CHAPTER: 2

Financial statement analysis and their objectives:

The term ‘financial analysis’ also known as analysis and interpretation of

financial statements’, refers to the process of determining financial strengths and
weaknesses of the firm by establishing strategic relationship between the items of the
balance sheet, profit and loss account and other operative data.

In the words of Myer, “Financial statement analysis is largely a study of

relationship among the various financial factors in a business as disclosed by a single set-
of statements and a study of the trend of these factors as shown in a series of
statements”.

The major purpose of financial analysis is to diagnose the information

contained in financial statements so as to judge the profitability and financial soundness of
the firm. So a financial analyst analyses the financial statements with various tools of
accounting before commenting upon the financial health or weaknesses of an enterprise.
However, both analysis and interpretation are interlinked and complimentary to each
other. Analysis is useless without interpretation and interpretation without analysis is
impossible. So, financial statements are the sources of information on the basis of which
conclusions are drawn about the profitability and financial position of a concern. They are
the major means employed by firms to present their financial situation to owners, creditors
and the general public. The primary objective of financial statements is to assist in
decision making. According to John N.Myer, “The financial statements are composed of
data which are the result of a combination of (1) recorded facts concerning the business
transactions, (2) conventions adopted to facilitate the accounting technique, (3)
postulates, or assumptions made to and (4) personal judgements used in the application
of the conventions and postulates”.

Objectives: 1. To assess the earning capacity or profitability of the firm.

2. To assess the operational efficiency and managerial effectiveness of

the firm.

3. To assess the short term as well as long term solvency position of the
firm
 4. To make forecasts about future prospects of the firm.

5. To assess the progress of the firm over a period of time.

6 .To help in decision making and control

7. To provide reliable financial information about economic resources and

obligations of a business firm.

8. To provide other needed information about changes in such economic

resources and obligations.

Tools to be used in measuring the financial performance of

AMUL INDIA:

1. Comparative Statements: It is a tool of financial analysis used to

study the magnitude and direction of changes in the financial position
and performance of a firm over a period of time. The preparation of
comparative statements is based on the premise that a statement
covering a period of a number of years. These are of two types:
1.1 Comparative balance sheet
1.2 Comparative Income statement
1.1 Comparative balance sheet: It is prepared to show different assets,
liabilities and capital as on two or more dates so as to compare and ascertain
any increase or decrease in absolute items and also percentage of changes.
A comparative balance sheet contains the following items:
(i) Particulars Column.
(ii) Data of Previous period/year’s balance sheet.
(iii) Data of the current year’s balance sheet.
(iv) Increase or decrease in the absolute data.
(v) Percentage change of increase or decrease of data.
1.2 Comparative income statement: The income statement gives the results
of the operations of a business. It shows the net profit or net loss on account of
business operations. It gives an idea of the progress of a business over a period
of time. The changes in absolute data in money values and percentages can be
determined to analyse the profitability of the business.
 A comparative income statement, like a comparative balance sheet contains the
following columns:
(i) Particulars Columns.
(ii) Data of previous period/year’s statement of profit and loss.
(iii) Data of current period/year’s statement of profit and loss.
(iv) Increase or decrease in the absolute data.
(v) Percentage change of increase or decrease.
2. Common-Size Statements: The common-size statements,
balance sheet and income statement are shown in analytical
percentages. The figures are shown as percentages of (statement of
profit and loss), (total assets revenue from operations), total liabilities
and total sales. The total assets are taken as 100 and different assets
are expressed as a percentage of the total. Similarly, various liabilities
are taken as a part of total liabilities. These statements are also known
as component percentage or 100 per cent statements because every
individual item is stated as a percentage of the total 100. Types of
these statements are:
2.1 Common Size balance sheet
2.2 Common Size income statement

2.1Common-Size balance sheet: It is a statement in which balance sheet

items are expressed as the ratio of each asset to total assets and the ratio of each
liability as a ratio of total liabilities is called common-size balance sheet.

2.2Common-size income statement: The items of profit and loss can be

shown as percentages of revenue from operations (sales) to show the relation of
each item to sales. A significant relationship can be established between items of
income statement and volume of sales.

3. Ratio Analysis: A ratio is a simple arithmetical expression of the

relationship of one number to another. It may be defined as the indicated quotient of
two mathematical expressions. According to Account’s Handbook by Wixon, Kell and
Bedford, a ratio “is an expression of the quantitative relationship between two
numbers”. Types of analysis to be done through various ratios:
 3.1Short term solvency:

(i) Current ratio or Working capital ratio: Current ratio may be defined as
the relationship between current assets and current liabilities. It is a measure of
general liquidity and is most widely used to make the analysis of a short-term
financial position or liquidity of a firm.

(ii) Liquid or Acid test ratio: It is more rigorous test of liquidity than the
current ratio. It may be defined as the relationship between the liquid asets and the
current liabilities.

(iii) Absolute liquid or Cash ratio: Absolute liquid ratio includes cash in
hand and at bank and marketable securities excluding the debtors and other
receivables.

3.2 Long term solvency:

(i) Debt-Equity ratio: It is calculated to measure the relative claim of

outsiders and the owners ie shareholders against the firm’s assets. This ratio
indicates the relationship between the external equities and the internal equities.

(ii) Debt to capitalisation ratio: It establishes the long-term funds from

outsiders and total long-term funds available in the business ie the Funded Debt and
Total Capitalisation.

(iii) Interest Coverage ratio: