Financial Statement Analysis- Definition, Method and Risk

Financial Statement Analysis
The term ‘financial analysis’, also known as analysis and interpretation of financial statements’, refers to the process of determining financial strengths and weakness of the firm by establishing strategic relationship between the items of the balance sheet, profit and loss account and other operative data. “Analyzing financial statement”, according to Metcalf and Titard, “is a process of evaluating the relationship between components parts of financial statement to obtain a better understanding of the firm’s position and performance.”
The 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.
The term ;’financial statement analysis’ includes both ‘analysis’, and ‘interpretation’. A distinction should, therefore, be made between the two terms. While the term ‘analysis’ is used to mean the simplification of financial data by methodical classification of the data given in the financial statement, ‘interpretation’ means, ‘explanation the meaning and significance of the data so simplified.’

Types of Financial Analysis
1. On the basis of material used
• External Analysis
• Internal Analysis

2. On the basis of modus operandi
• Horizontal Analysis
• Vertical Analysis

Procedure of Financial Statements Analysis
1. The analysis should acquaint himself with the principles and postulates of Accounting. He should know the plans and policies of the management so that he may be able to find out whether these plans are properly executed or not.
2. The extent of analysis should be determined so that the sphere of work may be decided. If the aim is to find out the earning capacity of the enterprise then analysis of incoming statement will be undertaken. On the other hand, if financial polition 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. It will involve the grouping of similar data under same heads, breaking down of individual components of statements according to nature. The data is reduced to a standard form.
4. A relationship is established among financial statements with the help of tools and techniques of analysis such as ratios, trends, common size, funds flow etc.
5. The information is interpreted in a simple and understandable way. The significance and utility of financial data is explained for helping decision-taking.
6. The conclusions drawn from interpretation are presented to the management in the form of reports.

Methods of Devices of Financial Analysis
1) Comparative statements;
2) Trend Analysis;
3) Common-size statements;
4) Fund Flow Analysis;
5) Cash Flow Analysis;
6) Ratio Analysis;
7) Cost-Volume-Profit Analysis

• Comparative Statements

The comparative financial statements are statements of the financial position at different periods; of time. The elements of financial position are shown in a comparative form so as to give an idea of financial position at two or more periods. Any statement prepared in comparative form will be covered in comparative statements. From practical point of view, generally, two financial statements (balance sheet and income statement) are prepared in comparative form for financial analysis purposes. Not only the comparison of the figures of two periods but also be relationship between balance sheet and income statement enables an indepth study of financial position and operative results. The comparative statement may show:
i. Absolute figures (rupee amounts).
ii. Changes in absolute figures i.e., increase or decrease in absolute figures.
iii. Absolute data in terms of percentages.
iv. Increase or decrease in terms of percentages.
The two comparative statements are (i) Balance Sheet, and (ii) Income statement.

(i) Comparative Balance Sheet
The 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. The changes in periodic balance sheet items reflect the conduct of a business. The changes can be observed by comparison of the balance sheet at the beginning and at the end of a period and these changes can help in forming an opinion about the progress of an enterprise.
Guidelines for Interpretation of Comparative Balance Sheet
While interpreting Comparative Balance Sheet the interpreter is expected to study the following aspects:
1. Current financial position and liquidity position.
2. Long – term financial position.
3. Profitability of the concern.

(ii) Comparative Income Statement
The Income statement gives the results of the operations of a business. The comparative income statement gives an idea of the progress of a business over a period of time. The changes in absolute data in money values and percentage can be determined to analysis the profitability of the business.

• Trend Analysis

The financial statements may be analysed by computing trend of series of information. This method determines the direction upwards or downwards and involves the computation of the percentage relationship that each statement item bears to the same item in base year. The information for a number of years is taken up and one year, generally the first year, is taken as a base year. The figures of the base year are taken as 100 and trend ratios for other years are calculated on the basis of base years. The analyst is able to see the trend of figures, whether upward or downward. For example, if sales figures for the year 1995 to 2000 are to be studied, then sales of 1995 will be taken as 100 and the percentage of sales for all other years will be calculated in relation to the base year, i.e., 1995 Suppose the following trends are determined.
1995-100
1996- 120
1997- 110
1998- 125
1999- 135
2000- 140
The trends of sales show that sales have been more in all the years since 1995. The sales have show an upward trend except in 1997 when sales were less than the previous year i.e., 1996. A minute study of trends shows that rate of increase in sales were less in the years 1999 and 2000. the increase in sales is 5% in 1998 as compared to 1997 and increase is 10% in 1999 as compared to 1998 and 5% in 2000 as compared to 1999.

• Common – Size Statement

The common size statements, balance sheet and income statement, are shown in analytical percentages. The figures are shown as percentages of total assets, total liabilities and total sales. The total assets are taken as 100 and different assets are expressed as a percentage of the total. Similarly, various liabilities are taken as a part of total liabilities. These statements are also known as component percentage or 100 per cent statements because every individuals item is stated as a percentage of the total 100. the short – coming in comparative statements and trend percentage where changes in items could not be compared with the totals have been covered up. The analyst is able to assess the figures in relation to total values. The common – size statements may be prepared in the following way.

i. The totals of assets or liabilities are taken as 100.
ii. The individual assets are expressed as a percentage of total assets, i.e., 100 and different liabilities are calculated in relation to total liabilities. For example, if total assets are Rs. 5 lakhs and inventory value is Rs. 50,000, then it will be 10% of total assets (50,000×100/5,00,000).

(I) Common – Size Balance Sheet
A statement in which balance sheet items are expressed as the ratio of each asset to total assets and the ratio of each liability is expressed as a ratio of total liabilities is called common – size balance sheet.

(ii) Common Size Income Statement
The items in income statement can be shown as percentages of sales to show the relation of each item to sales. A significant relationship can be established between items of income statement and volume of sales. The increase in sales will certainly increase selling expenses and not administrative or financial expenses. In case the volume of sales increases to a considerable extent, administrative and financial expenses may go up. In case the sales are declining, the selling expenses should be reduced at once. So, a relationship is established between sales and other items in income statement and this relationship is helpful in evaluating operational activities of the enterprise.

Limitations Of Financial Analysis
1) It is only a study of interim reports
2) Financial analysis is based upon monetary information and non-monetary factors are ignored.
3) It does not considerable changes in price levels.
4) As the financial statements are prepared on the basis of going concern, it does not give 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 only a means and not an end in itself. They analysis has to make interpretation and draw his own conclusions. Different people may interpret the same analysis in different ways.

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