Chapter One: Introduction

Learning Outcome

At the end of this topic, the learner should be able

Define financial analysis and Financial statement analysis
Describe the Features of Financial Analysis
Determine the Purpose of Analysis of financial statements
Outline the Procedure of Financial Statement Analysis
Appreciate the importance of Financial Statement Analysis:
In order to make rational decisions in keeping with objectives of the firm the stakeholders

especially the managers must have at their disposal certain analytical tools. These tools of

financial analysis are important as they give a feedback as to the contents of the financial

statements. These tools are also used by outside suppliers of capital, creditors, investors

and by the firm itself. The firm uses financial analysis not only for internal controls but

also for a better understanding of what capital suppliers seeks in the way of financial

conditions and performance of it.

The type of analysis names according to specific intensities

of parties involved

agriculture and trade creditor is interested pre-mainly on the liquidity of the firm this

claim is in the short-term and the ability of the firm to pay this claim is best judged by

means of through of its liquidity.

The claim of a bond holder on the other hand is longer accordingly he would be more

interested in the cash flow ability of the form to use debts over the long run. The bond

holder thus may evaluate this ability by analyzing the capital structure of the form, the

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major sources and use of the funds, its probability over time and projections of future

profitability.

1.1 Definition

Financial analysis is a process by which finance identifies the company‟s financial

performances by comparing the entities in the balance sheet and those in the profit and

loss account (P&L). This is so because balance sheet entities are usually responsible for

those to be found in the P&L i.e. assets shown in the balance sheet are responsible for

sales, revenue and expenses to be found in the P&L. Financial statement analysis is

defined as the process of identifying financial strengths and weaknesses of the firm by

properly establishing relationship between the items of the balance sheet and the profit

and loss account. Financial statement analysis (or financial analysis) is the process of

understanding the risk and profitability of a firm (business, sub-business or project)

through analysis of reported financial information, particularly annual and quarterly

reports.

Financial statement analysis consists of 1) reformulating reported financial statements, 2)

analysis and adjustments of measurement errors, and 3) financial ratio analysis on the

basis of reformulated and adjusted financial statements. The two first steps are often

dropped in practice, meaning that financial ratios are just calculated on the basis of the

reported numbers, perhaps with some adjustments. Financial statement analysis is the

foundation for evaluating and pricing credit risk and for doing fundamental company

valuation.
There are various methods or techniques that are used in analyzing financial statements,

such as comparative statements, schedule of changes in working capital, common size

percentages, funds analysis, trend analysis, and ratios analysis.

Financial statements are prepared to meet external reporting obligations and also for

decision making purposes. They play a dominant role in setting the framework of

managerial decisions. But the information provided in the financial statements is not an

end in itself as no meaningful conclusions can be drawn from these statements alone.

However, the information provided in the financial statements is of immense use in

making decisions through analysis and interpretation of financial statements.

1.2 Features of Financial Analysis

To present a complex data contained in the financial statement in simple and

understandable form.

To classify the items contained in the financial statement inconvenient and rational

groups.

To make comparison between various groups to draw various conclusions.

1.3 Purpose of Analysis of financial statements

To know the earning capacity or profitability.

To know the solvency.

To know the financial strengths.

To know the capability of payment of interest & dividends.

To make comparative study with other firms.

/To know the trend of business.

To know the efficiency of mgt.

To provide useful information to mgt

1.4 Procedure of Financial Statement Analysis
The following procedure is adopted for the analysis and interpretation of financial

statements:-

The analyst should acquaint himself with principles and postulated of accounting. He

should know the plans and policies of the managements that he may be able to

find out whether these plans are properly executed or not.

The extent of analysis should be determined so that the sphere of work may be

decided. If the aim is find out. Earning capacity of the enterprise then analysis of

income statement will be undertaken. On the other hand, if financial position is to

be studied then balance sheet analysis will be necessary.

The financial data be given in statement should be recognized and rearranged. It

will involve the grouping similar data under same heads. Breaking down of

individual components of statement according to nature. The data is reduced to

a standard form. A relationship is established among financial statements with the

help of tools & techniques of analysis such as ratios, trends, common size, fund

flow etc.

The information is interpreted in a simple and understandable way. The significance

and utility of financial data is explained for help indecision making.

The conclusions drawn from interpretation are presented to the management in the

form of reports.

Analyzing financial statements involves evaluating three characteristics of a company:

its liquidity, its profitability, and its insolvency. A short-term creditor, such as a bank, is

primarily interested in the ability of the borrower to pay obligations when they come due.

The liquidity of the borrower is extremely important in evaluating the safety of a loan.

Along-term creditor, such as a bondholder, however, looks to profitability and solvency

measures that indicate the company‟s ability to survive over a long period of time. Long-

term creditors consider such measures as the amount of debt in the company‟s capital

structure and its ability to meet interest payments. Similarly, stockholders are interested

in the profitability and solvency of the company. They want to assess the likelihood of

dividends and the growth potential of the stock

1.5 Advantages of Financial Statement Analysis:

There are various advantages of financial statements analysis. The major benefit is that

the investors get enough idea to decide about the investments of their funds in the

specific company. Secondly, regulatory authorities like International Accounting

Standards Board can ensure whether the company is following accounting standards or

not. Thirdly, financial statements analysis can help the government agencies to analyze

the taxation due to the company. Moreover, company can analyze its own performance

over the period of time through financial statements analysis.

Review Questions
Define financial analysis and Financial statement analysis
Describe the Features of Financial Analysis
Determine the Purpose of Analysis of financial statements
Outline the Procedure of Financial Statement Analysis
Appreciate the importance of Financial Statement Analysis:

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 i) References
The Analysis and Use of Financial Statements (3rd edition) by White, Sondi &
Fried (Wiley 2003)

Financial Reporting and Analysis (4th edition) by Revsine, Collins, Johnson, and
Mittelstaedt (McGraw-Hill Irwin 2009)

Financial Statement Analysis & Valuation (2nd edition) by Easton, McAnally,

Fairfield, and Zhang (Cambridge Business Publishers 2009)