Analysis of Financial Statements: 4 Steps | Accounting

Financial analysis is analysis of financial statements of a company to assess its financial health and soundness of its financial management. “Financial Statement Analysis” involves a study of the financial statements of a company to ascertain its prevailing state of affairs and the reasons therefore. Such a study would enable the public and investors to ascertain whether one company is more profitable than the other, and also to state the causes and factors that are probably responsible for this.

The term ‘financial statements’ as used in modern business refers to the balance sheet, or the statement of financial position of the company at a point of time and income and expenditure statement, or the profit and loss statement over a period. To this is added, the profit allocation statement which reconciles the balance in this account at the end of the period with that at the beginning. Thus, the financial statements provide a summary of the accounts of a company over a period of one year, and the balance sheet reflecting the assets, liabilities and capital as at a point of time say at the end of the year.

Analysis and Interpretation- With a view to interpret the financial statements, it is necessary to analyse them with the object of formation of an opinion with respect to the financial condition of that company.

This analysis involves the following steps:

1. Comparison of the financial statements, over two to five years.

2. Ratio analysis, for two to five years.

3. Funds Flow analysis, over a short period.

4. Trend analysis, over a period of 5 to 10 years.

Step # 1. Comparison of the Financial Statements:

Comparison is the precondition for a meaningful interpretation. It may be in the nature of:

(a) Figures of one year with that of another year;

(b) Inter-firm comparison of figures, within the same industry;

(c) Comparison of one product figures with that of another product; and

(d) Comparison of budgeted figures with the actual figures.

For the purpose of analysis, the figures in the balance sheet and the income statements are to be arranged properly which will facilitate the work.

The state­ments are prepared in single (vertical) column form as shown below for this purpose:

Balance Sheet as at. . . .

Fixed Assets

Investments

Working Capital:

Current Assets less:

Current  Liabilities

Capital Employed

Total

 

Meaningful analysis can be achieved by comparing the financial data and ratios of one firm with that of another. This process is called inter-firm comparison. When the performance in various departments of a single firm is compared, the term used is intra-firm comparison.

For inter-firm comparisons the financial statements must be made as far as practicable and comparable so as to derive reliable conclusions on anything. The stated amounts of two enterprises must be at the same price levels, and the account­ing methods used by them must be similar.

Step # 2. Ratio Analysis:

The ratio is a statistical yardstick that provides a measure of relationship between any two variables. It can be effectively used as a tool of management along with Fund Flow Statements and Trend Analysis for interpretation of the financial statements. As ratios are simple to calculate and easy to understand, there is a tendency to employ them profusely.

The ratios are conveniently classified as follows:

(i) Balance Sheet Ratios which deal with the relationships between two items or groups of items which are both in the Balance Sheet, e.g., the ratio of current assets to current liabilities (Current Ratio).

(ii) Revenue Statement Ratios which deal with the relationship between two items or groups of items which are both in the Revenue Statement, e.g., ratio of gross profit to sale or gross profit margin.

(iii) Balance Sheet and Revenue Statement Ratios which deal with real rela­tionships between items from the Revenue Statement and items from the Balance Sheet, e.g., ratio of net profit to own Funds (Composite Ratios).

Some examples of these ratios are given below:

(1) Revenue Statement Ratios:

i. Gross Profit Ratio.

ii. Operating Ratio.

iii. Expense Ratio.

iv. Net Profit Ratio.

v. Stock Turnover or Turnover of Inventory.

(2) Balance Sheet Ratios:

i. Current Ratio.

ii. Liquidity Ratio or Quick Ratio.

iii. Debt to Equity Ratio.

iv. Asset to Equity Ratio.

(3) Composite Ratios:

i. Return on Total Resources.

ii. Return on Own Funds.

iii. Turnover of Fixed Assets.

iv. Turnover of Debtors.

Usefulness of Ratio Analysis:

Ratio Analysis should be based on some common standards such as compa­rison between two companies in the same industry and within the same assets group. Since the performance of companies varies from industry to industry and from location to location, the ratios are not comparable exactly.

What is proper for Hotel Industry which is seasonal in nature may not be true for cement and steel industries which belong to infrastructure sector.

The use of Ratio Analysis depends on the object in mind. The question to be put to oneself is what do I want to know of the company? Let us say its capital efficiency is to be examined. Then ratios such as Gross Block to equity or Fixed Assets to Share Capital or Net Profit to Capital employed are to be used. Thus, there are different ratios for different purposes.

Ratio Analysis will be meaningful to establish relationship regarding financial performance, operational efficiency and profit margins with respect to companies over a period of time and as between companies within the same industry group.

In addition to the Ratio Analysis, financial analysis involves fund flow Analysis and the Trend Analysis. Fund Flow Analysis involves the examination of sources and uses of funds. Thus, inflow of funds is due to sale, and other income, whereas uses are increases in investment or purchase of assets or for regular wage and other payments etc. Cash accruals and how they are utilised will be studied in this process.

Step # 3. Fund Flow Analysis:

The Balance Sheet of a Company reveals its financial status at a point of time. The financial executive must know the flows of funds underlying the balance sheet changes. The operation of business involves the conversion of cash into non-cash assets which are recovered back into cash form. The statement showing sources and uses of funds is properly known as “Fund Flow Statements.” It shows the ebb and flow of funds into and out of a business.

It covers all movements that involves an actual exchange of assets and only transactions representing book-keeping adjust­ments are not reported. Thus, Funds Flow Statement is a useful tool in the kit of financial management and is a report of the financial operations of the company.

The term funds should not be interpreted as literal cash, but it extends the concept to include assets or financial resources which do not effect cash or working capital. Examples are the purchase of property in exchange for issue of shares and bonds. The broader approach provides a more complete and informative presentation.

The changes representing the “sources of funds” in the business may be issue of debentures, increase in net worth, addition to funds, reserves and surplus, reten­tion of earnings.

Changes showing the “uses of funds” include:

(a) Additions to assets — fixed and current.

(b) Addition to investments.

(c) Decrease in liabilities by paying off loans and creditors.

(d) Decrease in net worth by incurring of losses, withdrawal of funds from business and payment of dividends. If the net profit for a particular accounting year is a source of funds, a net loss as shown by an income statement is an application of funds. This is so because where a loss has been incurred, funds have gone out of the business.

The changes in net working capital take place either by the decrease in current assets or increase in the liabilities as sources of funds and the reduction in current liabilities. These changes in net working capital are available from the comparative balance sheet analysis.

An increase in net working capital in this manner represents a net application of funds. A statement of source and application of funds can be prepared from the two comparative balance sheets with an accompanying increase- decrease column. From the stand-point of the balance sheet, funds may come from three sources- an increase in liabilities, a decrease in assets and an increase in net- worth.

The increase in net worth is used to represent two sources of funds, namely, net-profits and contribution of own funds, Likewise, applications represent three uses of funds, decrease in liabilities, increase in assets and decrease in net worth. Here again, the decrease in the net worth represents the uses, namely, net losses and decrease in capital funds.

The fund flow statement helps in guiding the destiny of a business by enabling the analyst to visualise the movement of funds that constantly take place. A failure to detect pattern of change can perpetuate undesirable trends and lead to financial difficulties. An extended reliance on external sources can create a top heavy capital structure.

This statement helps in detecting the sources for financing the heavy accumulation of inventory and book-debts if any. It is also helpful in forecasting the flow of funds. It is used for projecting working capital requirements. It also high­lights future need for rinds and plays an important role in the evaluation of trade credit.

The Concept of Funds and Cash:

While funds flow is used in the sense of working capital, cash flow is used for only cash inflows and outflows. While the former refers to long-term and medium-term funds for all activities, the latter refers to only short-term needs which are substitutable for bank balances. The cash flows are prepared from cash budgets and operations of the company. The fund flows are for total activities say operations in financial and investment and related activities. In cash flows only cash and bank balances are involved and hence it is a narrower term than the concept of funds flows.

How to Prepare Cash Flow Statement?

The data come from the Balance Sheet and Income Expenditure statement in the form of changes over a period of each in the items of these financial statements.

The example of a cash flow statement is as follows:

Cash profits are brought forward from profit allocation statement, while the other items are derived from the Balance Sheet and income and expenditure state­ment. A reading of the above statement helps the cash management techniques adopted by the company and its liquidity position.

Statement of Cash Flows:

The usefulness of these data for the analysts is to assess the cash generated from the operations, financial activities and investment activities and the adequacy or otherwise of these cash flows to meet the emerging obligations involved in opera­tions.

The timing of the flows and whether outflows can be met by inflows during any period reflects the ability of the company to be solvent. The cash flow statement explains how the dividends are paid, how fixed assets are financed and the cost of financing reflected in the profitability and how the working capital requirements are met including bank borrowing?

If loss is shown, how is it financed? If loss is shown for tax purposes that is, as part of the tax planning, the analyst has to know the real cash flow position of the company, its liquidity and solvency which are reflected in the cash flow position and the statement thereof.

Step # 4. Trend Analysis:

Trend analysis refers to comparison of some important ratios and rates of growth over a time period of a few years. These trends in the case of GPM or Sales Turnover are useful to indicate the extent of improvement or deterioration over a period of time in the aspects considered. The trends in dividends, E.P.S., asset growth or sales growth are some examples of the trends used to study the operational performance of the companies. Any temporary rise in inventories to sales would indicate sluggish demand for the products of the company.

Thus, the trends of the results, rather than the actual ratios and percentages, are important. Structural relationships taken from the financial statements of one year only are of limited value and the trends of these structural relationships established from statements over a number of years may be more significant than absolute ratios. Investor wants to know how well the business is operating in comparison with planned performance and if actual results are not good enough, what should the future indicate for the company. The financial results of all businesses are affected by general economic condition, by competition, and local factors relating to company.

It should be particularly emphasized that one particular ratio used without reference to other ratios may be very misleading. In other words, the combined effect of the various ratios must be considered in arriving at a correct diagnosis which will be of assistance in interpreting the financial condition and earning performance of the business. Each ratio plays its part in this interpretation.

Finally, it should be realised that ratios are only preliminary step in interpre­tation and must be supplemented by rigorous investigation into all aspects of operations of company before safe conclusions can be drawn from them. Trend analysis should supplement the ratio analysis to assess the good and bad aspects of working of a company.

More importantly not only the objective factual data should be analysed from Balance Sheet and Income-Expenditure Statements of the company, but a scrutiny of subjective factors indicated in the Directors’ and Auditor’s Reports should also be made with particular reference to any mention in footnotes to contingent liabilities, unpaid taxes, doubtful debts etc. Besides research into practical day-to-day opera­tions of the company can be done only by a plant visit and study on the spot the prospects of the company in the coming year or two.