Financial Statements Analysis: Objectives and Procedure, Types, Limitations and Tools

In this article we will discuss about:- 1. Meaning and Process of Financial Statement Analysis and Interpretation 2. Objectives of Analysis and Interpretation 3. Procedure 4. Types 5. Techniques or Tools 6. Limitations.

Meaning and Process of Financial Statement Analysis and Interpretation:

Nature and importance of financial statements are explained in the preceding pages. It has been explained that facts disclosed by financial statements are of outstanding significance to the various parties interested in financial position of a business concern. The financial statements are helpful to the executives to assess the implications of their decisions, evaluate and review their performance and implement corrective action.

In fact the financial statements render invaluable service to owners, employees, customers, suppliers and the government in their respective fields of interest. The financial statements are useful and meaningful only when they are analysed and interpreted.

Scientific method has to be adopted to analyse and interpret these statements as done in the case of preparation of these statements. The effort taken to understand the implications of the statements is called interpretation. Some people call it ‘examination’, ‘criticism’ or ‘analysis’. Therefore, it is meaningful to call it ‘analysis and interpretation’.

Wood in his work ‘Business Accounting’ has defined the term interpretation as follows:

“To interpret means to put the meaning of a statement in simple terms for the benefit of a person”.

Analysis may be described as a critical examination of financial transactions effected during a definite period of time. Kennedy and Muller said “Analysis and interpretation of financial statements are an attempt to determine the significance and meaning of the financial statement data so that forecast may be made of the prospects for future earnings, ability to pay interest and debt maturities (both current and long term) and probability of a sound dividend policy”.

The balance sheet and profit and loss account are to be interpreted to convey meaningful message to the lay man who is still the typical shareholder in our country. Interpretation is considered to be the most important function of management accountant because the management of today needs relevant data and information to conduct its function efficiently. The information is more valuable if it is presented in analytical form than in absolute form. Management Accountant is expected to analyse and interpret the financial statements to perform his basic duty of ‘communication to the management’.

Interpretation in its widest sense includes many processes like arrangement, analysis, establishing relationship between available facts and finally making conclusions.

Objectives of Analysis and Interpretation:

The users of financial statements have definite objectives to analyse and interpret. Therefore, there are variations in the objectives of interpretation by various classes of people.

However, there are certain specific and common objectives which are listed below:

(1) To interpret the profitability and efficiency of various business activities with the help of profit and loss account;

(2) To measure managerial efficiency of the firm;

(3) To measure short-term and long-term solvency of the business;

(4) To ascertain earning capacity in future period;

(5) To determine future potential of the concern;

(6) To measure utilisation of various assets during the period;

(7) To compare operational efficiency of similar concerns engaged in the same industry.

Procedure for Analysis and Interpretation:

Certain preliminary steps are required to be completed before attempting analysis and interpretation of financial statements.

(1) The objectives of analysis of statements have to be thought about as the techniques of analysis are to be selected on the basis of objectives.

(2) The assumptions, principles, practices, etc., followed in the preparation of the financial statements are to be ascertained to understand their significance.

(3) Additional data and information required has to be collected.

(4) The data collected has to be presented in a logical sequence by rearranging and readjusting the different items.

(5) The data is to be analysed for making comparative statements, for computation of ratios and for ascertaining averages and for estimating trends.

(6) Facts gathered from analysis are to be interpreted by considering the general state of the market and economy also.

(7) The interpreted data and information has to be presented in a suitable form.

Types of Financial Statement Analysis:

The process of financial statement analysis is of different types. The process of analysis is classified on the basis of information used and ‘modus operandi’ of analysis.

The classification is as under:  

(1) On the Basis of Information:

(a) External Analysis:

This analysis is based on published financial statements of a firm. Outsiders have limited access to internal records of the concern. Therefore, they depend on published financial statements. Thus, the analysis done by outsiders namely, creditors, suppliers, investors and government agencies are known as external analysis. This analysis serves a very limited purpose.

(b) Internal Analysis:

This analysis is done on the basis of internal and unpublished records. It is done by executives or other authorised officials. It is very much useful and significant to employees and management.

(2) On the Basis of ‘Modus Operandi’ of Analysis:

(a) Horizontal Analysis:

This analysis is also known as ‘dynamic’ or ‘trend’ analysis. The analysis is done by analysing the statements of a number of years. According to John N. Myer “the horizontal analysis consists of a study of the behaviour of each of the entities in the statement”. Thus, under horizontal analysis we study the behaviour of each item shown in the financial statements.

We examine as to what has been the periodical trend of various items shown in the statements i.e., whether they have increased or decreased over a period of time. If the comparative statements are prepared for more than two periods, then one of the years is taken as basis to calculate the percentage of increase or decrease. Some analysts prefer to choose earliest year as basis, while some others prefer to take just the preceding year as basis.

(b) Vertical Analysis:

Vertical analysis is also known as ‘static analysis’ or ‘structural analysis’. This analysis is made on the basis of a single set of financial statements prepared on a particular date. Under vertical analysis, quantitative relationship is established between different items shown in a particular statement. Common-size statements are a form of vertical analysis. Different items shown in the statement are expressed as a percentage to any one item as base.

Use of both the methods of analysis is very much required for proper analysis. Each method provides specific type of information and in fact both methods constitute the backbone of financial analysis.

Techniques or Tools of Financial Statement Analysis:

The history of financial statement analysis is traced back to the beginning of 20th century. The analysis was started in western countries for the use of credit analysis. Till 1914, financial institutions used to rely on the facts of financial statements. But over a period of time, the need for analysis was felt and a number of techniques were invented and made use of for the purpose of analysis.

The most important techniques of analysis and interpretation, of financial statements are listed below:

(a) Ratio analysis;

(b) Cash flow analysis;

(c) Funds flow analysis;

(d) Comparative financial statements;

(e) Common measurement or size statements;

(f) Net working capital analysis;

(g) Trend analysis.

(a) Ratio Analysis:

An analysis of financial statements based on ratios is known as ratio analysis. A ratio is a mathematical relationship between two or more items taken from the financial statements. Ratio analysis is the process of computing, determining, and presenting the relationship of items. It also includes comparison and interpretation of ratios and using them as basis for the future projections. Ratio analysis is helpful to management and outsiders to diagnose the financial health of a business concern. It helps in measuring the profitability, solvency, and activity of a firm.

(b) Cashflow Analysis:

Cash flow analysis depicts the inflows and outflows of cash. Cashflow statement is the device for such analysis. It highlights causes which bring changes in cash position between two balance sheet dates.

(c) Funds Flow Analysis:

Funds flow statement signifies the sources and applications of funds. The term ‘funds’ refers to working capital. Funds flow analysis clearly shows internal and external sources of working capital and the way funds have been used. Funds flow is derived from analysis of changes which have taken place in assets and equities between two balance sheet dates.

According to Foulke “a statement of sources and application of funds is a technical device designed to analyse the changes in financial position of a business concern between two periods”.

Funds flow analysis is helpful in judging credit worthiness, financial planning and budget preparation.

(d) Comparative Financial Statements:

This is yet another technique used in financial statement analysis. These statements summarise and present related data for a number of years, incorporating therein changes (absolute and relative) in individual items of financial statements. These statements normally comprise comparative balance sheets, comparative profit and loss account, and comparative statements of change in total capital as well as in working capital. These statements help in making inter-period and inter-firm comparisons and also highlight the trends in performance efficiency, and financial position.

(e) Common Size Statements:

Common size statements indicate the relationship of various items with some common items, (expressed as percentage of the common item). In the income statements, the sales figure is taken as basis and all other figures are expressed as percentage of sales. Similarly, in the balance sheet the total assets and liabilities is taken as base and all other figures are expressed as percentage of this total.

The percentages so calculated are compared with corresponding percentages in other periods or other firms and meaningful conclusions are drawn. Generally, a common size income statement and common size balance sheet is prepared.

(f) Networking Capital Analysis:

Networking capital statement or schedule of changes in working capital is prepared to disclose net changes in working capitals on two specific dates (generally two balance sheet dates). It is prepared from current assets and current liabilities on the specified dates to show net increase or decrease in working capital.

(g) Trend Analysis:

‘Trend’ signifies a tendency and as such the review and appraisal of tendency in accounting variables are nothing but trend analysis. Trend analysis is carried out by calculating trend ratios (percentage) and /or by plotting the accounting data on graph paper or chart. Trend analysis is significant for forecasting and budgeting. Trend analysis discloses the changes in financial and operating data between specific periods.

Limitations of Financial Statement/Analysis:

Financial statement analysis is a very important device but it has certain limitations which are to be kept in mind.

Following are the limitations of financial statement analysis:

(1) Based on Past Data:

The nature of financial statements is historical. Past cannot be the index of future and cannot be cent per cent basis for future estimation, forecasting, budgeting and planning.

(2) Financial Statements Analysis cannot be a Substitute for Judgement:

Analysis is a tool which can be utilised usefully by an expert but may lead to erroneous conclusions by unskilled analyst. Thus results of analysis cannot be considered as judgement or conclusion.

(3) Reliability of Figures:

The accuracy and reliability of analysis depends on reliability of figures derived from financial statements. If financial statements are manipulated by window-dressing, analysis based on those figures will be misleading or meaningless.

(4) Different Interpretations:

Results of the analysis may be interpreted differently by different users.

(5) Change in Accounting Methods:

Analysis will be effective if the figures taken from financial statements are comparable. If there are frequent changes in accounting policies and methods, the figures of different periods will be different and uncomparable. Then the analysis will have little meaning and value.

(6) Price Level Changes:

Ever rising inflation erodes the value of money in the present day economic situation, which reduces the validity of analysis.

(7) Limitations of the Tools of Analysis:

Different techniques of analysis are used by an analyst. These tools are suitable for different types of analysis. Application of a particular tool or technique depends on the skill and expertise of the analyst. If an unsuitable technique is used, it gives misleading results. It may lead to wrong conclusions and prove harmful to the business concern.

We may conclude that financial statement analysis is a valuable tool in the hands of a skilled financial analyst who can dissect and diagnose the nature of sickness of commercial firms.