Financial Statement Analysis: Meaning, Objectives and Techniques

In this article we will discuss about Financial Statement Analysis:- 1. Meaning of Financial Statement Analysis 2. Objectives of Financial Statement Analysis 3. Techniques.

Meaning of Financial Statement Analysis:

Financial Statement Analysis is an analysis which highlights important relationships in the financial statements. Financial Statement analysis embraces the methods used in assessing and interpreting the results of past performance and current financial position as they relate to particular factors of interest in investment decisions. It is an important means of assessing past performance and in forecasting and planning future performance.

According to Lev:

“Financial Statement Analysis is an information processing system designed to provide data for decision-making models, such as the portfolio selection model, bank lending decision models, and corporate financial management models.”

Objectives of Financial Statement Analysis:

The major objectives of financial statement analysis are to provide decision makers information about a business enterprise for use in decision-making. Users of financial statement information are the decision-makers concerned with evaluating the economic situation of the firm and predicting its future course.

Financial statement analysis can be used by the different users and decision makers to achieve the following objectives:

1. Assessment of Past Performance and Current Position:

Past performance is often a good indicator of future performance. Therefore, an investor or creditor is interested in the trend of past sales, expenses, net income, cash flow and return on investment. These trends offer a means for judging management’s past performance and are possible indicators of future performance.

Similarly, the analysis of current position indicates where the business stands today. For instance, the current position analysis will show the types of assets owned by a business enterprise and the different liabilities due against the enterprise. It will tell what the cash position is, how much debt the company has in relation to equity and how reasonable the inventories and receivables are.

2. Prediction of Net Income and Growth Prospects:

The financial statement analysis helps in predicting the earning prospects and growth rates in the earnings which are used by investors while comparing investment alternatives and other users interested in judging the earning potential of business enterprises. Investors also consider the risk or uncertainty associated with the expected return.

The decision makers are futuristic and are always concerned with the future. Financial statements which contain information on past performances are analysed and interpreted as a basis for forecasting future rates of return and for assessing risk.

3. Prediction of Bankruptcy and Failure:

Financial statement analysis is a significant tool in predicting the bankruptcy and failure probability of business enterprises. After being aware about probable failure, both managers and investors can take preventive measures to avoid/minimise losses.

Corporate managements can effect changes in operating policy, reorganize financial structure or even go for voluntary liquidation to shorten the length of time losses.

In accounting and finance area, empirical studies conducted have suggested a set of financial ratios which can give early signal of corporate failure. Such a prediction model based on financial statement analysis is useful to managers, investors and creditors. Managers may use the ratios prediction model to assess the solvency position of their firms and thus can take appropriate corrective actions.

Investors and shareholders can use the model to make the optimum portfolio selection and to bring changes in the investment strategy in accordance with their investment goals. Similarly, creditors can apply the prediction model while evaluating the creditworthiness of business enterprises.

4. Loan Decision by Financial Institutions and Banks:

Financial statement analysis is used by financial institutions, loaning agencies, banks and others to make sound loan or credit decision. In this way, they can make proper allocation of credit among the different borrowers. Financial statement analysis helps in determining credit risk, deciding terms and conditions of loan if sanctioned, interest rate, maturity date etc.

Techniques of Financial Statement Analysis:

Various techniques are used in the analysis of financial data to emphasise the comparative and relative importance of data presented and to evaluate the position of the firm.

Among the more widely used of these techniques are the following:

(1) Horizontal Analysis,

(2) Vertical Analysis,

(3) Trend Analysis, and

(4) Ratio Analysis.

(1) Horizontal Analysis:

The percentage analysis of increases and decreases in corresponding items in comparative financial statements is called horizontal analysis. Horizontal analysis involves the computation of amount changes and percentage changes from the previous to the current year. The amount of each item on the most recent statement is compared with the corresponding item on one more earlier statements.

The increase or decrease in the amount of the item is then listed, together with the per cent of increase or decrease. When the comparison is made between two statements, the earlier statement is used as the base. If the horizontal analysis includes three or more statements, there are two alternatives in the selection of the base.

First, the earliest date or period may be used as the basis for comparing all later dates or periods or second, each statement may be compared with the immediately preceding statement.

Exhibit 17.1 and 17.2 present the comparative balance sheet and profit and loss account respectively of a company with the amount of increase or decrease and percentage changes shown.

The per cent change is computed as follows:

Percentage change = Amount of change/Previous year amount x 100

(2) Vertical Analysis:

Vertical Analysis uses percentages to show the relationship of the different parts to the total in a single statement. Vertical analysis sets a total figure in the statement equal to 100 per cent and computes the percentage of each component of that figure.

The figure to be used as 100 per cent will be total assets or total liabilities and equity capital in the case of balance sheet and revenue or sales in the case of the profit and loss account.

(3) Trend Analysis:

Using the previous year’s data of a business enterprise, trend analysis can be done to observe percentage changes over time in selected data. In trend analysis, percentage changes are calculated for several successive years instead of between two years.

Trend analysis is important because, with its long-run view, it may point to basic changes in the nature of the business. By looking at a trend in a particular ratio, one may find whether that ratio is falling, rising or remaining relatively constant. From this observation, a problem is detected or the sign of a good management is found.

Trend analysis uses an index number over a period of time. For index number, one year, the base year is equal to 100 per cent. Other years are measured in relation to that amount. For example, an analyst may be interested in sales and earnings trends for the past five years. For this purpose, sales and earnings data of a company are given to prepare further the trend analysis or percentages.

The above data show a fairly healthy growth pattern but the pattern of change from year to year can be determined more precisely by calculating trend percentages. To do this, a base year is selected and then the data are divided for each of the other years by the base year data.

The resultant figures are actually indexes of the changes occurring throughout the period. If year 1 is chosen as the base year, all data for year 2 through 5 will be related to year 1, which is represented as 100%. To create the following table, each year sales is divided—from year 2 through years 5—by Rs. 202, the year 1 sales. Similarly, the net earnings for years 2 through 5 are divided by Rs. 10.9, the year 1 net earnings.

The trend percentages reveal that the growth in earnings outstripped the growth in sales for years 2 and 3, and then fell below the sales growth in the last two years.

It is clear in this analysis of comparative statements that a disproportionate increase in operating expenses emerged in year 5. One may analyse the year 4 data to determine if net income was affected for the same reason or if the reduced growth was caused by other factors.

(4) Ratio Analysis:

Ratio analysis is an important means of expressing the relationship between two numbers. A ratio can be computed from any pair of numbers. To be useful, a ratio must represent a meaningful relationship, but use of ratios cannot take the place of studying the underlying data.

Ratios are guides or shortcuts that are useful in evaluating the financial position and operations of a company and in comparing them to previous years or to other companies. The primary purpose of ratios is to point out areas for further investigation. They should be used in connection with a general understanding of the company and its environment.

Comparison of income statement and balance sheet numbers, in the form of ratios, can create difficulties due to the timing of the financial statements. Specifically, the profit and loss account covers the entire fiscal period, whereas the balance sheet is for a single point in time, the end of the period.

Ideally then, to compare an income statement figure such as sales to a balance sheet figure such as receivable, we usually need a reasonable measure of average receivables for the year that the sales figure cover.

However, these data are not available to the external analyst. In some cases, the analyst should take the next best approach, by using an average of beginning and ending balance sheet figures. This approach smooth’s out changes from beginning to end, but it does not eliminate problem due to seasonal and cyclical changes. It also does not reflect changes that occur unevenly throughout the year.

Common Size Statements:

Common size statements involve expressing comparisons in percentages. Common size statements may be prepared in order to compare percentages of a current period with past periods, to compare individual business, or to compare one business with industry percentages published by trade associations and financial information services.

Common size financial statements contain the percentages of a key figure alone, without the corresponding amount figures. The use of percentages is usually preferable to the use of absolute figures. An illustration will make this clear. If company A earns Rs. 10,000 and Company B earns Rs. 1,000, which is more profitable? The answer is likely to be company A.

However, the total shareholder’s equity of company A is Rs. 10,00,000 and company B is Rs. 10,000 the return on equity will be as follows:

Comparing the return on equity, it can be clearly said that company B is more profitable than company A.

The use of common size statements can make comparisons of business enterprises of different sizes much more meaningful since the numbers are brought to common base, i.e., per cent. Such statement allows an analyst to compare the operating and financing characteristics of two companies of different sizes in the same industry.

Care must be exercised in the use of common size statements when the absolute figures are small, because a small absolute change can result in a very substantial percentage change. For example, if net profits last year amounted to Rs. 1,000 and increased this year to Rs. 5,000, this would be an increase of only Rs. 4,000 in net profits, but represents a substantial increase in percentage terms.

Common size statements can be prepared in vertical analysis and horizontal analysis formats. In vertical analysis format, a figure from a year is compared with a base selected from the same year. For example, if advertising expenses were Rs. 10,000 in 2008 and sales were Rs. 10,00,000, the advertising expenses will be 1% of sales.

In horizontal analysis format, the amount of an item (an account) is expressed in terms of that same account figure for a selected base year. For example, if sales were Rs. 8,00,000 in 2008 and Rs. 12,00,000 in 2009, then sales increased to 150% of the 2008 level in 2009, an increase of 50%.