Analysis of Financial Statements — Study Notes

1. Introduction

The analysis of financial statements is the process of evaluating the financial health and performance of a company by examining its financial statements. Since the raw figures in the Balance Sheet and the Statement of Profit and Loss do not by themselves reveal the true state of affairs, they must be analysed and interpreted. Analysis helps stakeholders such as investors, creditors, management, and regulators to make informed decisions.

Financial analysis may be performed using several techniques, including comparative statements, common-size statements, trend analysis, ratio analysis, and cash flow analysis. Each technique examines the financial statements from a different angle: comparative statements compare the figures of two or more years, common-size statements express each item as a percentage of a common base, and trend analysis studies the movement of items over a series of years.

The analysis of financial statements is both a science and an art. While the calculations are based on accounting data, the interpretation requires judgement and an understanding of the business environment. The tools of analysis discussed in this chapter lay the groundwork for the detailed study of ratio analysis and the cash flow statement in the subsequent chapters.

2. Objectives of Financial Statement Analysis

The main objectives of analysing financial statements are:

1. To assess the profitability and earning capacity of the enterprise.
2. To evaluate the liquidity and solvency of the business.
3. To judge the efficiency of management in utilising the firm's resources.
4. To compare the performance of the firm over time and with other firms.
5. To forecast future performance and assist in planning.
6. To appraise the financial strength of the enterprise for credit decisions.

3. Tools of Financial Statement Analysis

3.1 Comparative Statements

A comparative statement presents the financial data of two or more periods in a comparative form, showing the absolute increase or decrease in each item and the percentage change. Comparative Balance Sheets and Comparative Statements of Profit and Loss are the two common comparative statements.

$$\text{Absolute Change} = \text{Current Year Figure} - \text{Previous Year Figure}$$

$$\text{Percentage Change} = \frac{\text{Absolute Change}}{\text{Previous Year Figure}} \times 100$$

Comparative statements help to identify trends in items such as sales, expenses, profits, assets, and liabilities.

3.2 Common-Size Statements

In a common-size statement, each item is expressed as a percentage of a common base figure. In the common-size Balance Sheet, total assets (or total equity and liabilities) is taken as 100. In the common-size Statement of Profit and Loss, revenue from operations is taken as 100.

$$\text{Common-Size Percentage} = \frac{\text{Item Value}}{\text{Base Value}} \times 100$$

Common-size statements facilitate comparison between firms of different sizes.

3.3 Trend Analysis

Trend analysis studies the behaviour of financial items over a number of years by taking a base year and expressing the figures of subsequent years as index numbers relative to the base year.

$$\text{Trend Percentage} = \frac{\text{Current Year Figure}}{\text{Base Year Figure}} \times 100$$

The base year is usually the earliest year and is assigned an index of 100. The trend percentages help in identifying the direction and magnitude of changes.

3.4 Ratio Analysis

Ratio analysis establishes the relationship between two related items of the financial statements. It is the most widely used tool of financial analysis and includes liquidity ratios, solvency ratios, activity ratios, and profitability ratios. This is studied in detail in the next chapter.

3.5 Cash Flow Statement

The cash flow statement classifies the cash flows of the enterprise into operating, investing, and financing activities, and explains the change in cash and cash equivalents during the period. This is studied in detail in the chapter on the cash flow statement.

4. Advantages and Limitations of Financial Statement Analysis

4.1 Advantages

• It simplifies the financial data into understandable information.
• It helps in judging the profitability and efficiency of the firm.
• It assists in comparing the firm's performance over time and with industry peers.
• It supports decisions on investment, credit, and dividend policy.
• It helps management in planning and controlling operations.

4.2 Limitations

• Financial statements are historical in nature and may not reflect current conditions.
• They are based on historical cost, which ignores the effect of inflation.
• Different accounting policies used by different firms reduce comparability.
• Window dressing may make the statements look better than they are.
• Qualitative factors such as the skill of management and market reputation are not captured.
• The analysis depends on the accuracy of the data and the judgement of the analyst.

Quick Revision Tables

Table 1: Tools of Financial Statement Analysis

Table 2: Comparative vs Common-Size Statements

Table 3: Advantages and Limitations

Mind Map

Important Diagrams (SVG)

Diagram 1: Tools of Financial Statement Analysis

Diagram 2: Common-Size Balance Sheet Approach

Common Mistakes

1. Using the previous year's figure in the numerator instead of the denominator while computing percentage change.
2. Choosing the wrong base for a common-size statement; the base for the Balance Sheet is total assets, not revenue.
3. Taking revenue from operations as the base in a common-size Balance Sheet.
4. Selecting an inappropriate base year for trend analysis, which distorts the entire comparison.
5. Treating ratio analysis and cash flow analysis as unnecessary since they are studied separately; all tools are part of financial statement analysis.
6. Overlooking the fact that financial statements are historical and cost-based while interpreting results.
7. Ignoring qualitative factors and relying solely on quantitative analysis.

Exam Tips

1. While preparing comparative statements, show the absolute change and the percentage change for each item in separate columns.
2. Round off percentages to two decimal places to keep the presentation neat.
3. In common-size statements, verify that the percentages of all components total to 100.
4. For trend analysis, choose the earliest year as the base year and compute the index numbers correctly.
5. Mention the limitations of financial statement analysis in descriptive answers to score full marks.
6. Practise the numerical aspects of comparative and common-size statements since they are frequently tested.
7. Relate the results of analysis to liquidity, solvency, and profitability while interpreting.

Conclusion

The analysis of financial statements converts raw accounting data into meaningful information for decision-making. Comparative statements, common-size statements, trend analysis, ratio analysis, and the cash flow statement are the principal tools of analysis, each providing a distinct perspective on the firm's liquidity, solvency, and profitability. While the analysis has many advantages, its limitations such as the historical nature of data, the effect of inflation, and window dressing must be kept in view. A thorough grasp of these tools prepares the student for the detailed study of ratio analysis and cash flow statements in the following chapters.