UNIT 3
UNIT 3
SYNOPSIS:
- Financial statement analysis
- methods/tools of analysis and interpretation- comparative statements, common size statements, trend analysis
Financial
statement analysis is the procedure of analysing an enterprise’s financial statements for
making decisions for purposes and to understand the comprehensive health of
an organization. Financial statements document financial information, which
must be evaluated through financial statement analysis to become more helpful
to shareholders, managers, investors, and other interested parties. To put it in
other words, the term ‘financial analysis’ comprises both ‘analysis and
interpretation’.
Tools of Analysis of Financial Statements:
The most frequently used tools of
financial analysis are as follows:
- Comparative Statements: These
are the statements depicting the financial position and profitability of
an enterprise for a distinct timeframe in a comparative form to give a
notion about the position of 2 or more periods. It usually applies to the
2 important financial statements, namely, statements of profit and loss and
balance sheets outlined in a comparative form. Comparative figures signify
the direction and trend of financial position and operating outcomes. This
type of analysis is also referred to as ‘horizontal analysis’.
- Common Size Statements: Common
size statements are statements that signify the association of
distinct items of a financial statement with a generally known item by
depicting each item as a % of that common item. Such statements allow an
analyst to compare
the financing and operating attributes of 2 enterprises of distinct sizes
in a similar industry. This analysis is also referred to as ‘Vertical
analysis.
· Trend analysis: Trend analysis is an analysis of the trend of the company by comparing
its financial statements to analyze the trend of the market or analysis of the
future based on past performance results, and it’s an attempt to make the best
decisions based on the results of the analysis done. Trend analysis involves collecting information from multiple periods and
plotting the collected information on a horizontal line to find actionable
patterns from the given information.
2Q)OBJECTIVES:
The main objective of the financial
statement analysis for any company is to provide the necessary information
required by the financial statement users for informative decision-making,
assessing the current and past performance of the company, predicting the
success or failure of the business, etc.
The top 4 objectives of Financial Statement
Analysis are as follows –
1. To know the current position of the
company
2. Eliminating Discrepancies if any
3.
Future Decision Making
4.
Minimize the Chances of Fraud
#1 – To know the
Current Position
Promoters/owners want to know whether the
company is heading in the right direction or lagging in their targets, which
they have planned in the past. Regular recording of financial transactions
helps them understand their financial position and helps them analyze prospects
better.
#2 – Eliminating Discrepancies if any
Recording of day-to-day transactions, i.e.,
sales and purchases, expenses or incomes, or other statements, helps them
understand where they need to improve and make quick decisions in case of any
discrepancies.
#3 – Future Decision Making
Quarterly statements
like sales book, purchase, trading a/c, or manufacturing a/c help them execute
their plans better. This provides them the opportunity to make future decisions
with reliable information. There is a new practice of preparing provisional final
accounts even
for small companies. Analysing financial statements on a
short-term basis helps the organization make efficient decisions.
Financial statements help understand the reason and make future decisions depending on the situation. For example, let’s assume the reason is the decreasing Sales Price. Then, management can take the necessary steps to understand the future market sentiments, identify the reasons for the decrease in the sales price, and opt for a strategy according to it.
#4 – Minimize the Chances of
Fraud
This is not the
main objective of analyzing transactions but the one which cannot be neglected.
Often we come across the news that the employee cheated his boss, which led to
huge losses for the company. Analyzing the statements will make sure that the employee
will be aware that the management is aware of everything happening in the
company. Also, if any suspicion arises on any financial entry, management can look into the matter and will be able to solve it without incurring
extra losses.
Conclusion:
Financial statements are important for
all stakeholders. Investors need to analyze the financial statements before
making any investment in the company.
· the Same way, banks will be more comfortable granting loans to those
companies whose financial books are well-maintained and show a clear picture of
their profits. This makes them more confident that the company will be able to
pay future debt obligations.
·
Government agencies have their self-interest in the financials
of the company. The collection of taxes from the companies is done on the basis
of information provided by the accounting department of the
company.
Companies have to submit tax returns on a quarterly basis, which are analyzed
by government authorities.
·
Overall the financial statement analysis makes a difference in
the performance of companies. Companies with regular analysis of financials can
intercept their problems within time and can opt for a strategy that can help
them attain their future targets.
·
Also, companies with a better understanding of their financials
can cope with the worst business scenarios in a better way as they know the
financial strength of their balance sheet.
Business
organizations prepare financial statements in order to determine their
financial position for a particular period. The primary purpose of preparing
financial statements is to get an idea about the financial soundness of the
organization.
Comparative financial statements
are one of the most commonly used tools for undertaking the financial analysis
of the statements generated by the business.
Let us know in detail about the
comparative statements as we move ahead.
What are Comparative Statements?
Comparative statements or
comparative financial statements are statements of the financial position of a
business at different periods. These statements help in determining the
profitability of the business by comparing financial data from two or more accounting periods.
The data from two or more periods
are updated side by side, which is why it is also known as Horizontal Analysis.
The advantage of such an analysis is that it helps investors to identify the
trends of business, check a company’s progress and also compare it with that of
its competitors.
The financial data will be
considered to be comparative only when the same set of accounting principles are
being used for preparing the statements.
Types of Comparative Statements
There are two types of
comparative statements which are as follows
1. Comparative income statement
2. Comparative balance sheet
Comparative Income Statement
Income statements provide details about the results of the operations of the business, and
comparative income statements provide the progress made by the business over a
period of a few years. This statement also helps in ascertaining the changes that
occur in each line item of the income statement over different periods.
The comparative income statement
not only shows the operational efficiency of the business but also helps in
comparing the results with the competitors, over different time periods. This
is possible by comparing the operational data spanning multiple periods of
accounting.
The following points should be
studied when analyzing a comparative income statement
1. Compare the increase or
decrease in sales with a relative increase in the cost of goods sold
2. Studying the operational
profits of the business
3. Overall profitability of the
business can be analyzed by an increase or decrease in the net profit
Steps in preparing a comparative income statement
The below steps are followed
1. Specify absolute figures of
all the items related to the accounting period under consideration.
2. Determine the absolute change
that has occurred in the items of the income statement. It can be achieved by
finding the difference between the previous year's values with the current year's
values.
3. Calculate the percentage
change in the items present in the current statement with respect to the previous
year's statements.
Comparative Balance Sheet
A comparative balance sheet
analyses the assets and liabilities of a business for the current year and also
compares the increase or decrease in them in relative as well as absolute
parameters.
A comparative balance sheet not
only provides the state of assets and liabilities in different time periods,
but it also provides the changes that have taken place in individual assets and
liabilities over different accounting periods.
The following points should be
studied when analyzing a comparative balance sheet
1. The present financial and
liquidity position (study working capital)
2. The financial position of the
business in the long term
3. The profitability of the
business
Steps in preparing a comparative balance sheet
The below steps can be followed
1. Determine the absolute value
of assets and liabilities related to the accounting periods.
2. Determine absolute changes in
the items of the balance sheet relative to the accounting
periods in question.
3. Calculate the percentage
change in assets and liabilities by comparing current year values with values
of previous accounting periods.
Financial
statements are prepared for organizations or businesses to know about the state
of the business at that time or period. For an organization or a business
owner, the importance of financial statements is defined by their interpretation
and analysis.
The importance of financial
statements is different for different individuals in an organization. For a
manager, it would be the efficiency of the operations, and for a stockholder,
it will be related to the earnings and profits of the company.
What is Common Size Statement?
A common-size statement is a form
of analysis and interpretation of the financial statement. It is also known as
vertical analysis. This method analyses financial statements by taking into
consideration each of the line items as a percentage of the base amount for
that particular accounting period.
Common size statements are not
any kind of financial ratios but are a rather easy way to express financial
statements, which makes it easier to analyze those statements.
Common size statements are always
expressed in the form of percentages. Therefore, such statements are also
called 100 percent statements or component percentage statements as all the
individual items are taken as a percentage of 100.
Types of Common Size Statements
There are two types of common
size statements:
- Common size income statement
- Common size balance sheet
1. Common Size Income Statement
This is one type of common size
statement where the sales is taken as the base for all calculations. Therefore,
the calculation of each line item will take into account the sales as a base,
and each item will be expressed as a percentage of the sales.
Use of Common Size Income Statement
It helps the business owner in
understanding the following points
- Whether profits are showing an
increase or decrease in relation to the sales obtained.
- Percentage change in the cost of goods
that were sold during the accounting period.
- A variation that might have occurred
in expense.
- If the increase in retained
earnings is in proportion to the increase in profit of the business.
- Helps to compare income statements
of two or more periods.
- Recognizes the changes happening in
the financial statements of the organization, which will help investors in
making decisions about investing in the business.
2. Common Size Balance Sheet:
A common-size balance sheet is a
statement in which balance sheet items are calculated
as the ratio of each asset in relation to the total assets. For the
liabilities, each liability is calculated as a ratio of the total
liabilities.
Common-size balance sheets can be
used for comparing companies that differ in size. The comparison of such
figures for the different periods is not found to be that useful because the
total figures seem to be affected by a number of factors.
Standard values for various
assets cannot be established by this method as the trends of the figures cannot
be studied and may not give proper results.
Preparing Common Size
Balance Sheet
(1) Take the total assets or
liabilities as 100.
(2) Each individual asset is
expressed as a percentage of the total assets, i.e., 100, and different
liabilities are also calculated as per total liabilities. For example, suppose
total assets are around Rs. 4 lakhs, and inventory value is Rs. 1 lakh. In that
case, it will be counted as 25% of the total assets.
Limitations of Common Size Statement
- It is not helpful in the
decision-making process as it does not have any approved benchmark.
- For a business that is impacted by
fluctuations due to seasonality, it can be misleading.
The
Trend Analysis presents each financial item in percentage terms for each year.
These Trend Analyses not only help the accounting users to assess the financial
performance of the business but also assist them to form an opinion about
various tendencies and predict the future trend of the business.
Usefulness and Importance
of Trend Analysis
The following are the various
importance of Trend Analysis:
1. Assists
in forecasting
The trends provided by Trend
Analysis help accounting users forecast the future trend of the
business.
2. Percentage
Terms
The trends are expressed in
percentage terms. Analyzing the percentage figures is easy and also less time-consuming.
3. User
Friendly
As the trends are expressed in
percentage figures, it is the most popular financial analysis to analyze the
financial performance and operational efficiency of the company. In other
words, one need not have an in-depth and sophisticated knowledge of
accounting in order to analyze these percentage trends.
4. Presents
a Broader Picture
The trend analysis presents a
broader picture of the financial performance, viability, and operational
efficiency of a business. Generally, companies prefer to present their
financial data for a period of 5 or 10 years in the form of percentage trends,
whereas the other techniques of Financial Analysis lack this popularity.
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