FINANCIAL STATEMENTS ANALYSIS
FINANCIAL STATEMENTS ANALYSIS
FINANCIAL STATEMENTS ANALYSIS
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The Common Size Statement of Profit & Loss shows each element of Cost as a percentage
of sales. It helps in analysing costs and operating results of the year. Similarly, in a common
size Balance Sheet various assets can be expressed as percentage of total assets.
Since such type of analysis is based on the data of a single year, it is also called ‘Static
Analysis’. Vertical analysis is useful in comparing the performance of several companies in
the same group or departments in the same company.
Vertical analysis is not very useful for a proper analysis of the company’s financial position
because it depends on the data of a single period whereas the business is a dynamic
process. In comparison to vertical analysis, the horizontal analysis is more useful because it
brings out more clearly the nature and trends of current changes affecting the enterprise.
Horizontal presentation emphasises the fact that statement for a series of periods are far
more significant than those for a single period and that the accounts for one period are but an
instalment of what is essentially a continuous history.
Objectives or Purpose of Financial Analysis
The purpose of financial analysis depends on the needs of the person who is analysing these
statements. These varying needs may be :
(1) To Measure the Earning Capacity or Profitability : According to Robert Anthony, “The
overall objective of a business is to earn a satisfactory return on the funds invested in it,
consistent with maintaining a sound financial position.” Financial analysis helps in
ascertaining whether adequate profits are being earned on the capital invested in the
business. It is also disclosed by analysis of financial statements whether these profits are
increasing or decreasing over the years. For this purpose, the financial statements of a few
years are taken into account to compute the change in profits over the years. Such analysis
helps in ascertaining the future profitability or earning capacity of the business.
(2) Tθ Measure the Solvency : h can be ascertained from financial analysis whether the
business is in a position to pay its short-term and long-term liabilities in time. For example, the
liquidity ratios (current ratio and quick ratio) are calculated to ascertain whether the business
enterprise has sufficient liquid funds to meet its short term liabilities and Debt Equity Ratio is
calculated to ascertain whether the business enterprise has got the ability to repay the long
term liabilities.
(3) To Measure the Financial Strength ;The purpose of financial analysis is to assess the
financial potential of the business. Analysis helps in providing answers to the following
questions :
(i) Funds required for the purchase of new machinery and equipments will be available from
internal resources of the business or not?
(ii) Based on the current reputation of the business, how much funds can be raised from
external sources?
(4) To Make Comparative Study with other Firms :⊥ hc purpose of financial analysis is to
help the management to make a comparative study of the profitability of various firms
engaged in same trade. Such comparison helps the management to study the position of
their firm in respect of sales, expenses, profitability and working capital etc. in comparison to
other firms.
(5) To Measure the Capability of Payment of Interest and Dividend ;The purpose of
analysis is to assess whether the firm will have sufficient profits to pay the amount of interest
in time and whether it has the capacity to pay the dividend in future at a higher rate. Analysis
also indicates the number of times the profit is in comparison to interest. Analysis further
indicates the extent to which the profit of the firm may decrease without in any way affecting
its ability' to meet interest and dividend obligations.
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(6) To Identify the Trend of the Business : When data about sales, cost of production,
profits etc. are compared for two or more years of a firm, they indicate the direction in which a
business is moving. If sales are increasing continuously along with increase in profit margins,
it is an indication of a healthy growth trend of the business. Such analysis helps in
ascertaining whether the business is progressive or not.
(7) To Judge the Efficiency of Management: The purpose of financial analysis is to judge
that the financial policies adopted by the management are proper or not. For example, if the
actual ratios calculated on the basis of financial statements are in accordance with their
standard ratios, the policies of the management may be said to be proper and efficient.
(8) To Provide Useful Informations to the Management : The object ol financial analysis is
to find out the shortcomings of the business, so that the management can take remedial
measures to remove those shortcomings.
Uses of Financial Analysis :
Financial analysis can be used to take variety of decisions in the following areas :
(1) For taking Investment Decisions Analysis of financial statements helps an investor to
know whether the firm is fulfilling his expectations regarding the payment of dividend,
appreciation in the value of investments made by him and safety of his investment. It helps
him to take decision about continuation or discontinuation of his investment in the firm.
(2) For taking Credit Decisions : Analysis of financial statements is useful in making a
decision whether to grant or extend credit to a customer.
(3) For taking Dividend Decisions : Such analysis is useful in deciding about how much
portion of the profit is to be distributed as dividend and how much to retain.
(4) For Estimating Trend of the Business : Analysis of financial statements for a number of
years reveals the trend of costs, sales, profits etc. It helps in assessing the future growth
potential of the firm.
(5) For Taking Various Managerial Decisions : Analysis of financial statements discloses
the liquidity, solvency and profitability of the business enterprise. It helps in locating the weak
spots of the business. Such information enables the management to take various decisions.
Significance or Importance of Financial Analysis
At present, the analysis of financial statements has become of general interest. Various
parties have become interested in the financial statements of a company due to various
reasons. Different persons look at the same financial statement from different angles, i.e.,
there are different users of financial statements, all of them using the same statement but for
a different purpose. For example, a shareholder would be interested in the profitability
whereas a short-term creditor would be concerned about the liquidity, i.e., the firm’s ability to
pay its current liabilities. Therefore, the significance of the financial statement analysis may
be studied from the point of view of various parties as follows :
(1) Significance for Management: Management of a firm is always interested in the
solvency, profitability and the capital structure of the firm. They want to make sure that the
business must be in a solvent position to pay the debts as and when they fall due. Similarly,
they are interested not only in the current years’ profit but also in the capacity of the business
to earn more profits in future. By comparing the financial statements of their business with the
financial statements of other firms in the same trade managements can draw significant
conclusions about the sales, profits, expenses etc. In the words of Gerstenberg :
“The management can measure the effectiveness of its own policies and decisions,
determine the advisability of adopting new policies and procedures and document to owners,
the results of their managerial efforts.”
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(2) Significance for Investors : Investors and shareholders of the business are interested in
the longevity of the business enterprise and therefore, they want to know' the earning
capacity' of the business and its prospects for future growth and prosperity. Analysis of
financial statements of a company helps them a great deal in assessing the capacity of the
business to pay dividend at a higher rate and also the safety of their investments.
(3) Significance for Creditors : There are two types of creditors, (i) Short-term creditors, and
(ii) Long-term creditors.
(i) Short-term creditors want to know the liquidity of the business, i.e., to know whether the
company will have sufficient current assets and cash to pay their debts or not. Current ratio
and quick ratio calculated on the basis of financial statements help them in assessing this.
(ii) Long-term creditors want to know two things namely : (1) W hether the company will be
able to pay the interest consistently, and (2) W hether the company will be able to pay their
debts when they fall due. On the basis of interest coverage ratio they can ascertain whether
the company will be able to pay the interest regularly or not and on the basis of debt-equity
ratio they can ascertain whether the company will be able to pay their debts on maturity.
(4) Significance for Government: Government can judge on the basis of analysis of
financial statements, which industry is progressing on the desired lines and which industry
needs the financial help. Government can take a decision to reduce the GST in those
industries where the profit margins are low in comparison to the cost of production. On the
contrary, if the profit margins are too high in comparison to the cost of production.
Government can increase the GST or can enforce the price regulations.
(5) Significance for Financial Institutions : All the financial institutions which provide
finance to the industries such as Banks, Insurance companies, Unit Trust etc. want to know
the profit earning capacity of the business and its long-term solvency. They want to assess
not only the present position of the business enterprise but also its likely position in the future.
Analysis of financial statements helps them in ascertaining this.
(6) Significance for Employees : Analysis of financial statements helps the employees in
determining the profitability of the business enterprise. They can ascertain as to how much
bonus and increase in their wages is possible from the profits of the company. Analysis of
financial statements also helps the trade unions in negotiating wages agreements.
(7) Significance for Stock Exchange Authorities : They analyse the financial statements of
a company to determine its price earning ratio and earning per share (E.P.S.). W ith the help
of such analysis, the market price of a company’s share is determined.
(8) Significance for Taxation Authorities : They analyse the financial statements of a
company to know whether the financial statements have been prepared in accordance with
the legal provisions and whether the figures of production, sales and profits are correct for the
purpose of assessment of GST and income tax etc.
(9) Significance for Researchers : Analysis of financial statements of a company is of much
importance to a researcher who is conducting research in respect of the profitability,
efficiency, financial soundness and future growth potential of that company.
(10) Significance for Other Parties : Some other parties may also be interested in the
analysis of financial statements of a company from their own point of view, such as,
economists, trade associations, consumer organisations etc.
Limitations of Financial Analysis
Financial analysis helps the interested parties to make an assessment of the earning capacity
and financial soundness of a business enterprise. But such analysis has its own limitations.
Such limitations should be kept in mind while using the informations provided by the financial
analysis. Some of the limitations are as follows :
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(1) Limitations of Financial Statements : Financial analysis is based on financial
statements. But financial statements themselves suffer from certain limitations, hence the
limitations of financial statements are also the limitations of their analysis. For example, (i)
Sometimes the informations given in financial statements are incomplete and unauthentic, (ii)
Financial Statements are based on accounting concepts and conventions. As such, the utility
of financial analysis is decreased due to the shortcomings of financial statements.
(2) Affected by Window-dressing : Some firms resort to window-dressing their financial
statements to cover up bad financial position on the eve of accounting date. For example,
they may not record the purchases made at the end of the year or they may overvalue their
closing stock. In such cases, the results obtained by analysis of financial statements will be
misleading.
(3) Do not Reflect Changes in Price Level: Figures given in financial statements do not
show the effect of changes in price level. As such, the comparison of past year figures with
current year figures may lead to misleading conclusions. For example, if in 2017 a firm sells
10,000 metre of cloth for Rs.10 lac and the same firm in 2018 sells the same type of 10,000
metre of cloth for Rs.15 lac, it discloses an increase of 50% in sales, whereas, in actual, the
sales have not increased at all. As such, sufficient adjustments must be made for changes in
price level before making the analysis.
(4) Different Accounting Policies : If two firms adopt different accounting policies, the
comparison between the two will be unreliable. For example, one firm may provide
depreciation on original cost method, whereas the other firm may adopt the written-down
value method for providing the depreciation. Similarly, the method of valuation of closing
stock may also differ from one firm to another. The results obtained from the comparison of
the financial statements of such firms may give misleading picture.
(5) Effect of Personal Ability and Bias of the Analyst : Figures given in financial
statements do not speak by themselves, hence, any conclusion can be drawn from these
figures. Conclusions obtained from the analysis of these figures are affected to a great extent
by the personal ability and knowledge of the analyst. For example, for calculating ‘return on
capital’ one analyst may consider the profits after taxes, whereas, the other analyst may
consider the profits before taxes. Similarly, the term ‘Capital’ may mean only the
‘Shareholder’s Funds’ for one analyst, whereas the other analyst may take the ‘Shareholder’s
Funds and Long Term Debts’ as capital.
(6) Difficulty in Forecasting : Financial statements are a record of past events and historical
facts. In the fast changing and developing modem business, the analysis of past information
may not be of much use in future forecasting. Continuous changes take place in the demand
of the product, policies adopted by the firm, the position of competition etc. As such, no
estimate based on the analysis of historical facts can be made for future.
(7) Lack of Qualitativ e Analysis Financial statements record only those events and
transactions which can be expressed in terms of money. Qualitative aspects of business units
are omitted from the books at all as these cannot be expressed in monetary terms. Thus,
changes in management, reputation of the business, cordial management-labour relations,
firm’s ability to develop new products, efficiency of management, satisfaction of firm’s
customers etc. which have a vital bearing on the profitability of the company are all ignored
and omitted from being recorded because all of these are qualitative in nature.
(8) Limited Use of Single Year’s Analysis of Financial Statements : Results obtained
from financial analysis assume significance only when compared with the figures of previous
periods. For example, the profit of a firm to sales is 12%, whether this is satisfactory or not
will depend upon the figures of previous years. If the firm
earned 10% of sales as profit in the previous year, it may be considered to have done better
this year. However, the financial statements of two years may not be comparable due to the
changes in accounting policies.
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It is clear from the above mentioned limitations that the results obtained from analysis of
financial statements should not be taken as the true indicators of the strength and
weaknesses of the concern. The results obtained from analysis must be read carefully and
cautiously. The limitations of analysis must be kept in mind while taking decisions based on
the results obtained from such analysis.
Very Short Answer Questions (Questions Carrying 1 Mark)
Remembering
Q. 1, W hat is meant by ‘Financial Analysis’?
Ans. Financial analysis is a systematic process of classifying the data into simple groups and
making a comparison of various groups with one another to pin-point the strong points and
weaknesses of the business.
Q. 2, List any one objective of analysing the financial statements.
(C.B.S.E. 2017, Delhi)
Ans. To measure the earning capacity of the business.
or
To measure the short-term and long-term solvency of the enterprise.
Q. 3. W hat is Horizontal Analysis?
Ans. W hen financial statements for a number of years are analysed, the analysis is called
horizontal analysis. Such analysis is mostly in the form of ‘Comparative financial statements’.
Q. 4. W hat is Vertical Analysis?
Ans. W hen financial statements for a single year are analysed, the analysis is called vertical
analysis. The items in the financial statement are expressed as a percentage to total and the
total is taken as equivalent to 100. Statements containing such analysis are termed as
‘Common Size Statements’.
Q. 5. List any two uses of analysing the financial statements.
(C.B.S.E. 2013, Set III)
Ans. 1. Helpful in taking investment decisions.
2. Helpful in taking credit decisions.
Q. 6. Give one limitation of financial analysis. (C.B.S.E. 2013, 2014)
Ans. Do not reflect price level changes.
or
Comparison is unreliable if different firms adopt different accounting policies.
Q. 7, W hat is the interest of shareholders or Investors in the analysis of financial statements?
Ans. (i) They want to judge the present and future earning capacity of the business (ii) They
want to judge the safety of their investment.
Q. 8. State the interest of tax authorities in the analysis of financial statements. Ans. (1) To
judge whether the financial statements have been prepared in
accordance with the legal provisions.
(2) To judge whether various types of taxes have been paid appropriately.
Q. 9. W hat is the interest of lenders or Bankers in the analysis of financial statements?
Ans. (i) To judge the financial soundness of the business to repay their debts at maturity.
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(ii) To judge that the enterprise has sufficient profits so as to make payment of interest
regularly throughout the term of loan.
Q. 10. Give two areas of interest for management while analysing the financial statements.
Ans. (i) To know the profitability of the business enterprise,
(ii) To know the short-term and long-term solvency position of the enterprise.
Understanding
Q. 11. How can the financial strength of a business enterprise be judged?
Ans. The financial strength of a business enterprise can be judged on the basis of
(i) its earning capacity, i.e., profitability, and (ii) its ability to repay the loans and pay
dividends.
Q. 12. How the ‘solvency’ of a business is assessed by Financial Statement Analysis?
Ans. Solvency of a business is assessed through solvency ratios, i.e.. debt equity ratio, total
assets to debt ratio and proprietary ratio.
Q. 13. How the ‘Earning Capacity of a business’ is assessed by Financial Statement
Analysis?
Ans. Earning Capacity is assessed through ‘Profitability’ ratios.
Q. 14. How is ‘window dressing’ a limitation of Financial Statement Analysis?
Ans. W indow dressing refers to the manipulation of accounts to conceal vital facts and
presentation of the ‘Financial Statements’ in a way so as to show a position better than what it
actually is. On account of such a situation financial analysis may give false information to the
users.
Q. 15. How does ‘subjectivity’ become a limitation of Financial Statement Analysis?
Ans. Subjectivity means using personal judgement in making a choice out of alternatives
available, i.e., choice in the method of depreciation or choice in the method of inventory
valuation. Since the subjectivity is inherent in personal judgement, the financial statements
are not free from bias.
Q. 16. Explain how Financial Statements Analysis ignores qualitative elements? Ans. The
qualitative elements like quality of management, quality of labour force,
public relations etc. are ignored while carrying out the Analysis of Financial Statements.
Short Answer Questions
(Questions Carrying 2 Marks)
Q. 1. State who may be interested in the analysis of financial statements and why?
Q. 2. W hat is meant by ‘Financial Analysis’? What is the interest of shareholders and
prospective investors in such analysis?
Q. 3. How is analysis of financial statements important to Government Authorities?
Q. 4. W hy is analysis of financial statements important to Creditors?
Q. 5. “Financial Analysis is affected by window-dressing and the personal ability and bias of
the analyst.” Comment.
Q. 6. W hat is horizontal analysis of financial statements?
Q. 7. W hat is vertical analysis of financial statements?
Q. 8, W hat is the importance of analysis of financial statements?
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Q. 9. State any two objectives of analysis of financial statements.
(C.B.S.E. 2015, 2016. 2017)
Q. 10. State any two limitations of analysis of financial statements?
(C.B.S.E. 2015, 2016, 2017, 2018 Comptt.)
Q. 11. One θf the objectives of ‘Financial Statement Analysis’ is to identify the reasons for
change in the financial position of the enterprise. State two more objectives of this anlaysis.
(C.B.S.E. 2016. 2017)
Ans. Objectives of ‘Financial Statements Analysis’ : (any two)
• Assessing the earning capacity or profitability of the firm as a whole as well as its different
departments so as to judge the financial health of the firm.
• Assessing the managerial efficiency by using financial ratios.
• Assessing the short-term and the long-term solvency of the enterprise.
• Assessing their own performance in comparison to other firms in the same business.
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