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We know business is mainly concerned with the financial activities. In order to ascertain the financial status of the business every enterprise prepares certain statements, known as financial statements. Financial statements are mainly prepared for decision making purpose. But the information as is provided in the financial statements is not adequately helpful in drawing a meaningful conclusion. Thus, an effective analysis and interpretation of financial statements is required. Analysis means establishing a meaningful relationship between various items of the two financial statements with each other in such a way that a conclusion is drawn. By financial statements we mean two statements: (i) Profit and loss Account or Income Statement (ii) Balance Sheet or Position Statement These are prepared at the end of a given period of time. They are the indicators of profitability and financial soundness of the business concern. The term financial analysis is also known as analysis and interpretation of financial statements. It refers to the establishing meaningful relationship between various items of the two financial statements i.e. Income statement and position statement. It determines financial strength and weaknesses of the firm. Analysis of financial statements is an attempt to assess the efficiency and performance of an enterprise. Thus, the analysis and interpretation of financial statements is very essential to measure the efficiency, profitability, financial soundness and future prospects of the business units. Types of financial statement are: 1) Comparative statement 2) Common size statement 3) Trend analysis
Financial analysis serves the following purposes:
1. Measuring the profitability The main objective of a business is to earn a satisfactory return on the funds invested in it. Financial analysis helps in ascertaining whether adequate profits are being earned on the capital invested in the business or not. It also helps in knowing the capacity to pay the interest and dividend. 2. Indicating the trend of Achievements
Financial statements of the previous years can be compared and the trend regarding various expenses, purchases, sales, gross profits and net profit etc. can be ascertained. Value of assets and liabilities can be compared and the future prospects of the business can be envisaged. Assessing the growth potential of the business. The trend and other analysis of the business provides sufficient information indicating the growth potential of the business. 3. Comparative position in relation to other firms The purpose of financial statements analysis is to help the management to make a comparative study of the profitability of various firms engaged in similar businesses. Such comparison also helps the management to study the position of their firm in respect of sales, expenses, profitability and utilising capital, etc. 4. Assess overall financial strength The purpose of financial analysis is to assess the financial strength of the business. Analysis also helps in taking decisions, whether funds required for the purchase of new machines and equipments are provided from internal sources of the business or not if yes, how much? And also to assess how much funds have been received from external sources. 5. Assess solvency of the firm The different tools of an analysis tell us whether the firm has sufficient funds to meet its short term and long term liabilities or not.
Analysis of financial statements has become very significant due to widespread interest of various parties in the financial results of a business unit. The various parties interested in the analysis of financial statements are: (i) Investors : Shareholders or proprietors of the business are interested in the well being of the business. They like to know the earning capacity of the business and its prospects of future growth. (ii)Management : The management is interested in the financial position and performance of the enterprise as a whole and of its various divisions. It helps them in
preparing budgets and assessing the performance of various departmental heads. (iii)Trade unions : They are interested in financial statements for negotiating the wages or salaries or bonus agreement with the management.
(iv) Lenders :
Lenders to the business like debenture holders, suppliers of loans and lease are interested to know short term as well as long term solvency position of the entity. (v)Suppliers and trade creditors : The suppliers and other creditors are interested to know about the solvency of the business i.e. the ability of the company to meet the debts as and when they fall due.
(vi)Tax authorities :
Tax authorities are interested in financial statements for determining the tax liability.
They are interested in financial statements in undertaking research work in business affairs and practices. (viii)Employees : They are interested to know the growth of profit. As a result of which they can demand better remuneration and congenial working environment. (ix)Government and their agencies : Government and their agencies need financial information to regulate the activities of the enterprises/ industries and determine taxation policy. They suggest measures to formulate policies and regulations. (x)Stock exchange : The stock exchange members take interest in financial statements for the purpose of analysis because they provide useful financial information about companies. Thus, we find that different parties have interest in financial statements for different reasons.
Comparative statements are financial statements that cover a different time frame, but are formatted in a manner that makes comparing line items from one period to those of a different period an easy process. This quality means that the comparative statement is a financial statement that lends itself well to the process of comparative analysis. Many companies make use of standardized formats in accounting functions that make the generation of a comparative statement quick and easy.
IMPORTANCE AND USES
The benefits of a comparative statement are varied for a corporation. Because of the uniform format of the statement, it is a simple process to compare the gross sales of a given product or all products of the company with the gross sales generated in a previous month, quarter, or year. Comparing generated revenue from one period to a different period can add another dimension to analyzing the effectiveness of the sales effort, as the process makes it possible to identify trends such as a drop in revenue in spite of an increase in units sold. Along with being an excellent way to broaden the understanding of the success of the sales effort, a comparative statement can also help address changes in production costs. By comparing line items that catalogue the expense for raw materials in one quarter with another quarter where the number of units produced is similar can make it possible to spot trends in expense increases, and thus help isolate the origin of those increases. This type of data can prove helpful to allowing the company to find raw materials from another source before the increased price for materials cuts into the overall profitability of the company.
A comparative statement can be helpful for just about any organization that has to deal with finances in some manner. Even non-profit organizations can use the comparative statement method to ascertain trends in annual fund raising efforts. By making use of the comparative statement for the most recent effort and comparing the figures with those of the previous year’s event, it is possible to determine where expenses increased or decreased, and provide some insight in how to plan the following year’s event.
FEATURES OF COMPARITIVE STATEMENTS:1) A comparative statement adds meaning to the financial data. 2) It is used to effectively measure the conduct of the business activities. 3) Comparative statement analysis is used for intra firm analysis and inters firm analysis. 4) A comparative statement analysis indicates change in amount as well as change in percentage. 5) A positive change in amount and percentage indicates an increase and a negative change in amount and percentage indicates a decrease. 6) If the value in the first year is zero then change in percentage cannot be indicated. This is the limitation of comparative statement analysis. While interpreting the results qualitative inferences need to be drawn. 7) It is a popular tool useful for analysis by the financial analysts. 8) A comparative statement analysis cannot be used to compare more than two years financial data.
COMMON SIZE FINANCIAL STATEMENTS
Common size ratios are used to compare financial statements of differentsize companies or of the same company over different periods. By expressing the items in proportion to some size-related measure, standardized financial statements can be created, revealing trends and providing insight into how the different companies compare. The common size ratio for each line on the financial statement is calculated as follows: Item of Interest Common Size Ratio = Reference Item For example, if the item of interest is inventory and it is referenced to total assets (as it normally would be), the common size ratio would be: Inventory Common Size Ratio for Inventory =
The ratios often are expressed as percentages of the reference amount. Common size statements usually are prepared for the income statement and balance sheet, expressing information as follows: • • Income statement items - expressed as a percentage of total revenue Balance sheet items - expressed as a percentage of total assets
The following example income statement shows both the rupee amounts and the common size ratios:
Common Size Income Statement
Income Statement Revenue 70,134 Common-Size Income Statement 100%
Cost of Goods Sold Gross Profit SG&A Expense Operating Income Interest Expense Provision for Taxes Net Income
44,221 25,913 13,531 12,382 2,862 3,766 5,754
19.3% 17.7% 4.1% 5.4% 8.2%
For the balance sheet, the common size percentages are referenced to the total assets. The following sample balance sheet shows both the dollar amounts and the common size ratios:
Common Size Balance Sheet
Balance Sheet ASSETS Cash & Marketable Securities Accounts Receivable Inventory Total Current Assets Property, Plant, & Equipment Total Assets 6,029 14,378 17,136 37,543 2,442 39,985 15.1% 36.0% 42.9% 93.9% 6.1% 100% CommonSize Balance Sheet
LIABILITIES AND SHAREHOLDERS' EQUITY Current Liabilities Long-Term Debt 14,251 12,624 35.6% 31.6%
Total Liabilities Shareholders' Equity Total Liabilities & Equity
26,875 13,110 39,985
67.2% 32.8% 100%
The above common size statements are prepared in a vertical analysis, referencing each line on the financial statement to a total value on the statement in a given period. The ratios in common size statements tend to have less variation than the absolute values themselves, and trends in the ratios can reveal important changes in the business. Historical comparisons can be made in a timeseries analysis to identify such trends. Common size statements also can be used to compare the firm to other firms. Comparisons Between Companies (Cross-Sectional Analysis) Common size financial statements can be used to compare multiple companies at the same point in time. A common-size analysis is especially useful when comparing companies of different sizes. It often is insightful to compare a firm to the best performing firm in its industry (benchmarking). A firm also can be compared to its industry as a whole. To compare to the industry, the ratios are calculated for each firm in the industry and an average for the industry is calculated. Comparative statements then may be constructed with the company of interest in one column and the industry averages in another. The result is a quick overview of where the firm stands in the industry with respect to key items on the financial statements
FEATURES OF COMMON SIZE STATEMENT
1. A common size statement analysis indicates the relation of each component to the whole. 2. In case of a Common Size Income statement analysis Net Sales is taken as 100% and in case of Common Size Balance Sheet analysis total funds available/total capital employed is considered as 100%. 3. It is used for vertical financial analysis and comparison of two business enterprises or two years financial data. 4. Absolute figures from the financial statement are difficult to compare but when converted and expressed as percentage of net sales in case of income statement and in case of Balance Sheet as percentage of total net assets or total funds employed it becomes more meaningful to relate.
5. A common size analysis is a type of ratio analysis where in case of income statement sales is the denominator (base) and in case of Balance Sheet funds employed or total net assets is the denominator (base) and all items are expressed as a relation to it. 6. In case of common size statement analysis the absolute figures are converted to proportions for the purpose of inter-firm as well as intra-firm analysis. .
As with financial statements in general, the interpretation of common size statements is subject to many of the limitations in the accounting data used to construct them. For example: 1. Different accounting policies may be used by different firms or within the same firm at different points in time. Adjustments should be made for such differences. 2. Different firms may use different accounting calendars, so the accounting periods may not be directly comparable.
Trend analysis calculates the percentage change for one account over a period of time of two years or more.
To calculate the percentage change between two periods: Calculate the amount of the increase/ (decrease) for the period by subtracting the earlier year from the later year. If the difference is negative, the change is a decrease and if the difference is positive, it is an increase. Divide the change by the earlier year's balance. The result is the percentage change.
Calculation of Percentage Change : (amount in 000 rupees) (N/M: not meaningful) 2001 Cash Accounts Receivable, net 6,950 18,56 7 2000 6,330 19,33 0 Increase/ (Decrease) 620 (763) Percent Change 9.8% (3.9%)
Sales Rent Expense Net Income (Loss)
129,0 00 10,00 0 8,130
103,0 00 0
25.2% N/M N/M
(1,400 9,530 )
1. 2000 is the earlier year so the amount in the 20X0 column is
subtracted from the amount in the 2001 column. 2. The percent change is the increase or decrease divided by the earlier amount (2000 in this example) times 100. Written as a formula, the percent change is:
3. If the earliest year is zero or negative, the percent calculated will not be meaningful. N/M is used in the above table for not meaningful.
4. Most percents are rounded to one decimal place unless more are meaningful. 5. A small absolute rupee item may have a large percentage change and be considered misleading.
To calculate the change over a longer period of time—for example, to develop a sales trend—follow the steps below: 1. Select the base year. 2. For each line item, divide the amount in each non base year by the amount in the base year and multiply by 100. 3. In the following example, 2007 is the base year, so its percentages (see bottom half of the following table) are all 100.0. The percentages in the other years were calculated by dividing each amount in a particular year by the corresponding amount in the base year and multiply by 100. Calculation of Trend Percentages (amount in rupees) 2001 Historical Data Inventory Property & equipment Current liabilities Sales 12,30 12,20 12,10 11,97 11,74 9 2 2 3 3 74,42 2 27,94 5 129,0 00 78,93 64,20 65,23 68,45 8 3 9 0 30,34 27,67 28,25 26,73 7 0 9 7 97,00 95,00 87,00 81,00 0 0 0 0 59,74 48,10 47,20 45,50 0 0 0 0 38,05 32,99 29,69 27,05 5 0 0 0 (1,40 7,869 5,093 3,812 0) 2000 2009 2008 2007
Cost of goods sold 70,95 0 Operating expenses Net income (loss) 42,60 0 8,130
2001 Trend Percentages Inventory Property & equipment Current liabilities Sales 104.8 108.7 104.5 159.3
2000 2009 2008 2007
103.9 103.1 102.0 100.0 115.3 93.8 95.3 100.0
113.5 103.5 105.7 100.0 119.8 117.3 107.4 100.0 131.3 105.7 103.7 100.0 140.7 122.0 109.8 100.0 (36.7) 206.4 133.6 100.0
Cost of goods sold 155.9 Operating expenses Net income (loss) 157.5 213.3
Calculation notes: 1. The base year trend percentage is always 100.0%. A trend percentage of less than 100.0% means the balance has decreased below the base year level in that particular year. A trend percentage greater than 100.0% means the balance in that year has increased over the base year. A negative trend percentage represents a negative number. 2. If the base year is zero or negative, the trend percentage calculated will not be meaningful. 3. In this example, the sales have increased 59.3% over the five-year period while the cost of goods sold has increased only 55.9% and the operating expenses have increased only 57.5%. The trends look different if evaluated after four years. At the end of 2000, the sales had increased almost 20%, but the cost of goods sold had increased 31%, and the operating expenses had increased almost 41%. These 2000 trend percentages reflect an unfavourable impact on net income because costs increased at a faster rate than sales. The trend percentages for net income appear to be higher because the base year amount is much smaller than the other balances.
FEATURES OF TREND ANALYSIS
1) In case of a trend analysis all the given years are arranged in an ascending order. 2) The first year is termed as the “Base year” and all figures of the base year are taken as 100%. 3) Item in the subsequent years are compared with that of the base year. 4) If the percentages in the following years is above 100% it indicates an increase over the base year and if the percentages are below 100% it indicates a decrease over the base year. 5) A trend analysis gives a better picture of the overall performance of the business. 6) A trend analysis helps in analysing the financial performance over a period of time. 7) A trend analysis indicates in which direction a business is moving i.e. upward or downwards. 8) A trend analysis facilitates effective comparative study of the financial performance over a period of time. 9) For trend analysis at least three years financial data is essential. Broader the base the more reliable is the data and analysis.
1. 2. 3. 4. 5. 6. 7. 8.
JAIVEER DUGGAL HARDIK GOKEL AFTAB KHAN RAJDEEP PANDERE POOJA PATIL RITEN SAKHIYA SAGAR SANGANI SWATI TIKKU
21 29 45 71 76 85 86 101
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