Module - 3 Analysis of Financial Statements

Syllabus: Limitations of Financial Statements; Meaning and Purpose of Financial Statement

Analysis, Trend Analysis, Comparative Analysis, Financial Ratio Analysis, Preparation of
Financial Statements using Financial Ratios, Case Study on Financial Ratio Analysis.
Preparation of Cash flow Statement (indirect method).

Financial statement analysis

Financial statement analysis is the process of examining relationships among financial

statement elements and making comparisons with relevant information. It is a valuable tool
used by investors and creditors, financial analysts, and others in their decision-making
processes related to stocks, bonds, and other financial instruments.

Process of Financial Statement Analysis

Following are the main functions that are used in the process of analysis and interpretation of
Financial Statement.

 Rearrangement of Financial Statements: It is necessary to reclassify the complex

data contained in the financial statement into purposive classes so that maximum
desired information from every data for analysis can be obtained.
 Comparison: Once the classification of the complex data is done, it is necessary to
obtain comparative data of the same enterprise of the past periods if it is a time series
analysis. If it is a cross sectional analysis, it is necessary to obtain comparative data of
the same accounting period of similar or comparable enterprises.
 Analysis: The comparative financial data is then analysed with reference to financial
characteristics like profitability, solvency and liquidity.
 Interpretation: This is the concluding part of the financial statement analysis. The
interpretation should be precise and directed towards indicating the movement if
various financial characteristics

Limitation of Financial Statement

• Financial statements are derived from historical costs.

• Financial statements are not adjusted for inflation.
• Financial statements do not contain some intangible assets.
• Financial statements only cover a specific period of time.
• Financial statements may not be comparable.
• Financial statements could be wrong due to fraud.

USERS OF FINANCIAL STATEMENTS ANALYSIS

 1. Creditors: Creditors are concerned with the company’s ability to pay interest and
principal when due and are concerned with the company’s cash flow ability.
 2. Shareholders: Shareholders provide company with the much needed capital and are
interested to know company’s ability to pay dividend, and growth of dividends and
maximize shareholders wealth.
 3. Prospective Investors: Financial statement analysis is used by the prospective
investors to evaluate the attractiveness of the investment in the business.

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Module - 3 Analysis of Financial Statements

 4. Management: Management uses financial statement analysis to analysis the

efficiency of operations and make important business decisions. For example whether
or not to continue or discontinue part of its business, to make or buy certain material,
or to acquire or rent/lease certain equipment.
 5. Regulatory Authorities: For publicly traded companies, financial statements are
analyzed to ensure compliance to various rules and regulations.

Process of Financial Analysis

The detailed process of conducting financial analysis is summarized in the below Exhibit

Financial Statement
Analysis Framework

1. Reformulating Reported Financial Statements:

Reformulating reported financial statement is restating financial statement in such a way that
financial statements serve the purpose of analysis better and allows to more efficiently and
accurately interpret the performance of the company. In case of income statement
reformulation takes form of dividing reported items into recurring and non-recurring items,
separating earnings into core and transitory earnings. In case of balance sheet reformulation
takes form of breaking the balance sheet items into operating assets/liabilities and financial
asset/liabilities. For cash flow statements removing financing activities(for example interest
expense) from cash flow from operations etc.

2. Adjustments of Measurement Errors: Adjustment of measurement errors is done to remove

the noise present in the input data to enhance the quality of the reported accounting numbers.
For example removing the R&D expenses from the income statement and showing in the
balance sheet.

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3. Financial Ratio Analysis on the Basis of Reformulated and Adjusted Financial Statements:
Conducting ratio analysis on the adjusted financial statements involves calculating various
ratios to derive insight about the performance of a company.

Phase Sources of Information Output

1. Articulate the purpose and The nature of the analyst’s function, Statement of the purpose or
context of the analysis. such as evaluating an equity or debt objective of analysis
investment or issuing a credit rating.
A list (written or unwritten) of
Institutional guidelines related to specific questions to be
developing specific work product. answered by the analysis.

Nature and content of report to

be provided Timetable and
budgeted resources for
completion.
2. Collect data Financial statements, other financial Organized financial
data, questionnaires, and industry / statements.
economic data.
Financial data tables.
Discussions with management,
suppliers, customers, and Completed questionnaires, if
competitors, Company site visits applicable
(e.g., to production facilities or retails
stores).
3. Process data Data from the previous phase, Adjusted financial statements,

Common-size statements.

Ratios and graphs.

Forecasts.
4. Analyze / interpret the Input data as well as processed data. Analytical results.
processed data.
5. Develop and communicate Analytical results and previous Analytical report answering
conclusions and reports. questions posed in Phase 1.
recommendations (e.g.,
with an analysis report). Institutional guidelines for published Recommendation regarding the
reports. purpose of the analysis, such as
whether to make an investment
or grant credit.
6. Follow up. Information gathered by periodically Updated report and
repeating above steps as necessary to recommendations.
determine whether changes to
holdings or recommendations are
necessary.

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ATTRIBUTES OF GOOD FINANCIAL STATEMENT ANALYSIS

 1. Objectivity: Results of financial statement analysis should be analyzed objectively

to reduce the possibility of any behavioral bias to minimum.
 2. Precision and Brevity: Financial statement analysis should done with precision and
should provide relevant information in concise form.
 3. Understandability: Information provided by financial statement analysis should be
presented in such a way that the analysis fosters understandability.
 4. Relevance: Analysis of financial statement should be relevant to the purpose of the
analysis. Financial statements used in analysis should be timely and should have a
predictive value.
 5. Reliability: The information derived from the analysis of financial statement must
be free of material error and bias and should provide full and fair disclosure of the
financial performance and other relevant information.

TOOLS OF FINANCIAL ANALYSIS

Tools Of
Financial
Analysis

 Comparative Statements: These are the statements showing the profitability and
financial position of a firm for different periods of time ina comparative form to give
an idea about the position of two or more periods.It usually applies to the two
important financial statements, namely,balance sheet and statement of profit and loss
prepared in a comparativeform.

The financial data will be comparative only when same accountingprinciples

are used in preparing these statements. If this is not the case,the deviation in the use of
accounting principles should be mentioned asa footnote. Comparative figures indicate
the trend and direction of financialposition and operating results. This analysis is also
known as ‘horizontalanalysis’.

 Common-size Statements: These are the statements which indicate the relationship
of different items of a financial statement with a common item by expressing each
item as a percentage of that common item. The percentage thus calculated can be
easily compared with the results of corresponding percentages of the previous year or
of some other firms, as the numbers are brought to common base. Such statements

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also allow an analyst to compare the operating and financing characteristics of two
companies of different sizes in the same industry.

Thus, common size statements are useful, both, in intra-firm comparisons over
different years and also in making inter-firm comparisons for the same year or for
several years. This analysis is also known as ‘Vertical analysis’.

 Trend Analysis: It is a technique of studying the operational results andfinancial

position over a series of years. Using the previous years’ data of abusiness enterprise,
trend analysis can be done to observe the percentagechanges over time in the selected
data. The trend percentage is thepercentage relationship, in which each item of
different years bear to thesame item in the base year.

Trend analysis is important because, with itslong run view, it may point to
basic changes in the nature of the business.By looking at a trend in a particular ratio,
one may find whether the ratiois falling, rising or remaining relatively constant. From
this observation, aproblem is detected or the sign of good or poor management is
detected.

 Ratio Analysis: It describes the significant relationship which exists between various
items of a balance sheet and a statement of profit and loss of a firm. As a technique of
financial analysis, accounting ratios measure the comparative significance of the
individual items of the income and position statements. It is possible to assess the
profitability, solvency and efficiency of an enterprise through the technique of ratio
analysis.

 Cash Flow Analysis: It refers to the analysis of actual movement of cashinto and out
of an organization. The flow of cash into the business is called as cash inflow or
positive cash flow and the flow of cash out of the firm iscalled as cash outflow or a
negative cash flow. The difference between theinflow and outflow of cash is the net
cash flow.
Cash flow statement isprepared to project the manner in which the cash has
been received andhas been utilized during an accounting year as it shows the sources
ofcash receipts and also the purposes for which payments are made. Thus,it
summarizes the causes for the changes in cash position of a businessenterprise
between dates of two balance sheets.

LIMITATION OF FINANCIAL STATEMENTS ANALYSIS

1. Comparing companies with different fiscal year end can be difficult.

2. Comparing companies with different accounting methods (for example Inventory LIFO
vs. FIFPO, depreciation method) can be difficult.
3. Estimates are as accurate as input and depends on the integrity of the input data.
4. Takes into account only quantitative factors and ignore qualitative factors such as
efficiency, loyalty and honesty of the human resource.
5. Explanation of the results of the analysis involves human decision.
6. Data based on historical events which may not hold in future.

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Formulae used in Financial Analysis

Rupee and Percentage Changes are computed by using the following formulas:

1. Dollar Change = Amount of the item in comparison year – Amount of the item in base
year

2. Percentage Change =

b. Vertical analysis: On the balance sheet, individual assets can be expressed in terms of
their relationship to total assets.

Liabilities and shareholders’ equity accounts can be expressed in terms of their relationship to
the total of liabilities and shareholders’ equity.

On the income statement, each item is stated as a percentage of sales.

In a vertical analysis the percentage is computed by using the following formula:

Percentage of base =

2. Common-Size Financial Statements: Common-size income statements provide

information concerning what proportion of sales is absorbed by cost of goods sold and
various expenses.

3. Trend Analysis: Trend analysis indicates in which direction a company is headed. Trend
percentages are computed by taking a base year and assigning its figures as a value of 100.
Figures generated in subsequent years are expressed as percentages of base-year numbers.

4. Ratio Analysis: A ratio is an expression of a mathematical relationship between one

quantity and another.

Ratios of Financial Statement Analysis

1 Current Ratio =

2 Quick Ratio =

3 Cash Ratio =

4 Defensive Interval Ratio =

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5 Receivables Turnover Ratio =

6 Days of Sales Outstanding (DSO) =

7 Inventory Turnover Ratio =

8 Days of Inventory on Hand (DOH) =

9 Payables Turnover Ratio =

10 Days Payable Outstanding (DPO) =

11 Cash Conversion Cycle (Net Operating Cycle) = DOH + DSO – DPO

12 Working Capital Turnover Ratio =

13 Fixed Asset Turnover Ratio =

14 Total Asset Turnover Ratio =

15 Gross Profit Margin =

16 Operating Profit Margin =

17 Pretax Margin =

18 Net Profit Margin =

19 Operating Return on Assets =

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20 Return on Assets =

21 Return on Equity =

22 Return on Total Capital =

23 Return on Common Equity =

24 Tax Burden =

25 Interest Burden =

26 EBIT Margin =

27 Financial Leverage Ratio (Equity Multiplier) =

28 Debt-to-Assets Ratio =

29 Debt-to-Equity Ratio =

30 Debt-to-Capital Ratio =

31 Interest Coverage Ratio =

32 Fixed Charge Coverage Ratio =

33 Dividend Payout Ratio =

34

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35 Earnings Per Share =

36 Book Value Per Share =

37 Free cash Flow to Equity (FCFE) = Cash flow from Operating Activities – Investment
in Fixed Capital + Net Borrowing

38 Free cash flow to the firm (FCFF) = Cash Flow from Operating Activities + Interest
Expenses *(1 – Tax rate) – Investment in Fixed Capital

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Module - 3 Analysis of Financial Statements

Format of Common Size Income / Profit & loss

1. Particulars 2. Base 3. Current 4. Base Curren
year year year t Year
amoun Amount % %
t
I. Revenue/Income
from operations
II. Other Incomes
III. Total Revenue/
income (I+II)
IV. Expenses
Cost of Materials
Consumed
Purchases of WIP
Changes in Inventory of
finished goods
WIP (Work in Progress) &
SIT (Stock in Trade)
Employees benefit
expenses
Finance costs
Depreciation
Amortisation Expenses
Other Expenses
Total Expenses
V. PBT (profit
before tax) (III –
IV)
VI. (-) Tax
VII. Profit after tax
(PAT)
(V-VI)

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Format: Common Size Balance sheet

Balance sheet as on
Particulars Absolute Amounts Percentage of balance sheet
total
Previous/base Current year Previous/base Current year
year amount year % %
I. Equity and Liability
1. Share holders’ funds
a) Share capital
b) Reserves and
Surplus
2. Non Current
Liabilities
a) Long term
Borrowings
b) Long term Provisions
3. Current Liabilities
a) Short-term
borrowings
b) Trade payables
c) Other current
liabilities
d) Short term provisions
TOTAL
II. Assets
1. Non-current Assets
a) Fixed assets
(tangible assets)
(intangible assets)
b) Non-current
investments
c) Long term loans and
advances
2. Current assets
a) Current investments
b) Inventories
c) Trade receivables
d) Cash and cash
equivalents
e) Short term loan and
advances
f) Other current assets
TOTAL

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Problems:

1. From the following details prepare comparative balance sheet.

Particulars 2018 2019

I. Equity and Liabilities
1. Shareholders' Funds
Share Capital 3,00,000 3,50,000
Shareholders' Fund 3,00,000 3,50,000
2. Non - Current Liabilities
Long-Term Borrowings 2,00,000 1,00,000
3. Current Liabilities
Trade Payables 1,00,000 1,50,000
Total 6,00,000 6,00,000
II. Assets
1. Non - Current Assets
Fixed Assets (Tangible) 3,00,000 4,00,000
2. Current Assets
Trade Receivables 3,00,000 2,00,000
Total 6,00,000 6,00,000

2. From the following balance sheet prepare comparative balance sheet.

Particulars 31st March 2014 31st March 2015

Shareholder's Equity:
Common Stock Rs.5,000 Rs.7,500
Retained earnings Rs.1,400 Rs.2,280
Total Shareholder's Equity: Rs.6,400 Rs.9,780
Current Liabilities:
Accounts Payable Rs.1,000 Rs.1,200
Notes Payable Rs.500 Rs.500
Interest Payable Rs.100 Rs.120
Total Current Liabilities Rs.1,600 Rs.1,820
Total Liabilities Rs.8,000 Rs.11,600
Current Assets:
Cash Rs.500 Rs.600
Accounts Receivables Rs.2,000 Rs.3,000
Inventory Rs.1,500 Rs.2,500
Total Current Assets Rs.4,000 Rs.6,100
Fixed Assets:
Buildings Rs.3,000 Rs.4,000
Furniture & office equipment’s Rs.1,000 Rs.1,500
Total Fixed Assets Rs.4,000 Rs.5,500
Total Assets Rs.8,000 Rs.11,600
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Module - 3 Analysis of Financial Statements

3. From the following Balance Sheet of Samir Auto Ltd, for the yearsended31stMaarch,2014
and 2015 prepare comparative balance sheet.

Liabilities 2014 2015 Assets 2014 2015

Equity Capital 3,00,000 4,95,000 Fixed Assets (net) 3,60,000 5,25,000
Preferential Capital 1,50,000 2,25,000 Stock 60,000 75,000
Reserves 30,000 45,000 Debtors 1,50,000 1,87,500
Profit and Loss
22,500 30,000 Bills Receivable 30,000 90,000
Account
Bank Overdraft 75,000 75,000 Pre-paid expenses 15,000 18,000
Creditors 60,000 75,000 Cash at bank 60,000 79,500
Provision for
30,000 37,500 15,000 45,000
Taxation Cash in Hand
Proposed Dividends 22,500 37,500
Total 6,90,000 10,20,000 Total 6,90,000 10,20,000

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