widely used tool is ratio analysis. Simply stated ratio analysis is an analysis of financial
statements done with the help of ratios. A ratio expresses the relationship that exists between two
numbers and in financial statement analysis a ratio shows the relationship between two interrelated
accounting figures. Both the accounting figures may be taken from the balance sheet and the
resulting ratio is called a balance sheet ratio. But if both the figures are taken from profit and loss
account then the resulting ratio is called as profit and loss account ratio. Composite ratio is that ratio
which is calculated by taking one figure from profit and loss account and the other figure from
balance sheet. A detailed discussion on ratio analysis is made available in the pages to come.
Funds Flow Analysis:
The purpose of this analysis is to go beyond and behind the information contained in the financial
statements. Income statement tells the quantum of profit earned or loss suffered for a particular
accounting year. Balance sheet gives the assets and liabilities position as on a particular date. But in
an accounting year a number of financial transactions take place which have a bearing on the
performance of the concern but which are not revealed by the financial statements. For e.g. A
concern collects finance through various sources and uses them for various purposes. But these
details could not be known from the traditional financial statements. Funds flow analysis gives an
opening in this respect. All the more, funds flow analysis reveals the changes in working capital
position. If there is an increase in working capital what resulted in the increase and if there is a
decrease in working capital what caused the decrease, etc. Will be made available through funds flow
analysis.
Cash Flow Analysis:
While funds flow analysis studies the reasons for the changes in working capital by analysing the
sources and application of funds, cash flow analysis pays attention to the changes in cash position
that has taken place between two accounting periods. These reasons are not available in the
traditional financial statements. Changes in the cash position can 109
be analysed with the help of a statement known as cash flow statement. A cash flow statement
summarises the change in cash position of the concern. Transactions which increase the cash position
of the concern are labelled as `inflows’ of cash and those which decrease the cash position as
`outflows’ of cash.

Illustration 9:

Comment on the performance of arasu limited from the ratios given below:

Industry average Ratios of

Ratios Arasu ltd.

1. Current ratio 2:1 2.5:1

2. Debt-equity ratio 2:1 1:1

3. Stock turnover ratio 9.5 3.5

4. Net profit margin ratio 23.5% 15.1%

(i) Current Ratio:

This ratio indicates the liquidity position of a firm. The ability of a firm in meeting its current liabilities
could be understood by this ratio. The calculated results show that the liquidity in arasu limited is even
greater than industry average, showing the safety. However, excess liquidity locks up the capital in
unnecessary current assets.

(ii) Debt-Equity Ratio:

It is an indicator of a firm’s solvency in terms of its ability to repay long term loans in time. The
calculated ratio shows better solvency of 1:1 indicating that for every one rupee of debt capital, to repay
one rupee of equity base exists in arasu ltd. However, this ratio is not likely to ensure the leverage
benefits that a firm gains by using higher dose of debt.143

(iii) Stock Turnover Ratio:

Stock velocity is an indicator of a firm’s activeness. It directly influences the profitability of a firm. The
calculated ratio for arasu ltd. Is very poor when compared to industry average. This poor ratio indicates
the inefficient use of capacities, consequently, the likely low profitability.

(iv) Net Profit Margin Ratio:

Although the firms in a particular industry could sell the product more or less at same price, the net
profits differ among firms due to their cost of production, excessive administrative and establishment
expenses etc. This picture is found true in case of arasu ltd. A poor profitability of 15.1% compared to an
industry average of 23.5% may be due to low stock turnover, inefficiency in management, excess
overhead cost and excessive interest burdens.