Management Accounting

Unit 02

Financial statements Analysis and Interpretation

Introduction

Financial statements refers to two basic statements which an accountant prepares at the
end of an accounting period for a business enterprise. These are :

Balance sheet : Which reflects the assets, liabilities and capital as on a certain date.

Profit and Loss Account : Which shows the results of operation i.e., profit or loss during a
certain.

Other statements : Apart from the balance sheet and profit and loss account, the following
financial statements are also prepared.

Funds flow statement : This explains increase or decrease in working capital during the
accounting.

Cash flow statement : This explains changes in cash position between the beginning and
end of the accounting period.

Meaning of Financial Statements

The financial statements provide a summary of the accounts of a business enterprises.

According to the American Institute of Accountants, Financial statements reflects a
combination of recorded facts, accounting conventions and personal judgments, and the
judgments and conventions applied affect them materially.

Nature of Financial Statements

• Recorded facts : The financial statements show the factual data drawn from the
financial accounts. For example, items like cash in hand and at bank, cost of fixed
asset, salaries paid, etc. are the facts recorded in the books.

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Management Accounting
• Accounting conventions : Financial statements are affected to a large extent by the
various accounting concepts and conventions. For example, because of going concern
concept, fixed assets are recorded at cost and not at their market value. Similarly, due
to the convention of conservatism, the stock in trade is valued at cost or market price
whichever is less.
• Personal judgements : Although an accountant is guided by accounting concepts and
conventions in preparing the financial statements, he has to exercise personal
judgment in many cases which affect the financial statements. For example, an
accountant has to decide whether to use straight line method or written down value
method for depreciation of fixed assets.

Limitations of Financial Statements

• Historical costs : Financial reports are dependent on historical costs. The recording of
all the transactions occurs at historical costs as per the GAAP requirement. As such, a
change occurs in the value of the assets and the liabilities concerning time. This
change is dependent on certain market factors. So, you will not get the current value
of such assets and liabilities from financial statements.
• Inflation adjustments : Inflation Adjustments of the assets and liabilities of an
organization do not take place. Suppose the inflation is extremely high, the financial
report items will be recorded at lower costs during such a time. Therefore, the
readers will not receive such information. Due to a lack of inflation adjustments,
financial statements do not reflect the current situation during such time.
• No discussion on non financial issues : There is no discussion of non-financial issues
during the preparation of financial statements. Such non-financial issues can be as
follows:
The environment
Social and governance concerns,
Steps were taken by the Company to improve the same
These issues are highly relevant, but the financial statements do not cover
them.
• Bias : The financial statements are made based on personal judgments. As such, they
can be easily subject to the maker’s bias. So, the value of assets and liabilities in a
financial statement is mainly dependent on the accounting standard chosen.

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Management Accounting
• Fraudulent practices : The financial statements have a possibility of being inflicted
with fraudulent practices. People can skew the result of financial statements for their
benefit. Therefore, financial statements are not 100% trustworthy. It is also why they
do not reflect on the current situation all the time.
• Specific time period reports : The financial statements are prepared based on a
specific period. Therefore, there may impact reporting results due to a sudden spike or
dullness in the market or stock. This makes one period to be incomparable to other
periods. As such, the assets may not realize their true value at the time of reporting.
• Intangible assets : The recording of the company’s intangible assets does not take
place on the balance sheet. Intangible assets, in particular, include the following two
important parts:
Brand value
Company’s reputation earned over a while
This lack of intangible assets is one of the biggest limitations of financial
statements. It is another strong reason why financial statements do not reflect
the current situation.
• Comparability : Comparing the organization’s performance is an important practice
for investors. However, the results of financial statements are, but they are not
usually comparable. This is because of various factors such as:
Different accounting practices used
Different Valuation methods
Personal judgments of different individuals in the organization All of this
makes comparability a difficult task.

Essentials of good financial statements

• Easy to Prepare : The contents of the financial statements should be easily and
readily available from the books of accounts of the business concern. If so, the
calculation is very easy and irrelevant information cannot be recorded in the financial
statements. Moreover, the size of the form of financial statements should not be
abnormally too large.
• Depict True Financial Position : The information contained in financial statements
should be clear and correct so that true financial position should be disclosed in the
financial statements. Moreover, all the material information should be included in the
financial statements.
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Management Accounting
• Understand by Common man : A common man or layman does not know the
accounting rules, principles and conventions. These are necessary to understand the
contents of financial statements. But, the financial statements should be prepared in
simple and common language and non-technical in order to understand the financial
statements without any specialized training or education.
• Effective Presentation : The utility of the financial statements is enhanced only
through effective presentation. A simple format is used so as to understand the
statements without much difficulty.
• Easy Comparison : The columns and amounts should be arranged in such a way that
the figures of current year is easily compared with previous year. Likewise, the
comparison of actual results with budgeted ones or with standards should also be
made possible. Moreover, the format of similar company is followed so that inter firm
comparison is made possible.
• Relevance : The prepared financial statements should achieve the objectives of the
business concern. This is possible if relevant information alone included in the
financial statements.
• Attractive : The financial statements should be prepared in such a way that important
information is underlined so that it attracts every interested parties of the financial
statements.
• Focus on Significant Items : Every reader of the financial statements wants to identify
the significant items. Hence, it is necessary that such facts or items should be written
in bold figures and letters or in different ink.
• Analytical Representation : The contents of the financial statements can be analyzed
in different directions so that new facts of the accounting data can be highlighted. A
relationship can be established in similar type of information. Moreover, logical
interpretation can be carried out for analytical presentation of financial statements.
• Brief : There is no need of detailed information in financial statements. Only brief
information is enough. The reason is that detailed information leads to difficulty to
judge the financial position and performance of the business concern.
• Easy Calculation of Accounting Ratios : The financial statements should be presented
in such a way that required items and figures are easily obtained for calculating
various accounting ratios. These ratios are used by the interested parties for proper
analysis and interpretation.
• Promptness : The financial statements should be prepared and presented as early as
possible. In nutshell, the statements should be ready soon after completion of the
accounting year.

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Management Accounting
Meaning of Analysis and Interpretation

Analysis : Analysis of financial statements means to critically examine the composition of

an item or amount appearing in the financial statements. Such an analysis makes use of
various analytical tools and techniques to data of financial statements so as to derive from
them certain relationships that are significant and useful for decision making.

Interpretation : Analysis leads to interpretation of financial data. Interpretation is

determining the meaning and drawing inferences or conclusions with regard to the results
of significant relationship between the items correlated.

Definition of Financial Statement Analysis

According to John N. Myers, “ Financial Statement analysis is largely a study of the

relationships among the various financial factors in a business as disclosed by a single set of
statements and a study of the trends of these factors are shown in a series of statements.

Types of Financial Statement Analysis

• Internal and external analysis : When analysis in done on behalf of the management
who have access to the internal accounting records of the firm, it is called internal
analysis. Such an analysis serves the purpose of measuring the management
efficiency of various functions of the business.

External analysis is done by outsiders like shareholders, creditors, investors and

potential investors, government agencies etc. Who don’t have access to the detailed
internal records of the firm. Thus, external analysis is dependent on the published
financial statements of the firm.
• Horizontal and vertical analysis : Horizontal analysis is that which covers financial
data of more than one year (maybe up to five or ten years). The figures for various
years are presented horizontally over a number of columns. Trend, percentage and
comparative financial statements are types of horizontal analysis. These types of
analysis is also called dynamic analysis.

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Management Accounting
Vertical analysis, also known as static analysis, covers a period of one year only and
analysis is made on the basis of one set of financial statements. Common size
financial statements and ratio analysis are techniques employed in vertical analysis.
However, this type of analysis fails to incorporate changes in the firms position over a
period and therefore may not be very conducive to proper understanding of financial
position of the firm.

Principle Tools and Techniques of Financial Analysis

• Comparative financial statements : Comparison of financial statements is one of the

very important tools of horizontal analysis of financial statements. It has been seen
that balance sheet and profit and loss account are the two most important financial
statements. Information contained in these financial statements for a particular year
is extremely important and useful.
• Common size financial statements : Common size statement is a type of comparative
financial statement in which each item of the financial statement is expressed as a
percentage of the appropriate total. The appropriate total is taken as 100% and each
item is shown as a proportion of this 100%. Such a statement is also known as 100%
statement or vertical analysis.
• Trend percentages : Trend percentages is a technique of studying financial
statements of a company over a number of years. Under this method, a
representative year is selected as the base year and the values of items in the base year
are assumed to be 100. Then the relationship of each item in the subsequent years is
expressed as a percentage of the same item in the base year.
• Financial Ratio Analysis : Financial ratio analysis is the technique of comparing the
relationship (or ratio) between two or more items of financial data from a company’s
financial statements. It is mainly used as a way of making fair comparisons across
time and between different companies or industries.

Significance and purpose of Financial Statement Analysis

• Judging efficiency : Profitability is a measure of the efficiency and success of a

business enterprise. A company which earns profits at a higher rate is definitely
considered a good company by the potential investors.

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Management Accounting
• Judging liquidity : Liquidity of a business refers to its ability to pay off its short term
liabilities when these become due. Short-term creditors, like trade creditors and
bankers make an assessment of liquidity before granting credit to the company.
• Judging solvency : Solvency refers to the ability of a company to meet its long term
debts. Long term creditors like debenture holders and financial institutions that the
solvency of a company before any lending decisions.
• Judging the efficiency of management : Performance and efficiency of management
of a company can be easily judged by analysing its financial statements. Profitability
of the company is not the only measure of company’s managerial efficiency. There
are a number of other ways to judge the operational efficiency of management.
Financial analysis tells whether the resources of the business are being used in the
most effective and efficient way.
• Inter-firm comparison : A comparative study of financial and operating efficiency of
different firms as possible only after proper analysis of their financial statements. For
this purpose it is also necessary that the financial statements are kept on a uniform
basis, so that financial data of various firms are comparable.
• Forecasting and budgeting : Financial analysis is the starting point for making plans
by forecasting and preparing budgets. Analysis of the financial statements of the past
years helps a great deal in forecasting for the future.

Rajesha M M com B.Ed K-SET Shantidhama Degree College