FINANCIAL STATEMENT ANALYSISMeaning and Definitions of Financial Statement Analysis

Metcalf and Titard defined as, Financial Statement Analysis is a process of evaluating the relationship between component parts of a financial statement to obtain a better understanding of a firms position and performance.

Objectives of Financial Statement Analysis

The objectives of Financial Statement Analysis are stated as follows:

(i) To find out the operating performance of a company.

(ii) To find out the Financial performance of a company.

(iii) To Compare the performance of a company for different periods.

(iv) To find out the long-term solvency and liquidity of a concern.Advantages or Uses of Financial Statement Analysis1. Advantages to the owners of the Company:

2. Advantages to the Investors:

3. Advantages to the Management:

4. Advantages to the Suppliers:

Types of Financial Statement Analysis

1. Classification according to Material used

According to material used, financial Statement Analysis is classified as

(i) Internal Analysis and

(ii) External Analysis.

2. Classification according to Modus Operandi

According to Modus Operandi Financial Statement Analysis is classified as

(i) Horizontal Analysis and

(ii) Vertical Analysis

Procedures for Financial Statement Analysis

The following are the procedures in the Financial Statement Analysis.(i) The purpose for which the analysis is conducted should be determined well in advance.

(ii) On the basis of the purpose the items in the Financial Statement should be identified.

(iii) If the analysis to be carried on about the Income Statement, the items should be clearly arranged on the basis of Sales, Cost of goods sold, Gross Profit, Operating expenses, Operating Profit and Net Profit. This is to establish a relationship between various items of the income statement.(iv) If the analysis is to be carried on about the Balance Sheet, then the items should be classified as Fixed Assets and Current Assets for Asset side and Current Liabilities, Debt and Equity for the Liability side.

(v) After the classification of the items in the Income Statement and Balance Sheet increase or decrease of each items from one period to another should be calculated. Also percentage of increase or decrease should be calculated. The comparison may be done for each item on the basis of percentage on sales for Income Statement and on total assets and total liabilities for Balance Sheet.(vi) Interpretation about the analysis should be very clearly explained after the analysis in order to provide valuable information for managerial decision making.

Methods or Devices of Financial Statement 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.

1.Comparative Statement

Comparative Statement deal with the comparison of different items of the Profit & Loss Account and Balance Sheets of two or more periods. In the process of comparison, the good or poor performance of each items for a period can be known in order to take corrective action for the future.Comparative Income Statement Income statement gives detail about the Profit of a company. This statement explains the Profit in three different stages namely, Gross Profit, Operating Profit and Net Profit. The comparative income statement shows whether there is any improvement in the profitability of a concern over a period of time. If the profitability is low compared to the previous year, the management can able to identify the reasons for it so that corrective action can be taken.

Prepare a Comparative Income Statement of K Ltd. For the following Profit and Loss. Account for the year ended 31st March 2006 and 2007. Profit & Loss Account for the year ended 31st March 2006 and 2007Particulars2006Rs.2007Rs.Particulars2006Rs.2007Rs.

To Cost of goods soldTo Operating expenses Administrative exp.

Selling expenses

To Net Profit 7,00,000 90,000

60,000

1,50,000 8,90,000 1,40,000

40,000

1,30,000By Sales10,00,00012,00,000

10,00,00012,00,00010,00,00012,00,000

Solution:

Comparative Income Statement

Particulars2006

Rs.

2007

Rs.Change

Rs.Percentage

Sales

Less: Cost of Good Sold

10,00,000

7,00,00012,00,000

8,90,000 2,00,000

1,90,000

20

27.14

Gross Profit

3,00,000 3,10,000 10,000 3.33

Operating Expenses:

Administrative Expenses

Selling Expenses 90,000

60,0001,40,000

40,000 50,000

- 20,000 55.55

33.33

Total Operating Expenses

1,50,0001,80,000 30,000 20

Net Profit

1,50,000 1,30,000 -20,000 13.33

Interpretation:1. Gross Profit of the company increased by 3.33% . But the Net Profit reduced by 13.33%.

2. The reasons for the reduced net profit is due to increase in administrative expenses and cost of goods sold.

Comparative Balance Sheet AB Ltd. Provided the Balance Sheets for the year ended 31st March 2006 and 2007 as follows

Balance Sheets ParticularsShare Capital

Profit & Loss A/c

Loan

Current Liabilities2006

Rs.

11,00,000

1,45,000

2,00,000

75,0002007

Rs.

14,00,000

1,75,000

1,50,000

95,000Particulars

Fixed Assets

Current Assets2006

Rs.

12,80,000

2,40,0002007

Rs.

15,20,000

3,00,000

15,20,00018,20,00015,20,00018,20,000

Prepare a Comparative Balance Sheet.Solution:

Comparative Balance SheetParticulars2006

Rs.2007

Rs.Change

Rs.Percentage

Assets

Current Assets

Fixed Assets 2,40,000

12,80,000 3,00,00015,20,000 60,000

2,40,00025.00

18.75

Total Assets15,20,00018,20,000 3,00,00019.74

Liabilities

Current Liabilities:

75,000 95,000 20,000 26.67

Debt-Loan 2,00,000 1,50,000 -50,000-25.00

Equity:

Share Capital

Profit & Loss Account11,00,000

1,45,00014,00,000

1,75,000 3,00,000

30,000 27.27

20.69

Total Equity12,45,00015,75,000 3,30,00026.51

Total Liabilities15,20,00018,20,000 3,00,00019.74

Interpretation:(i) There is an increase in the total Assets and Liabilities by 19.74%.

(ii) The growth of Fixed Assets is low when compared to the growth of Current Assets

(iii) There is an increase in the value of Equity to the extent of 26.51%. But the Debt reduced by 25%.

(iv) The Net Profit also increased by 20.69%.

(v) Increase in Current Assets when compared to Current Liabilities showed the increase in Working Capital.

In this analysis, the important items of the financial statements (both Profit & loss Account and Balance Sheet) for a long period can be taken for Trend analysis. The period of comparison may be 5 years or more than that. Trend percentage should be calculated by taking one year as base. Normally, the first year of comparison in taken as base year. The index of base year should be 100 and from that trend percentages for the subsequent years should be calculated.Procedures for calculating Trend Percentages The following are the procedures for calculating the Trend Percentage(i) The base year should be identified. Normally the first year is considered as base year.

(ii) The items to be compared should also be identified.

(iii) The values of base year should be considered as 100.

(iv) Compare the values of the subsequent years with the base year and convert it into Trend values (by dividing the value of current year with the value of base year. This value should be multiplied by 100).

Illustration:7The following are the information related to Sales and Profit of G Ltd. Calculated the Trend Percentages by taking 2003 as base. Also interpret the result. (Rs. in 000s) Year Sales Stock Profit Before Tax

2003

2004

2005

2006

2007

4,500

5,300

6,000

6,500

7,000

340

450

700

550

400 420

370

510

300 750

Solution:

Statement of Trend PercentageYear

Sales Stock Profit Before Tax

AmountRs.TrendPercentageAmountTrendPercentageAmountRs.TrendPercentage

2003

2004

2005

2006

2007 4,500

5,300

6,000

6,500

7,000 100

117.78

133.33

144.44

155.55 340

450

700

550

400 100

132.35

205.88

161.76

117.64 420

370

510

300

750 100

88

121.43

71.42

178.57

Interpretation:(i) Sales improved by 155.55% in the year 2007 compared to the year 2003. The improvement is gradual and steady.

(ii) Stock position is very high during 2005 when compared to other periods. More or less same level of stock is maintained in 2007 also (i) e., 117.64% when compared to 2003.

(iii) There is a wide fluctuation in the improvement of Profit before tax. It reduced to 88% in 2004 and immediately raised to 121.43%. Then it reduced to 71.42% level in 2006 and improved to 178.57%. The overall improvement to 178.57% compared to 2003 is good.3. Common Size Statement Common size statement is concerned with the analysis of the financial statements (Income statement and Balance Sheet) on percentage basis. It explains each item of the financial statements in terms of the percentage to the total. Hence, the share of each items of Expenses or Income, Assets or Liabilities to total can be known through this analysis.

Common size statements are prepared on the following basis.

(i) Common-size Income Statement

(ii) Common-size Balance sheet

(i) Common Size Income Statement: In this statement, the value of each item of expenses are analysed as a percentage to the total sales. For example, if the sales is Rs. 4,00,000 and the administrative expensesIllustration: 8The Income Statement of a manufacturing Company for 31st March 2006 and 2007 are stated as follows.

Particulars2006

Rs.2007

Rs.

Sales

Non-operating income (Dividend received)

Expenses

Cost of production

Administrative Expenses

Selling Expenses

Interest

Total Expenses

Net Profit

29,00,000

1,50,000 34,00,000

1,00,000

30,50,000 35,00,000

16,40,000

5,40,000

2,10,000

3,70,000

18,85,000

6,20,000

2,75,000

3,90,000

27,60,000 31,70,000

2,90,000 3,30,000

Solution:

Particulars 2006 2007

Rs.%Rs.%

Sales

Less:Cost of production

Gross Profit

Operating Expenses

Administrative Expenses

Selling ExpensesTotal Operating ExpensesOperating Profit

Non-operating income

(Dividend)

Total Income

Less: Non-operating Expenses

Interest

Net profit 29,00,000

16,40,000 100.00

56.55 34,00,000

18,85,000 100.00

55.44

12,60,000 43.45 15,15,000 44.56

5,40,000

2,10,000 18.62

7.24 6,20,000

2,75,000 18.24

8.08

7,50,000 25.86 8,95,000 26.32

5,10,000

1,50,000 17.59

5.17 6,20,000

1,00,000 18.23

2.94

6,00,000 3,70,000 22.76 12.76 7,20,000 3,90,000 21.17 11.47

2,90,000 10.00 3,30,000 9.70

Interpretation

(i) The operating efficiency of the company is more or less same. This is seen from the percentage of Operating Expenses, Operating Profit and Net Profit on Sales.

(ii) The Gross Profit for 2006 and 2007 on Sale are almost same as 43.45% and 44.56% respectively.

(iii) The Net profit on Sales for 2006 and 2007 are same as 10% and 9.7%.

(ii) Common-size Balance Sheet

Common size Balance Sheet is prepared by analysing each item of the Balance Sheet as on percentage of the Total Assets or Total Liabilities.

Illustration:10

The Balance Sheets of N Ltd. And H Ltd. As on 31st March 2007 are stated as follows.

ParticularsN Ltd.Rs.H Ltd.Rs.

AssetsCash

Sundry Debtors

Stock

Outstanding Income

Prepaid Expenses

Fixed Assets

Total Assets 75,000

70,000

79,000

26,000

20,000

10,20,000 95,000

77,000

85,000

23,000

10,000

12,10,000

12,90,000 15,00,000

LiabilitiesSundry Creditors

Bills Payable

Long-term Loan

Capital

Total Liabilities 45,000

25,000

4,00,000

8,20,000 32,000

13,000

5,00,000

9,00,000

12,90,000 15,00,000

Prepare a common size Balance Sheet and interpret the result.

Solution :

Common Size Balance Sheet

Particulars

N Ltd. Rs. H Ltd. Rs.

Amount %Amount %

Current AssetsCash

Sundry debtors

Stock

Outstanding Income

Prepaid expenses

Total Current Assets

Fixed Assets

Total Assets

Current Liabilities

Sundry Creditors

Bills Payable

Total Current Liabilities

Long term Loan

Capital

Total Liabilities

75,000

70,000

79,000

26,000

20,000 5.81

5.43

6.12

2.02

1.55 95,000

77,000

85,000

23,000

10,000 6.33

5.13

5.67

1.53

0.67

2,70,000 20.93 2,90,000 19.33

10,20,000 79.07 12,10,000 80.67

12,90,000100.00 15,00,000 100.00

45,000

25,000 3.49

1.94 32,000

13,000 2.13

0.87

70,000 5.43 45,000 3.00

4,00,000 31.00 5,55,000 37.00

8,20,000 63.57 9,00,000 60.00

12,90,000100.00 15,00,000 100.00

Interpretation:

(i) H Ltd. has more Total Assets compared to N Ltd.

(ii) The Current Assets to Total Assets for H Ltd. is slightly low than N Ltd. But it is compensated by low amount of Current Liabilities for H Ltd. compared to N. Ltd. Hence, the Working Capital of H Ltd. is comparatively better.

(iii) The Debt-Equity of H Ltd. is not good compared to N Ltd. since N Ltd. has more percentage of equity compared to H ltd.