Welcome Approach to Financial Reporting and Financial tatement Analysis For SEM VI(Honours) period. Thus, it is a statement which shows the movement of cash between two balance sheet dates by enlisting the different sources from where cash is generated and the different uses where it spends and thereby shows the changes in cash balances. Moreover, this statement generally reflects the liquidity position of the business. As per Ind AS 7 the components of Cash Flow Statement is as follows: (i) Cash Flows from Operating Activities: Operating Activities of the business mean the production sales, and delivery of finished goods and collection of dues from debtors. In this component of cash flow statement, cash inflows consist of collection from sales of goods and services and refund of taxes, while cash outflows consist of purchasing of materials, advertising and cost of shipping the product. This also includes payment to suppliers and employees and payment of taxes (ji) Cash Flows from Investing Activities: It refers to investments and it consists of purchase of assets, gains or losses through investments in the financial market or in subsidiaries. and other related items. (iii) Cash Flows from Financing Activities: It refers to activities of business entity which enable them to mobilize funds and repayment of investors. Cash flows from financing activities might include cash dividends, adding or changing loans or issue of shares’stocks. It generally reveals the financial health of a business entity. Financial activities that involve positive cash inflows include cash from issue of shares, debentures and stocks while negative cash inflows under this activity include payment of interest or dividends, repayment of loans, buy back of shares and redemption of preference shares. 5.4 Meaning of Financial Statement Analysis: Primarily the financial statements are prepared for the purpose of making various economic decisions, Ithough the financial statements contain information relating to financial results but they are not readily usuable for making effective decision making. As such, they need to be analysed, scrutinised, evaluated and interpreted. Financial statement analysis is basically a process of identifying the strength and weakness of the concem by truely setting up the relationship between the items that are usually contained in the financial statements Itprovides assistance to the analysis in assessing the past performance on the basis of which they can predict about the future performance and the risk of the firm. In this context two important definitions can be forwarded. According to Myer, “Financial statement analysis is largely a study of relationships among the various financial factors in a business, as disclosed by a single set of statements and a study of trends of these factors, as shown in a series of statements.” Again in the words of Kennedy and Muller, “The analysis and interpretation of financial statements are an attempt to determine the significance and meaning of financial statements data so that the forecast may be made of the prospects for future eamings, ability to pay interest and debt maturities (both current and long term and profitability and sound dividend policy.” From the understanding and analysis of these two definitions, itis observed that to ascertain the significance of the information contained in the financial statements with the view to understanding the liquidity, solvency, leverage effect and the profitability of the enterprises. The analysis and interpretation of financial statements depict four steps, out of which the first three are related to the works of accountants which contain the accumulation and summarisation of financial and operation data as well the preparation of financial statements. Thus, the process includes the following steps— ‘Step 1 : Ascertainment of debit and credit along with the determination of amounts involved by analysisNts & Introduction to Financial Statement Analysis and evaluation of all transactions. Step 2 : Recording and summarisation of information develop from step 1 in the books of account and preparation of a work sheet Step 3 : Drafting of financial statements. The fourth step of this process involves the analysis and interpretation of financial statements with a view to provide information that assists business management, investors and other interested outside parties. ‘Such process can be adopted by the management and the other interested parties like the owners, creditors, investors, long term loan providers and others Thus financial statements analysis is basically learnt about the relationship among the various financial factors in a business as revealed by a single set of statements and a study of the trends of these factors as reflected in a series of statements. With reference to the analysis and interpretation of financial statements the users may come to the conclusion about the strength and weakness of the firm, make anticipation about the future and recommend the course of action to be adopted for the overall improvement. The area of modern financial statements analysis is not merely restricted to financial statements but it also covers the studies of environment—both external and internal, in which the firm is functioning. Thus at present, the process of financial statements analysis means the analysis of relevant financial ano operational data derived from the financial statements along with the non-financial factors affecting the firm such as competative and regulatory environment, employees’ morale, customers relation, risk involved, attitude of the rivals etc. The financial statement analysis involves the following steps (a) Lear about the surrounding environment in which the firm is operating. (b) Extraction of relevant information from the financial statements. (c) Classification of information derived from financial statements in such a manner so as to build up a significant relationship. (d) Drawing conclusion on the basis of evidence by applying various measuring devices of financial analysis such as ratio, preentage, trend ete 5.5 Need For Financial Statement Analysis: Itis beyond saying that the objective of the financial statement is to provide information regarding the financial result and financial position of the firm to the different users of these statements. The stakeholders may take various economic decisions on the basis of the valuable information contained in the financial statemnents. But such information is not readily usable for decision making, Ithas to be analysed, scrutinised and interpreted in proper view to make it useful for decision making, Analysis of financial statements assists the analyst to familiar with the information extracted from the financial data contained in the financial statements and to evaluate the financial health of the firm. This analysis also assists us to predict for the future and which in turn also assists us in the preparation of budgets and estimates. Thus analysis of financial statements has been done for numbers of reason. These are noted below : 1. Investment Decision : Different categories of investors may be foundin a firm. They make investment with different expections. The equity investors expecting reasonable return more or less regularly and also expect its steady growth. Long term debt providers expect to receive interest and repayment of principal amount when they fall due. Although, the expectations of different types of investors are different, but both of them feel risk in receiving their return. Therefore, here lies the need for financial statement analysis to Predict their expected returns and along with this evaluate the risk involved with those return. Accordingly they can make appropriate investment decisions.A Welcome Approach to Financial Reporting and Financial tement Analysis For SEM Vi(Honours) me, a Seo i. Limitations : It is needless to mention that the modern approach to financial statement analysis has given @ new dimension to the analysis but still itis not free from certain limitations. These are stated below aorta (i) Problem of Measurement : This approach takes into account the non-financial informa fon along with the financial information. But it is quite impracticable to assign monetary value to such non factors, al statement analysis, it (ii) Problem of Utilisation : For the adoption of modern approach to financial state ie bon int needs sophisticated and logical statistical tools and techniques, which are quite impractical v analysts to collect. : uy Piecemeal Development : Modem approach to financial statement is developed by adopting the piecemeal method. No isolated tool of this approach can analyse the whole picture of an enterprise, Bi traditional tools are useful in this regard. For instance with the assistance of traditional tools like ratio analysis, we can analyse all the aspects of financial position and operating performance of an enterprise. 5.8 Traditional Vs. Modern Approach to Financial Statement Analysis: be highlighted below The major sae traditional and modem approaches to financial statement analysis can Points of Traditional Approach Modern Approach Difference (i) Scope This analysis is based only on financial | This analysis is not restricted to the information, reported in the financial statement. | financial informatioin only, but it also takes into account the relevant non- financial information. ii) Focus | As the analysis is confined to only financial| The main argument of the modern information, obtained from historical records it is past oriented. Estimation of the future of the firm can not be made with the assistance of traditional approach. approach to financial statement analysis is that, it is future looking approach. It processes both the historical as well as present data and on the basis of that makes estimation about the future. (ii) Approach to the Analysis (iv) Measures of Decision rules are made by setting a standard or norms. Market testing is ignored to the | principle developed. This analysis is basically done on the basis of Decision rules are framed after adopting emperical verification. Advance and sophisticated statistical Analysis ratio analysis, common size analysis, inter-firm | and mathematical tools have been comparison. No advance statistical or | adopted in this analysis mathematical measure is usually considered in e this analysis. (v) Users Bankers and other financial institutions usually conduct financial statement analysis by adopting the well popular traditional techniques. Recently, all the stakeholders of the business also decide to conduct their financial statement analysis by applying the said traditional techniques. It satisfies the information need of multiple stakeholders. That is why it is more broad based compared to traditional financial statement analysis which is primarily adopted to satisfy the interest of the borrowers.Introduction to Financial Statement Analysis @ Points of Traditional Appracch Modern Approach Difference (Wi) Relationship | This analysis is mainly done on the basis of | This approach attempts to integrate the with other | financial reports. It has not integrated the | financial statement analysis with other branches of | financial statement analysis with other| branches of studies specifically with knowledge | disciplines. It implies that the analysis is| reference to economics and advanced basically done in isolation of other branches | financial theories. of knowledge. (vil) Vision This analysis puts special importance on| This approach puts special importance profitability, liquidity, solvency, and overall | on profitability, solvency, liquidity and financial position of the firm from the angle | overall financial position of the firm of short term point of view. both from the short term and long tem point of view. (viii) Merger and | Amalgamation and absorption are basically | Merger and acquisitions are done as Acquisitions | done on the basis of historical data and it is | per Accounting Standard 14 and most a static concept. modem concepts ate synergy concepts of merger. (ix) Pictorial Pictorial representations through charts, graphs | Pictorial representations through charts, Representation | and diagrams are not practised in static| graphs and diagrams are compulsory concept for every large-sized companies (®) Stages of | This approach conveys the firm to prepare | This approach conveys, the company, Income multiple steps income statement. even a listed jont stock company, to Statement prepare single step income statement including disbursement of income. (x) Inflationary | The inflationary effects are not acknowledged | Few large-size companies disclose the Effect in this approach inflationary effect in financial statements, even though it represents a hopeless picture, in reporting annual reports. 5.9 Parties to Financial Statement Analysi The primary objectives towards the preparation of financial statements are to provide information which js useful to the internal as well as external use* The different users who are interested in financial statements analysis are stated below: (i) Management : Management needs financial information for ensuring survival and growth of the firm, On the basis of such information they formulate plans, make policies, select strategy, allocate financial resources and initiate control. Management also needs financial and operating information for the porpose pinpointing the loopholes ofthe business and making effective investing, financing, operating and strateaic business decisions (ii) Proprietors) Shareholders! Partners : They_are interested to know the rate of return on the investment of long term solvency ofthe firm, the profit earning capacity ofthe firm and the growth potential Accordingly, they can make sensible and judicial decision regarding the investment or withdrawal of capital ‘by way of acquiring or disposing shares on the basis of information available from the financial staternents (iii) Creditors, Bankers and other Lenders : Bankers, creditors and other lenders are interested t© know the ultimate solvency, liquidity position and the coverage of interest. As such they need information for‘AWelcome Approach to Financial Reporting and Financial oie a Statement Analysis For SEM VI(Honours) \N ascertaining existing and proposed debt and interest paying capacity. Financial statement analysis helps them to collect information in this regard. (iv) Government : Government is interested to know about the resource allocation, profit earning capacity and the activities of the firm. For this purpose, whatever information is needed by the firm supplied by the financial statements. Accordingly, it will assist the government in ascertaining tax liability andl the economic development of the country. Again the Government needs information for formulating plans for effective economic development and growth of the different sectors of economy. (v) Customers : Customers are interested to know whether the firm is able to supply quality products over the long period of time at reasonable price. As such, the customers may go through the financial statements of the firm to know their efficiency and financial validity for long term association with the business firm. (vi) Rivals : Rivals are interested to study financial statements to compare the relative performance of the firms (oii) Employees : They need information to evaluate the ability oftheir employer regarding remuneration, retirement benefits and employment opportunities. Accordingly, they are interested to study the financial statements to know about the profitability and economic stability of the firm. (vlli) Research Scholars : They are interested to use the accounting information for their research work. Financial statement analysis is of great help to the research scholers to a great extent. They analyse the financial information and evaluate their requirement to satisfy the information need of the users If the existing accounting and reporting system appear to be inadequate or it fails to help the users in making decision, then they must highlight the same and provide suggestion for their development. That is why, the research scholars depend heavily on the financial statement analysis for their research work. (bx) General Public : Business concem can influence the general public both individually and collectively They have substantial contribution to the society in many ways. Such as providing job opportunities, infrastructure development, patronage of local suppliers etc. Financial statement anaiysis may help the general public by supplying information in studying the trend and current development in the sphere of prosperty of the firm and the span of its activities. (x) Auditors : Financial statement analysis assists the auditors in determining the field of work which needs special care during the course of performing their duties. (xi) Merger and Acquisition Analysts : They need information for the purpose of determining the economic value and evaluating the financial health of potential merger firms. (xil) Trade Union : Financial statement analysis assists the trade unions by providing information in respect of the following causes :-— (a) Increase in wages, (b) Evaluation of working condition, (c) Evaluation of faimess of wages presently active, pension plan etc. Beyond that, analysis of financial statement is socially desirable and the signals of social desirability are. (a) Capital output ratio, (b) Cost-benefit ratio; (c) Value added Per rupee of capital, (d) lc Potential, () area development, (f) foreign exchange benefit to country, (g) value adcled a sia a 5.10 Comparative Statement: Comparative Statements or Comparative Financial Statements refers to a comparative study of components or elements or items of financial statements (I.e., Balance Sheet and Income Statement) for two or more years or with that of other entities. It is a historical summary of the same item or group of items of consecutive Income Statements or Balance Sheets of an entity.Introduction to Financial Statement Analysis 69) The comparative Statement is prepared to reveal: (i) Absolute Figures/Data- in rupee amount. (ii) Increase or decrease in absolute amounts. (if) Increase or decrease in absolute figure in percentage (iv) Comparisons expressed in ratios. (v) Percentage of total amounts. 5.10.1 Advantages of Comparative Statemen' (a) For Evaluation of Financial Performance: It is a useful tool for evaluation and analysis of financial performance of an entity over a period of two or more years or with respect to other entities. (b) Earmarked Changes: Itis helpful in indicating the changes either in terms of absolute amount or in terms of percentage. (c) Highlighting nature of changes: It provides information regarding changes in the financial position to measures the influences of such changes. (a) Indicating, Strength and Weakness: It provides information regarding strengths and weaknesses about the liquidity, solvency and profitability of the business entity. (e) Comparison with other entities and Industry Performance: It reveals the comparative position of an entity's performance with that of the average performance of similar entities and also that of with the industry. (f) Helps to make Forecasting and Planning: It ensure analysis of past multi- year financial data. This will in turn helps the management in forecasting and planning. (g) Key Financial Statistics: It act as a guide to the movement of Key financial statistics. (h) Key Help in Decision Making: It provides information regarding financial health of the enterprises to help them to make decisions pertaining to various important and crucial financial matters. (i) Trend Analysis: Financial statements provide information regarding changes in the financial performance and financial position of the business enterprises. It indicates the trends in respect of various components of financial items and thereby helps the analyst to evaluate the performance of the entity and thus helps in forecasting. 5.10.2. Weakness of Comparative Statements: (a) Historical records: It enables analysis of past data i.e. analysis of past financial statements. Thus, it reveals the trends of those happening that are occurred in the past. It is not reflective of future, which is more relevant. (b) Price Level Changes: As data and transactions are recorded in the financial statement at historical cost, thus Inter-period comparison on the basis of comparative statement produce misleading results. Because when comparison is made the value of money does remain same due to change in price level. As such, whatever comparison is made are meaningless. (©) Difficult to make Inter-firm Comparison: Intr-firm comparison on the basis of comparative statement produce erroneous conclusion particularly when the firms under comparison differ in sizes and adopting different accounting policies (4) Difficult to make detailed analysis: Comparative statements reveals the changes in liquidity, solvency and profitability of the entity but it failed to indicate the causes of such changes. (e) Chance of Providing Misleading Information: Sometimes comparative statement failed to provide meaningful information. For instance, when in respect of an item a negative amount appears‘AWelcome Approach to Financial Reporting and Financial e = A Statement Analysis For SEM VI(Honours) in the base year and positive amount appears in the current year, then itis dificult to make meaningful percentage change. Moreover, if there is no figure in the base year then it is also very difficult to compute percentage change. A. Types of Comparative Statements: (a) Comparative Balance Sheet; (b) Comparative Income Statement; (c) Comparative Fund Flow Statement; (d) Comparative Cash Flow Statement. (a) Comparative Balance Sheet: Comparative Balance Sheet refers to a statement of assets and liabilities which shows the position of assets and liabilities of two or more balance sheet dates or two or more business enterprises. It studies the trend of same items or group of items between two or more balance sheets dates or two or more business enterprises. According to Foulke, “Comparative Balance Sheet Analysis is the study of the trend of the same items. Group of items and computed items in two or more Balance Sheets of the same business enterprise on different dates.” Purpose for preparation of Comparative Balance Sheet: (a) To study the trend of short-term financial position; (b) To study the trend of long-term solvency position; (c) To study the growth of the business enterprise. Advantages of Comparative Balance Sheet: (a) Acomparative study of balance sheets of two or more years focus on the changes that have prevailed in the figures of different components of assets and liabilities. (b) The increase or decrease in the figures of different assets and liabilities (both in absolute terms as well in percentage term) can easily be noticed which helps in forming an opinion about the progress made by the business enterprises. (c) Asingle Balance Sheet throws light on status while the Comparative Balance Sheet throws light is on changes. (d) A Comparative Balance Sheet is a more useful statement than single balance because it provides the scope of understanding the trend in the business enterprises. (¢) Itreveals the effect of business operation on assets, liabilities and equity and create a link between the Balance Sheet and Statement of Profit and Loss. Preparation of Comparative Balance Sheet: Generally following five columns are drawn in Comparative Balance Sheet which contains the following information: Column 1: The details of components or items or elements of Balance Sheet are recorded in this column; Column 2: The data or amount pertaining to components of previous year is recorded inthis column; Column 3: The data or amount pertaining to components of current year is recorded in this column: Column 4: The differences (i.e., either increase or decrease) in amount betwe current year are recorded in this column; Column 5: The percentage of above changes taking previous year as base are recorded in this column. (b) Comparative Income Sheet: Comparative Income Statement refers to that statement which reveals the operating results of two or more accounting periods so that the changes in the data or amount both in terms of absolute amount and percentage can be known. From this statement ‘we can understand the en the previous year anda i 4 “Yast & Introduction to Financial Statement Analysis trend of financial performance over two or more accounting periods. It helps to identify financial trends and measure performance over time. It may also use to compare the items of revenue income and expenses of one company with other companies and depict the trend thereof. Purpose for preparation of Comparative Income Statement: (a) To analyses the change in income and expenditure for two or more accounting periods or between two or more enterprises. (b) To analyse the increase or decrease in the items of income or expenditure in terms of rupees and also in terms of percentage. (c) To understand the overall profitability of the business enterprise by taking into consideration the changes in the net profit in the given accounting period. (a) To review the operating performance of the past year and its likely effect on the current year. Advantages of Comparative Income Statement: (a) It makes analyses simple and fast as past figures can easily be compared with the current figures without the need for referring to separate past Income Statement. (b) Itmakes comparison across different companies also easy and helps in analyzing the efficiency both at Gross Profit Level and Net Profit Level. (c)_ Itshows percentage in all line items of the Income Statement which makes analysis and Interpretation of Top Line (Sales) and Bottom Line (Net Profit) easy and more informative. Preparation of Comparative Income Statement: Generally following five columns are drawn in Comparative Income Statement which contains the following information: Column 1: The details of items of Statement of Profit & Loss or Income statement (i.e., Sales, other Income, Cost of Materials consumed, Purchase of stock-in-trade, change in inventories of Finished Goods, Work-in-progress and Stock-in-trade, Employee Benefits Expenses, Depreciation and amortization, Finance Cost etc.) are recorded in this column; Column 2: The data or amount pertaining to items of previous year is recorded in this ‘column; Column 3: The data or amount pertaining to components of current year is recorded in this column; Column 4: The differences (ie., either increase or decrease) in amount between the previous year and current year are recorded in this column; Column 5: The percentage of above changes taking previous year as base are recorded in this column. 5.11 Common-size Statement Common size statements refers to those statements in which figures reported are converted into percentage tosome common base. Common-size may prepare for two or more years. Common-size statements provides vertical analysis. In this type of statement, the comparisons are made vertically from top to bottom for an analysis of component changes that occur with certain common base. In this form every items of financial statement are in percentage on the basis of a common base (viz. In case of Common-size Income Statement on the basis of sales and in case of Balance Sheet on the basis of total assets or total ‘equities. Thus, analysis financial statements aftr they ave common. based is generally known as Common-size Financial Statement is. According to Kohler, “Common-size statements are : c game ibace rather than rupees” ‘accounting statements expressed in percentages ‘Common-size Statement is prepared to reveal: (@) Items of common-size financial statement are evaluat. ; ‘ed from top tc te (b) Itreveals the trend in different items of incomes and »P to bottom or bottom to top. expenditures.‘AWelcome Approach to Financial Reporting and Financial 3 Statement Analysis For SEM VI( Honours) 4 in. (c) It reveals the change in individual items of Income Statement in percentage with reference to a common base. 5.11.1, Advantages of Common-size Statement: (a) Itreveals Sources and Application of Funds in a nutshell which help in taking decision. (b} If common size statements of two or more years are compared it indicate the trends of various components of Assets, Liabilities, Cost, Net Sale & Profit. (c) When Inter-firm Comparison is made with the help of Common size statement it helps in doing corporate evaluation and ranking. (d) It facilitates cross-sectional analysis because under this analysis size of the concern is not bar. (e) Ithighlights the difference in corporate strategies. () The purpose of common-size financial statements is to eliminate those financial differences between concems that have nothing to do their primary operations 5.11.2 Disadvantages of Common-size Statement: (a) Common-size statements becomes useless if consistency is not maintained in accounting policies, concepts and conventions. () Common-size Statement is prepared on the basis of historical data, so it does not consider the time value of money i.e. change in price levels, (c) The common-size statement ignores the qualitative elements of the firm. (2) Common-size failed to ascertain different ratios like Current ratio, Liquid ratio, Debt-equity ratio, Capital Gearing Ratio etc. which are essential for ascertaining the liquidity and solvency ratio of a concem. (e) Common Size Statements are regarded as useless as there is no established standard proportion of an asset to the total asset or an item of expense to net sales. (| Iffinancial statement of a certain business concem is not prepared year after year on consistent basis, comparative study of common-size statement will be misleading, ‘Types of Common-size Statements: (2) Common-size Balance Sheet; (b) Common-size Income Statement. (a) Common-Size Balance Sheet: ’ The common-size Balance Sheet shows the relation between each elements of assets with total assets and each element of liabilities to total equity and liabilities in terms of percentages. In common-size Balance Sheet all total assets and total equity and liabilities is considered as 100 and all the figures are expressed as a percentage of total. Comparative Balance Sheet of two or more years help to observe the trends in different items. Moreover, if it is prepared for different concerns in an industry, it facilitates to judge the relative soundness and helps to understand their financial strategy. Objectives of Preparation of Common-size Balance Sheet: (2) To analyze the changes of different items of Balance Sheet. (b) To establish a relationship between different items of Balance Sheet. (c) To reveals the trends of different items of assets, liabilities and equity. (€) To judge the relative financial position of different concerns under the same industry common-size balance sheet of two or more years may be prepared. (e) Toevaluate the financial strategy adopted by different enterprises in an industry.ey & Introduction to Financial Statement Analysis 3 Advantages of Common-size Balance Sheet: (a) pe to clearly understand the percentage of each individual item of asset as a percentage of total assets. (0) It helps to clearly understand the percentage of each individual item of liability and equity as a percentage of total equity and liability. (©) Ithelps a user to ascertain the trend related to the percentage share of each item of the assets part and percentage share of each item of the liability and equity part. (@) A financial user can also use it to compare the financial performance of different entities at a glance since each item is expressed in terms of percentage of total assets and the user can determine any required ratio quite easily. Disadvantages of Common-size Balance Sheet: (a) As there is no approved standard proportion of each item to the total asset so a common-size balance sheet is considered as impracticable and it does not aid any decision-making process. (b) Incase the balance sheet of a concern is not prepared year after year on a consistent basis, then it is misleading to cary on any comparative study of a common -size Balance Sheet. (c) If there is inconsistency in preparing Financial Statements due to change in accounting principles, concepts and conventions, then preparation of common-size balance sheet becomes a meaningless exercise. (d) During the period of seasonal fluctuations in different components of assets and liabilities a common size balance sheet does not convey proper records. As such, it fails to provide the actual information to the users of financial statements. (e) Acommon-size balance sheet fails to detect the ill effects of window dressing of balance sheet to provide the true positions of assets and liabilities. () Acommon-size balance sheet fails to detect the qualitative elements while gauging the performance ‘of a company, although it is not a good practice to ignore it. Examples of qualitative elements are customer relations, efficiency and talent of workers, quality of products, quality of after sales services, etc. (@) It also fails to ascertain the solvency and liquidity position of a company. It just measures the percentage changes in various components of assets, liabilities and equity. Moreover, it fails to ascertain the different balance sheet ratios like current ratio, acid test ratio, debt equity ratio, proprietary ratio, capital gearing ratio etc. which are essential for determining the solvency and liquidity position of a company. Preparation of Common-size Balance Sheet: Generally following five columns are drawn in Common-size Balance Sheet which contains the following information: Column 1; The details of components or items or elements of Balance Sheet are recorded in this column; : Column 2: The data or amount pertaining to components of previous year is recorded in this column; Column 3: The data or amount pertaining to components of current year is recorded in this column; Column 4: Ascertain and enter the percentage relation of different components of previous year’s Balance Sheet to total equity and liabilities/ total assets, which are considered as 100, in this column; Column 5: Ascertain and enter the percentage relation of different components of the current yeat’s Balance Sheet to total equity and liabilities/ total assets, which are considered as 100, in this column. (b) Common-size Income Statement: Common-size income statement refers othe statement which expresses all tems of income statement a5‘A Welcome Approach to Financial Reporting and Financial Sk a/ Statement Analysis For SEM VI(Honours) x oo a percentage of revenue from operations. In other words, itis that statement in which revenue from operations is considered as 100 and all other items income statement are expressed as a percentage of revenue from operations. Common-size Income staternent for different period helps to reveals the efficiency or inefficiency, Moreover, ifitis prepared for two or more companies at a time it reveals the relative efficiency of cost items of them. Objective of preparation of Common-size Income Statement: (a) To analyses the change in individual item of Income Statement. (b) To study the trend in various items of Incomes and Expenses. () To consider a common base for comparison. Advantages of Common-size Income Statement: (a) Itbecomes easy to compares companies as the size does not matters L.e., cross sectional analysis. (b)_Itis useful in time series analysis. {c)_ Itsnapshots the variation in the corporate strategies. Disadvantages of Common-size Income Statement: (a) Ifconsistency is not maintained in accounting principles, concepts and conventions, then preparation of common size income statement becomes misleading. (b) Asitis prepared on the basis of historical data, so it does not recognize the change in the price level. () The common-size income statement fails to provide data for ascertaining the different ratio like Gross Profit Ratio, Net Profit Ratio, Operating Ratio and Operating Profit Ratio etc. to ascertain the profitability of a company or companies. Preparation of Common-size Income Statement: Generally following five columns are drawn in Common-size Income Statement which contains the following information Column 1; The details of items of Statement of Profit & Loss or Income statement (i.e., Sales, other Income, Cost of Materials consumed, Purchase of stock-in-trade, change in inventories of Finished Goods, Work-in-progress and Stock-in-trade, Employee Benefits Expenses, Depreciation and amortization, Finance Cost etc.) are recorded in this column; Column 2: The data or amount pertaining to different items (ie., Income/Expenses) of the Income Statement of previous year is recorded in this column; Column 3: The data or amount pertaining to different items (i.e., Income/Expenses) of the Income Statement of current year is recorded in this column; Column 4: Ascertain and enter the percentage relation of different items of Income Statement for the previous year to revenue from operations (which are considered as 100) in this column; Column 5: Ascertain and enter the percentage relation of different items of Income Statement for the previous year to revenue from operations (which are considered as 100) in this column. 5.12 Trend analysis: The word ‘trend’ signifies future possibilities. It is the smooth, regular and long-term movement of data showing the basic tendency to expansion, diminution or stagnation over a period of time. An efficient and effective management tries to know the actual performance and also discovers future prospect of the business. ‘The trend analysis acquaints us with the profitability and the short term as well as long term liquidity of the business. Moreover, it also discovers the future prospects of the business in terms of profitability, operational efficiency and financial soundness of the enterprise. It indicates the ‘increasing trend’ or ‘decreasing trend’ ofIntroduction to Financial Statement Analysis any particular series of data. The essential features of trend analysis are its smooth pattern of movement, ‘end analysis is generally done when data are available for a series of accounting period. More specifically, itisa statistical method of identifying direction, speed and extent of trends in individual components in the financial statements over a longer period of time of 5 years or even 10 years. It highlights how prime financial numbers say sales, profits, current assets, current liabilities etc. moved in the past and this in turn guides the financial analysts how they could behave in the future. This analysis is also named as Intra-firm analysis and horizontal analysis, 5.12.1. Various Tools of Trend Analysis: Following are the different methods that are generally used for trend analysis: (a) Percentage Change Method: Under this method accounting figures are converted into percentage over a series of accounting period. The figures in the base year is considered as 100. The main drawback of this method is that it ignores the effect of price level changes. (b) Graphical Method: Under this method financial data of the period of study may be presented graphically with the help of line diagram. The main merit of this method is that it helps the financial analyst tounderstand the trends of data at a glance. Graphical presentation helps to understand the trends of sales, net profit etc. quickly, (c) Trend Ratios: Trend radios indicates the direction of change of a specific component over the period ofstudy. It shows the indication of how the results over a series of accounting year are compared and show the general direction of trend. Generally, trend ratios include — current ratio, acid test ratio, gross profit ratio, net profit ratio, net income to proprietor fund ratio, fixed assets to proprietor fund ratio, equity ratio, proprietary ratio, capital ratio, earning per ratio etc. Generally, trend ratio is calculated with the help of the following formula: Trend Ratio = Absolute value of a particular item in the vear of comparison x 100 Absolute value of that item in the base year The following steps are generally followed for ascertain the trend ratios and executing trend analysis: Step 1: Selection of Base Year: One specific yearis selected as base year on the basis of which comparison isto be made. In any case, it must be normal year i.e. the year which is free from any abnormal activities and may have minimum fluctuations. The figures of base year are considered as 100. Step 2: For each individual item trend percentage is to be calculated on the basis of above stated formula. Step 3: In the final step, conclusion is to be drawn logically and meaningfully by considering the patter of trend values or trend ratios. » Objectives : Trae (i) Indicating the profitability of the enterprise. (ii) Showing operational efficiency of the business. (iii) Indicating actual and prospective performance of the business. (iv) Assisting in decision making regarding future course of action. (v) Manifesting short term and long term financial soundness of the enterprise. Advantages of Trend Analysis: (a) Prompt Understanding of the Progress: The progress of the business can be expeditiously evaluated by determining the trend of sales, production, profit, capital employed etc.AWelcome Approach to Financial Reporting and Financial ‘Statement Analysis For SEM VI(Honours) (b) Possibility of making inter-firm Comparison: Comparative trend data of the given business and its rivals enable inter-firm comparison for evaluating the strength and weakness of the given business. (c) Ensure control and Decision Making; Comparison of trend ratios in related items enable management to ensure control and decision making. For instance, the hike of trend ratio of cost of sales over the hike of trend ratio of sales give indication to the management for further investigation and necessity to take corrective action. (d) Investment Decision: On the basis of trend analysis, an investor can make investment decisions more rationally and judicially. {e) Forecasting of Future: It enables the analyst to make forecasts about the future growth and prospects, () Measuring the Liquidity and Solvency: Trend analysis helps management and the analyst to understand the short-term solvency and liquidity position of a business concem over a period of time with the help of related trend ratios. (g) Useful for Comparative Study: Trend analysis is very effective for making comparative analysis of data to measures the financial performance of the business concern over time period and which helps management to make decisions for the future i.e. it helps to predict the future. (h) Measuring Profitability Position: Trend Analysis also helps to measures the profitability position of the business concer over the time on the basis of few related financial trend ratios (i.e. Operating ratio, Net Profit Ratio, Gross Profit Ratio etc.) Limitations of Trend Analysis: {a) Inflationary Factor: Trend analysis data are generally influenced by inflationary factor i.e. by the factors which cause a rise in the price level. Thus, it creates problems to identify the real growth by the trend analysis. Occasionally, it is recommended to use price deflator to arrest inflationary effect from the time series data. However, the selection of appropriate price index is another problem. (b) Consistency of Business Factors: Trend analysis over a long period of time is not always meaningful because the accounting policies followed by the entity may have changed over time. The environmental and competitive conditions may have changed considerably. (c) Problem in selection of base year: Selection of base year for trend analysis is also a very difficult exercise. A base year should always be a normal year. It should be free from any abnormality. (d) Useless in Inflationary Situation: Analysis of trend ratios is useless at the time of inflationary period. Trends of data which are considered for comparison create misleading results. 5.13. Distinguish between Comfarative Statement Analysis and Common- size Statement analysis: Points of | Comparative Statement Analysis Common-size Statement Analysis Difference 1, Definition | Comparative study of financial statement is the | Common size statement means the statement ‘comparison of the financial statement of the | which is prepared by expressing every itern of business with the previous years ‘financial published financial statements in the form of statement and with the performance of other _| percentage of its important heading competitive enterprise, so that weakness and shortcomings may be identified and remedial measures applied.‘stl 8 Introduction to Financial Statement Analysis Points of Difference Comparative Statement Analysis Common-size Statement Analysis 2. Base year Under this statement analysis, previous year 's considered as the base year: The normal year in which financial information is analyzed, is considered as the base year. In this statement analysis there is no other specific base year. 3, Scope Under this statement analysis information of two or more years financial statements are compared. Thus, its scope is wide. Under this statement analysis information of only one year’s financial statement is compared. Thus, its scope is very narrow, 4, Analysis As under Comparative Financial Statement, we have to look after the analysis of a couple of years’ financial statements, hence this statement analysis is termed as Horizontal Analysis or Dynamic Analysis, Under Common size Financial Statement Analysis, we have to make analysis of the financial statement of only one year. Thus, itis termed as Vertical Analysis or Static Analysis. 5, Comparison Inter-firm comparison is difficult. Because the firm differs with size, capital, turnover ete. Inter-firm comparison can be made easily. Because all the elements can be expressed in the form of percentage 6. Importance of each item Under this analysis the relative importance of financial statements is very low, Because all the items of such statements are disclosed in absolute figure. Under this analysis all the figures of each item are expressed in the form of percentages. As such, the relative importance of each item of financial statements is much more. 7. Basis of Comparison Under this system comparison is made in terms of absolute figure. Under this system comparison is made in terms of percentage. 5.14 Distinguish between Comparative Fi size Financial Statement: ras slg Statement and Common- Points of Comparative Financial Statement Common-size Financial Statement Difference 1.Nature of | Comparative statement analysis is a horizontal. | Common-size statement analysis is a vertical Analysis analysis. It is also a dynamic analysis. analysis Its also a structural analysis 2. Base of Data | In this analysis, the figures of previous year are_| In this analysis the total figures i.e, sales, total taken as base assets etc.are taken as the base. 3. Contents Both absolute change and percentage change | Only percentage of the elements in respect to are reflected through this analysis. total figure are expressed through this analysis. 4. Nature of __| In this analysis inter-firm comparison is very _| In this analysis both intra-firm and inter-firm Comparison | difficult. So, only intra-firm comparison is, comparison are possible because these are possible expressed in percentage = 5. Importance | This analysis does not disclose the relative This analysis can clearly disclose the relative Relative importance of the component items. importance of component items. -_ aAccounting Ratios for Financial Statement Analysis | vi ia : 6.1 Introduction: “The Financial Statements are the end products of financial accounting, Traditionally financial statements consist of (a) Income Statement (i.e. Profit & Loss account/Statement of profit & Loss ~ in case of company) and (b) Position Statement (i.e. Balance Sheet). While, the Income Statement reflects the financial performance of the entity for a defined period of time, the Balance Sheet exhibits the financial position of the firm at a point of time ending that period. The absolute figure included in the conventional financial statements failed to serve the information needs of various stakeholders directly or indirectly associated with the business. But itis very difficult to deduce any meaningful inference on the basis of absolute figures of the financial statements, In order to gauge accurately the financial health of a business concern accounting figure must be related to some other relevant accounting figure. Here arises the need of ratio analysis. 6.2 Meaning Rati The term ratio refers to the numerical or quantitative relationship between two items or variable. It is calculated by dividing one item of the relationship with the others. For instance, there are 50 teachers ina degree college having 2,000 students. Thus, the teachers-students ratio of that college is 50: 2000= 1:40. 6.3 Meaning of Accounting Rati Accounting ratio refers to the quantitative relationship between the relevant accounting figures. It is calculated by dividing one item of the relationship with the others. Itset up a causal relationship between two accounting figures. It indicates the mathematical relationship between two or more accounting data used in the financial statements of a firm. It can be expressed as (a) Pure Ratio e.g. ratio between current assets and current liabilities say 2:1. (b) Rates ie. ratio with reference to time period e.g. Fixed Assets Turnover ratio say 2 times in a year (©) Percentage e.g. Gross Profit Ratio say 30%. 6.4 Meaning of Ratio Analysis a Ratio analysis is the process of analyzing the performance of a concei i help of different ratios of relevant accounting figures available in the franc sui dine — abi I 7 an altemative method of expressing items which are related to each other for the purpose of finencial analysis. Ratio is the numerical or quantitative expression of relationship that exist between two iterre or variables and the expression may be either in the form of percentage or rates or pure ratio. But mere formulation of different accounting ratios will not serve any useful purpose unless itis purely analyzed and interpreted. Basically, accounting ratios are the symptom, by the analysis of which the financial analyst may | OORT na“Sf it & ‘Accounting Ratios for Financial Statement Analysis al anived at the conclusion about the profitability, solvency, liquidity and the managerial efficiency of the | concem. 6.5 Ob%ectives of Ratio Analysi: The objectives of ratio analysis are: {a) To simplify the accounting information. (b) To assess the operating efficiency of the business. (c) To analyze the profitability of the business (d) To help in inter-form and intracfirm comparison. (e) To assess the performance of the business entity and improve the management functions i. planning coordination and control. (0) Toascertain the financial strength and weakness of the business entity, (@) Todetermine the liquidity or short-term solvency and long-term solvency. Short-term solvency refers to the ability of the firm to meet its short-term financial obligations. Whereas, the long-term solvency refers to the ability of the firm to meet its long-term financial obligations. (h) To find out the deviationibyicomparing the actual with the standards so that corrective action can be taken on time "ym 6.6 Advantages of Ratio Analysis: we Sh Following are the few important advantages of ratio analysis: (a) Forecasting and Planning: The trend in costs, sales, profits and other related matters can « known by the management by computing different accounting ratios of relevant accounting figures of the last few years. This trend analysis with the help of ratios may be useful for forecasting and planning future business activities. (b) Budgeting: Budget is an estimate of future activities on the basis of past experience, Accounting ratios help to estimate budgeted figures. For example, with the help of last year's stock turnover ratio, current year’s production budget can be prepared with respect to forecasted sales. (c) Communication: Pertinent information regarding financial strength, earning capacity, liquidity, solvency, production capacity, sales capacity, collection capacity can be meaningfully communicated to outsiders with the help of ratios. (d) Measurement of Efficiency: The technique of ratio analysis provides sufficient data and information by which the efficiency of management or the managerial ability can be clearly measured in the utilization of various assets. It indicates the degree of efficiency in the management and utilization of assets. (c) Control of Performance and Cost: Ratios may also be used for control of performances of different divisions or departments of an entity along with control of cost. (9 Inter-firm Comparison: Inter-firm comparison with the help of relevant ratios with those of competitors or with the average ratios of the industry reveals efficient and inefficient firms, thereby Gnabling the inefficient firms to adopt proper measures for improving their efficiency (@) Indication of Liquidity Position: Ratio analysis helps to assess the liquidity position i., the short-term debt repayment ability of the entity. Itreveals the debt repayment ability of the entity and helps in credit analysis by creditors, banks and other suppliers of short-term loans. (h) Decision Making: The techniques of ratio analysis provides sufficient information to the management to assist them in making decisions like whether to supply goods on credit to a firm, whether bankA Welcome Approach to Financial Reporting and Financial &, y Statement Analysis For SEM VI(Honours) Se fi” loans will be made available etc. (i) Indication of Long-term Solvency Position: The technique of ratio analysis is also used to assess the long-term debt paying capacity of a firm. Long-term solvency position of a borrower is a prime concem to the long-term creditors, security analysts and the present and potential owners of the business. It is ascertained by the leverage/capital structure and profitability ratios which reveals the earning ability and operating efficiency. It indicates the strength and weakness of the firm in respect of determination of long-term solvency position. (%) Signal of Corporate Sickness: The extent of corporate sickness can be known well in advance with the help of the technique of ratio analysis. It provides signal in this respect at the proper time, so that corrective measures can be undertaken to prevent the occurrence of such eventualities. (\) Simplification of Financial Statements: Ratio analysis makes it easy to grasp the relationship between different items and helps the analyst to understand the financial statements. () Indication of Overall Profitability: The management of an entity always want to know the overall profitability of the firm. They may also want to know the short-term and long-term solvency position of the firm to judge the debt repayment capacity. This is possible only when all the ratios are considered together. 6.7 Limitations of Ratio Analysis: te Accounting ratios are nof free from limitations. These are stated below: (2) Incomparability: Inter-firm comparison is possible only when the firm in question adopt the same accounting principles and procedures. Butit is quite absurd, that the two firms will follow the same accounting principles and procedures. As such, in such cases itis quite impossible to make inter-firm comparison and if done it will give misleading results. () Dependence on Current Data: The efficiency of ratio analysis is relied on the reliability of the accounting data. Ifthe accounting data fabricated, the ratio analysis will provide misleading conclusion. (c) Lack of Standard: Fixation of standard is not a very easy task. Apart from this, the standard ratio of two related items may vary from industry to industry. In reality, it is quite impossible to calculate universally applicable standard ratios for the purpose of making comparisons with the actual ratios, and assess. (a) Historical Data: Ratios do not provide definite answers because financial statements are historical in nature based on estimated data such as provision for bad debt and are subject to arithmetical accuracy. (e) Solution of Problem Remain Unsolved: Ratio analysis only snapshot the problem but failed to provide any solution for such problem. Identification of problem is not enough. It is just at the doorstep. Further investigation is essential for the solution of this problem. () Defect of Single Ratio: A single ratio, whatever important it may be, cannot be considered as the prime indicator of a particular affair of a concern. As such, a bunch of co-related accounting ratios must be calculated from the different angle for the purpose of making unambiguous and healthy diagnosis of an affairs and for providing meaningful information. (@) Misuse of Multiple Ratios: Use of too many ratios for the purpose of drawing a conclusion about an affair of a concem is also very dangerous. Instead of giving better diagnosis, it will distort the result, because the use of too many ratios may create confusion in the mind of analyst to come to a clear conclusion and making a decision. (h) Change in the Price Level: Frequent change in the price level very often distort the trend analysis done through ratio analysis.‘oa B ‘Accounting Ratios for Financial Statement Analysis, (i) Personal judgementand Bias: Knowledge in selecting quality data with personal judgement are attached to the significance and reliability to ratio, (i) Presentation of Misleading Picture: Since ratios account for only one variable, hence they cannot always give correct picture. As such, this cannot be used as a sole technique for decision making. Other techniques of management accounting should also be applied parallelly along with Tatio analysis for clear analysis and detailed investigation in a particular is essential for the purpose of decision making () Analysis of Past Data: Since ratios are usually computed on the basis of past financial statement hence these are not true indicators of the future. As such, forecasting and decision making cannot always give sufficient and satisfactory result. () Useful Phenomenon: Ratio analysis is said to be useless when it is not compared with the number of years result. 6.8 Classification of Ratios: Accounting Ratios may be classified in different ways. However the most widely used classification of ratios are as follows Classification of Ratios We According to Source According to Function Aspects of Firm's Operation Economic Aspects of the Firm Balance Sheet / Position Statement Ratios Profit & Loss Account or Income Statement Ratios Balance Sheet and Profit & Loss Account Ratios or Mixed Ratios or Position Statement. Cum Income Staement Ratios Liquidity Ratios Long term Solvency Ratios Efficiency or Turnover Ratios Profitability Ratios RENE