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Paper: 02, Accounting & Financial Analysis

Module: 24, Concept of Financial Analysis

Prof. S P Bansal
Principal Investigator Vice Chancellor
Maharaja Agrasen University, Baddi

Prof YoginderVerma
Co-Principal Investigator Pro–Vice Chancellor
Central University of Himachal Pradesh. Kangra. H.P.

Dr. O.P Verma

Paper Coordinator Department of Commerce
Himachal Pradesh University shimla

Content Writer Ms. Deepika Gautam

Assistant Professor
St. Bede‟s College Shimla
Department of Commerce & Management
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Items Description of Module

Subject Name Management
Paper Name Accounting & Financial Analysis
Module Title Concept of Financial Analysis
Module Id Module No-24
Pre- Requisites Basic knowledge of Financial Analysis
Objectives To study the basic concepts of financial Analysis
Keywords Finance, Financial Statements, Procedure of Analysis

QUADRANT-I

Module-24 Concept of Financial Analysis

1. Learning objectives
2. Introduction
3. Meaning
4. Definitions
5. Objectives
6. Concept
7. Rationale
8. Procedures
9. Role of Financial Analyst
10. Loop Holes
11. Summary

LEARNING OBJECTIVES:

The primary objective of financial reporting is to provide information to present and potential investors
and creditors and others in making rational investment, credit and other decisions. Effective decision
making requires evaluation of the past performance of companies and assessment of their future
prospects. This module will focus on developing a framework for analyzing financial statements to make
business decisions. The framework is intended to enhance the ability to qualitatively and quantitatively
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assess financial information. Goals of the course include learning to read financial statements for relevant
information, understanding the impact of a business‟ accounting choices and estimates. Cases are
incorporated in modules and assignments in order to illustrate concepts and allow students to put into
practice the tools presented.

INTRODUCTION:

It is important for the manager to understand the finance in debt as it is considered as a language of a
business and one most understand the language to control. Finance is an essential and exciting area of
management that many executives want to discover or explore in more depth. In any organization a
manager has to take number of decisions say it Production related decision, Market related, Human
Resource related etc. and the best tool used to take various decisions are financial statements, which are
prepared primarily for decision making. But the information provided in the financial statement is not an
end in itself as no meaningful conclusions can be drawn from these statements alone. However, the
information provided in the financial statements is of immense use in making decisions through analysis
and interpretation of financial statements. In this way, financial analysis is very important part of the
overall function of finance. Financial analysis can be applied in a wide variety of situations to give
business managers the information they need to make critical decisions. Financial analysis is an aspect of
the overall business finance function that involves examining the past information to draw conclusion and
set inferences for the current and future health of a company.

MEANING OF FINANCIAL ANALYSIS

It is a process of analyzing the data contained in various financial statements so that valuable information
can be withdrawn to take various decisions related to management. Financial Analysis helps to analyze
the company's accounts and statements which contains a great deal of information. Discovering the full
meaning contained in the statements is at the heart of financial analysis. It is an analysis that highlights
the important relationship in the financial statements and focuses on the evaluation of past performance of
the business firm in terms of liquidity, profitability, operational efficiency and growth potentiality.
Financial statements analysis includes the method use in assessing and interpreting the result of past
performance and current financial position as they relate to particular factors of interest in investment
decisions. Therefore financial statement analysis is an important means of assessing past performance and
in forecasting and planning future performance. The goal of financial analysis is to assess the
performance of a firm in the context of its stated goals and strategy. There are two principle tools which
involves assessing how various lines items in a firm‟s financial statements relate to one another.

DEFINITIONS OF FINANCIAL ANALYSIS

(It is an attempt to measure the enterprise’s liquidity, profitability, solvency and other indicators to
access its efficiency and performance)

1. “It is a process of evaluating the relationship between component parts of a financial statement to
obtain a better understanding of a firm‟s position and performance.”
(Metcalf and Titard)
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2. “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 the series of statements.”
(Myers)

THE OBJECTIVES OF FINANCIAL STATEMENT ANALYSIS IN A FIRM:

Financial Statement Analysis is the collective name for the tools and techniques that are projected to
provide relevant information to manager for decision making. The purpose of financial statement analysis
is to assess a company‟s financial health and performance. Financial statement analysis consists of
comparisons for the same company over a period of time and comparison of different companies either in
the same industry or in different industries. Financial statement analysis enables investors and creditors to
(a) Evaluate past performance and financial position, and (b) Predict future performance.

Evaluation of Past Performance and Financial Position

The starting point in the analysis of a company is to look at the record. Past information serves as the base
for the future. For example, trends of past sales, earnings, cash flow, profit margin and return on
investment provide a basis for evaluating the efficiency of a company‟s performance and aid in assessing
its prospects. An assessment of current status will show where the company stands at present, such as the
company‟s inventories, borrowings and cash position. To a large extent, the expectations of investors and
creditors about future performance are shaped by their evaluation of past performance and current
position. Individual investors are often passive and they rarely intervene in the working of a company as
long as the company is reasonably successful. Their evaluations of the company help them assess
prospects for their investments, and investors who are dissatisfied with a company‟s performance will
typically sell their shares in the company.
Predict Future Performance
Financial performance analysis helps to predict the future on the basis of previous or last year data which
are available. It is general accepted fact in company organization that in order to decide for the future a
company needs the base year, here base year means previous year. The sales can be predicted for the
future on the basis of past year sales, similarly profit can be estimated for the coming years by using
various tools of analysis in which base year can be taken. Estimating budget is one of the significant
functions of company organization and financial statement analysis play enormous role in estimating
budget for the future period.

STANDARDS OF COMPARISONS:
Pertinent Standards are used by an analyst to determine whether the results as per the financial statement
analysis are favorable or unfavorable. For this purpose, comparisons are made with the *General Rule of
Indicators and with the **Past Performance of the Company and *** Industry Standards.
*
General rule of Indicators: Financial analyst and bankers use rule of thumb or benchmark financial
ratios. Rule of Thumb measures are useful in making broad comparisons of companies in different
industries.
**
Past Performance: It is common for financial analyst to compare measure of performance of the
company over a period of time. Seven or Nine year summaries of selected financial data appear in some
annual reports.
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***
Industry Standard: The performance of the company can be compared with that of other companies in
the industry. The comparison help overcome the limitations of historical comparisons.

CONCEPT OF FINANCIAL STATEMENT ANALYSIS:

The term „financial statement analysis‟ is the combination of two words „analysis‟ and „interpretation‟
and it is important to distinction between the two terms. The term „analysis‟ is used to mean the
simplification of financial data by methodical classification of the data given in the financial statements,
„interpretation‟ means, explaining the meaning and significance of the data so simplified. However both
are interlinked and complimentary to each other. Analysis is useless without interpretation and
interpretation without analysis is difficult or even impossible. Financial statement analysis gives structural
relationships of the various items in the financial statements. Financial analysis of a company should
include an examination of the financial statements of the company, including notes to the financial
statements, and the auditor's report. The auditor's report will state whether the financial statements have
been audited in accordance with generally accepted auditing standards. The report also indicates whether
the statements fairly present the company's financial position, results of operations, and changes in
financial position in accordance with generally accepted accounting principles. Notes to the financial
statements are often more meaningful than the data found within the body of the statements. The notes
explain the accounting policies of the company and usually provide detailed explanations of how those
policies were applied along with supporting details. Analysts often compare the financial statements of
one company with other companies in the same industry and with the industry in which the company
operates as well as with prior year statements of the company being analyzed.

DIFFERENT SOURCES TO COLLECT COMPANY INFORMATION

The various individual investors and creditors often interested in the company‟s report where they have
invested their capital. The most common sources of information from where investors can collect all the
relevant information are company‟s reports, Stock exchange, business periodicals and information
services. The brief discussions of all these sources are discussed as follows:
Official record of Company: It is mandatory as per the company‟s act 1956 for every company to publish
an annual report which contains valuable financial and other information about the company. The typical
Indian company includes directors‟ report, financial statements, Schedule and notes to the financial
statements and auditor‟s report.
Stock Exchanges: Listed companies must file copies of their annual reports, as well as additional
documents such as a statement of distribution of share ownership and the quarterly statement, with the
stock exchanges in which they are listed. The investors are interested to know the market value of their
share.
Business periodicals: Business newspapers and magazines are important and often, timely sources of
financial and business news. All the newspapers give daily stock prices and carry news items and
analytical write-ups on companies. It helps the investors to take decisions regarding further investing or
withdrawing.
Information Services: In recent years, a number of information services have spring up. Interested parties
can draw information from various sources like Economic Reports, Reserve Bank of India and from
private sources.
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RATIONALE OF FINANCIAL STATEMENT ANALYSIS

The purpose of financial statement analysis is to examine past and current financial data so that SWOT
analysis can be done by the company.
S- Strength
W- Weakness
O- Opportunity
T- Threats
It helps the company to analyze its strength to compete in the market and to avail the various
opportunities available in the environment. Through this SWOT analyses company makes various
strategies to overcome the threats. Moreover Financial statement analysis can yield valuable information
about trends and relationships, the quality of a company's earnings. The another 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 as it is linked to the objectives and interests of various agencies
involved, like Investors, bankers, lenders, suppliers and regulatory authorities.

For Instance: Just like a doctor examines his patient by recording his body temperature, blood
temperature etc. before making his conclusion regarding the illness and before giving his treatment.

Similarly., The financial analyst analysis the financial statements with various tools of analysis before
commenting upon the financial health or weaknesses of an enterprise. The analysis and interpretation is
essential to bring out the mystery behind the figures in financial statements. However, on the basis of
financial statements, the objective of financial analysis is to draw information to facilitate decision
making, to evaluate the strength and the weakness of a business, to determine the earning capacity, to
provide insights on liquidity, solvency and profitability and to decide the future prospects of a business
entity.

USES OF FINANCIAL ANALYSIS

On the basis of financial analysis one can take variety of decisions in various areas such as security
analysis, credit analysis, debt analysis, dividend analysis, mergers and general business analysis. These
are discussed as follows:
Security Analysis: It is a process by which the investor comes to know whether the firm is fulfilling his
expectations with regard to payment of dividend, capital appreciation and security of money.
Credit Analysis: Such analysis is useful when a firm offers credit to new customer or a dealer. The
manager of the firm would like to know whether to extend credit to them or not.
Debt Analysis: Such analysis is done by the firm to know the borrowing capacity of a prospective
borrower.
Dividend Decision: Dividend is that part of the profit which is distributed among the shareholders and
financial analysis helps the firm in deciding about the rate of dividend. Management would have to decide
about how much portion of earnings to distribute and how much to return. Such decisions indicate the
profitability of the firm.
General Business Analysis: Financial Analysis can be used to identify the key profit drivers and business
risk in order to assess the profit potential of the firm. It helps in future growth scenarios for the firm.

PROCEDURES OF FINANCIAL STATEMENTS ANALYSIS:

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Analysis of Financial Statements is a systematic process of the critical examination of the financial
information contained in the financial statements in order to understand and make decisions regarding the
operations in the firm. It is a step by step procedure to understand the relationships among various
financial facts and figures as set out in the financial statements i.e., Balance sheet and Profit and Loss
Account the complex data given in these financial statements is divided/broken into simple and valuable
elements and relationships are established between the elements of the same statement or different
financial statements. The following procedure is adopted for the analysis and interpretation of financial
statements:

(1) The analyst should acquaint himself with the various accounting principles, concepts and
conventions so that he may able to find out whether the framed plans and policies are properly
executed or not.
(2) The extent of analysis should be determined in advance by the manger so that that the domain of
work may be decided.
For instance: “If the aim is to find out the earning capacity of the enterprise then analysis of
income statements will be undertaken and if on the other side , financial position is to be studied
then balance sheet analysis will be necessary.”

(3) The financial data given in the statements should be re-organized and re-arranged so that data
may reduce to a standard form and rearrangement of financial Statements for analysis is
necessary to reclassify the data contained in the financial statements into purposive classes so that
maximum information from available data for analysis can be obtained.
(4) A relationship is established among financial statements with the help of various tools and
techniques of analysis such as ratios, trends, common size, fund flow etc.
(5) The interpretation should be specific and directed towards indicating the movement of various
financial characteristics. The various conclusions drawn from financial statements are then
presented to the management in the form of reports.

(Step by Step Procedure to analysis the financial statements)

Step-1 Setting objectives by defining the purpose and context.

Step-2 Collection of necessary information from different sources

Step-3 Process the data gathered in the second phase to preparing common-size financial
statements and graphical representation.
Step-4 Conduct analysis on processed data and interpret the results
Step-5 Develop recommendations in the light of inferences drawn from analysis conducted and
report/communicate them to relevant personnel.
Step-6 Follow up (Review), if necessary, so that if any deviation occurs action may be taken to
rectify the same.
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ROLE PLAYED BY FINANCIAL ANALYST IN INTERPRETATION

Finance is one of the key departments of an organization as it involves organizing data according to
logical and consistent accounting procedure. It covers a range of activities from basic bookkeeping to
providing relevant, reliable, timely and accurate financial information in the form of various financial
reports to assist management in the process of strategic decision making. The financial information in turn
forms a basis for financial analysis. Financial analysts are required to analyze different types of financial
information and provide recommendations to their clients or end users. In that sense analysts work as an
adviser who advise or recommend appropriate actions that user should take to gain favorable results. In
this way, financial analyst plays a vital role in a business organization and performs various roles and
responsibilities. Some major duties of a financial analyst are as follows:

(1) Financial analyst has a key role in determining the company‟s current value and future business
prospects.
(2) Financial analyst involves analyzing financial information to produce forecasts of a business that
aids greatly in making investment decisions. He needs to interpret data influencing investment
decisions, so that he may offer reliable and accurate information to management and recommend
course of actions.
(3) An analyst, in order to enable management in making various decisions accordingly, involves in
creating various spreadsheets, making analysis, and graphs, so that the financial trends may be
illustrated as well as clear and understandable information may be presented.
(4) An analyst holds the responsibility of developing several models in order to predict business
opportunities in terms of investments leading to maximizing profits and minimizing the chances
that pose risks on business.
(5) One of the most important job activities of a financial analyst is, while reviewing and presenting
the financial information to management, to analyze trends in terms of revenues and expenses of
a business entity that consequently facilitate management to take necessary steps to increase
profitability and decrease and control the expenses.
(6) While participating in forecasting and planning cycles and develop tools for improving the
forecasting and actual /processes roll them out to the larger population together with identifying
projects

LOOP HOLES IN FINANCIAL ANALYSIS:

Financial statement analysis has its number of limitations. Statements represent the past and do not
necessarily predict the future. However, financial statement analysis can provide clues or suggest a need
for further investigation. Financial statements say little directly about changes in markets, the business
cycle, technological developments, laws and regulations, management personnel, price-level changes, and
other critical analytical concerns. Some of the important limitations of financial analysis are, however,
summed up as follows:

(1) Financial statement analysis is only a study of interim reports.

(2) It is based upon only monetary information and non-monetary information factors are totally
ignored.
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(3) It does not consider changes in price levels which have major impact on the EPS (Earning Per
Share) of the company.
(4) As the financial statements are prepared on the basis of a going concern, it does not give always
an exact position. Thus accounting concepts and conventions cause a serious limitation to
financial analysis.
(5) Changes in accounting procedure by a firm may often make financial analysis misleading.
(6) Analysis is on a means and not an end in itself. The analyst has to make Interpretation and draw
his own conclusions. Different people may interpret the same analysis in different ways. This is
one of the basic limitations of financial statement analysis.

FUTURE PERFORMANCE

Financial analysis can assist small businesses in their Planning and Evaluation of a company's balance
sheet, income statement and cash flow statement. It helps in interpreting trends and identifying strengths
and weaknesses of a business to enable management to make projections of revenues and profits for
future. With knowledge of trends in the general economy and in the company's industry, they can form a
reasonable estimate of how well the company might fare in the coming years. Such analyses can be
helpful to businesses that need to plan equipment purchases and other initiatives. The process of division,
establishing relationship and interpretation thereof to understand the working and financial position of a
business is known as analysis of financial statements. It indicates certain absolute information about
assets, liabilities and profit or loss of an enterprise. There are various parties in Financial Statements

ANALYSIS AND THEIR AREAS OF INTEREST ARE AS FOLLOWS:

Parties Areas of Interest

Investors of Owners or shareholders (i) Profitability, (iii) Financial Position
(ii) Future prospects of business.
Management (i) Short-term and long term solvency
(ii) Liability of the concern
(iii) Profitability in relation to turnover
Employees and Trade Union (i) Profitability
(ii) Financial Position of the concern
Supplier (i) Financial Position
(ii) Profitability‟s
Researchers (i) Profitability
(ii) Growth
(iii) Future Prospectus

SUMMARY:
Financial Statements Analysis is a continuous process being applicable to every business to evaluate its
past performance and current financial position. Since there is recurring need to evaluate the past
performance, present financial position, the position of liquidity and to assist in forecasting the future
prospects of the organization, various financial statements are to be examined in order that the forecast on
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the earnings may be made and the progress of the company be ascertained. It is useful in various
situations to provide managers the information that is needed for critical decisions. The process of
financial analysis provides the information about the ability of a business entity to earn income while
sustaining both short term and long term growth. Financial statements analysis can help the government
agencies to analyze the taxation due to the company. Moreover, company can analyze its own
performance over the period of time through financial statements analysis. Financial analysis can be an
important tool for small business owners and managers to measure their progress toward reaching
company goals, as well as toward competing with larger companies within an industry. When performed
regularly over time, financial analysis can also help small businesses recognize and adapt to trends
affecting their operations. It is also important for small business owners to understand and use financial
analysis because it provides one of the main measures of a company's success from the perspective of
bankers, investors, and outside analysts.