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Analysis of Financial Statements

Analysis of Financial Statements

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Finance, Accounting, Financial statements, Analysis
Finance, Accounting, Financial statements, Analysis

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Published by: Apollo Institute of Hospital Administration on Dec 02, 2009
Copyright:Attribution Non-commercial

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03/15/2013

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Y
ou have learnt about the financial statements(Income Statement and Balance Sheet) ofcompanies. Basically, these are summarisedfinancial reports which provide the operating resultsand financial position of companies, and the detailedinformation contained therein is useful for assessingthe operational efficiency and financial soundnessof a company. This requires proper analysis andinterpretation of such information for which anumber of techniques (tools) have been developedby financial experts. In this chapter we will have anoverview of these techniques.
4.1 Meaning of Analysis of Financial Statements
The process of critical evaluation of the financialinformation contained in the financial statements inorder to understand and make decisions regardingthe operations of the firm is called ‘FinancialStatement Analysis’. It is basically a study ofrelationship among various financial facts andfigures as given in a set of financial statements, andthe interpretation thereof to gain an insight into theprofitability and operational efficiency of the firm toassess its financial health and future prospects.The term ‘financial analysis’ includes both‘analysis and interpretation’. The term analysismeans simplification of financial data by methodicalclassification given in the financial statements.Interpretation means explaining the meaning andsignificance of the data. These two arecomplimentary to each other. Analysis is useless
L
EARNING
O
BJECTIVES
 After studying this chapter,you will be able to :
explain the nature and significance of financialanalysis;
identify the objectives of financial analysis;
describe the various toolsof financial analysis;
state the limitations of financial analysis;
 prepare comparative and commonsize statementsand interpret the datagiven therein; and 
calculate the trend  percentages and interpretthem.
Analysis of Financial Statements
4
 
without interpretation, and interpretation without analysis is difficult or evenimpossible.
Box
Financial statement analysis is very aptly defined by Bernstein as, “a judgementalprocess which aims to estimate current and past financial positions and theresults of the operation of an enterprise, with primary objective of determiningthe best possible estimates and predictions about the future conditions.” Itessentially involves regrouping and analysis of information provided by financialstatements to establish relationships and throw light on the points of strengthsand weaknesses of a business enterprise, which can be useful in decision-makinginvolving comparison with other firms (cross sectional analysis) and with firms’own performance, over a time period (time series analysis).
4.2Significance of Financial Analysis
Financial analysis is the process of identifying the financial strengths andweaknesses of the firm by properly establishing relationships between the variousitems of the balance sheet and the profit and loss account. Financial analysiscan be undertaken by management of the firm, or by parties outside the firm,viz. owners, trade creditors, lenders, investors, labour unions, analysts andothers. The nature of analysis will differ depending on the purpose of the analyst. A technique frequently used by an analyst need not necessarily serve the purposeof other analysts because of the difference in the interests of the analysts.Financial analysis is useful and significant to different users in the followingways:(a)
Finance manager:
Financial analysis focusses on the facts andrelationships related to managerial performance, corporate efficiency,financial strengths and weaknesses and creditworthiness of the company. A finance manager must be well-equipped with the different tools ofanalysis to make rational decisions for the firm. The tools for analysishelp in studying accounting data so as to determine the continuity of theoperating policies, investment value of the business, credit ratings andtesting the efficiency of operations. The techniques are equally importantin the area of financial control, enabling the finance manager to makeconstant reviews of the actual financial operations of the firm to analysethe causes of major deviations, which may help in corrective actionwherever indicated.(b)
Top management:
The importance of financial analysis is not limited tothe finance manager alone. Its scope of importance is quite broad whichincludes top management in general and the other functional managers.
201 Analysis of Financial Statements
 
202Accountancy : Company Accounts and Analysis of Financial Statements
Management of the firm would be interested in every aspect of the financialanalysis. It is their overall responsibility to see that the resources of thefirm are used most efficiently, and that the firm’s financial condition issound. Financial analysis helps the management in measuring thesuccess or otherwise of the company’s operations, appraising theindividual’s performance and evaluating the system of internal control.(c)
Trade creditors:
 
 A trade creditor, through an analysis of financialstatements, appraises not only the urgent ability of the company to meetits obligations, but also judges the probability of its continued ability tomeet all its financial obligations in future. Trade creditors are particularlyinterested in the firm’s ability to meet their claims over a very short periodof time. Their analysis will, therefore, confine to the evaluation of thefirm’s liquidity position.(d)
Lenders:
Suppliers of long-term debt are concerned with the firm’s long-term solvency and survival. They analyse the firm’s profitability overtime,its ability to generate cash to be able to pay interest and repay the principaland the relationship between various sources of funds (capital structurerelationships). Long-term tenders do analyse the historical financialstatements. But they place more emphasis on the firm’s projected financialstatements to make analysis about its future solvency and profitability.(e)
Investors:
Investors, who have invested their money in the firm’s shares,are interested about the firm’s earnings. As such, they concentrate onthe analysis of the firm’s present and future profitability. They are alsointerested in the firm’s capital structure to ascertain its influences onfirm’s earning and risk. They also evaluate the efficiency of themanagement and determine whether a change is needed or not. However,in some large companies, the shareholders’ interest is limited to decidewhether to buy, sell or hold the shares.(f)
Labour unions:
Labour unions analyse the financial statements to assesswhether it can presently afford a wage increase and whether it can absorba wage increase through increased productivity or by raising the prices.(g)
Others:
The economists, researchers, etc. analyse the financial statementsto study the present business and economic conditions. The governmentagencies need it for price regulations, taxation and other similar purposes.
4.3Objectives of Financial Analysis
 Analysis of financial statements reveals important facts concerning managerialperformance and the efficiency of the firm. Broadly speaking, the objectives ofthe analysis are to apprehend the information contained in financial statements

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