ANALYSIS OF FINANCIAL ANALYSIS OF FINANCIAL STATEMENTSSTATEMENTS

By Dr. B. Krishna ReddyProfessor and Head_SKIM

• 1) 1) MEANING OF FINANCIAL STATEMENTMEANING OF FINANCIAL STATEMENT• 2)2) NATURE OF FINANCIAL STATEMENTNATURE OF FINANCIAL STATEMENT• 3)3) ESSENTIAL QUALITIES OF FINANCIAL ESSENTIAL QUALITIES OF FINANCIAL STATEMENTSTATEMENT• 4)4) LIMITATION OF FINANCIAL LIMITATION OF FINANCIAL STATEMENTSTATEMENT• 5)5) FINANCIAL STATEMENT ANALYSISFINANCIAL STATEMENT ANALYSIS• 6)6) TOOLS & TECHNIQUES OF ANALYSISTOOLS & TECHNIQUES OF ANALYSIS• 7)7) TYPES OF COMPARISONTYPES OF COMPARISON• 8)8) INTERPRETATIONINTERPRETATION

NATURE OF FINANCIAL NATURE OF FINANCIAL

STATEMENTSTATEMENT

• The data exhibited by financial The data exhibited by financial statements are affected by statements are affected by

• a)a) Recorded factsRecorded facts

• b)b) Accounting Concepts, Accounting Concepts, Conventions & PrinciplesConventions & Principles

• c)c) Personal JudgmentPersonal Judgment

Accounting PrinciplesAccounting Principles

•Accounting conceptsAccounting concepts Accounting Conventions Accounting Conventions

• a)a) Entity ConceptEntity Concept a)a) DisclosureDisclosure• b)b) Going Concern ConceptGoing Concern Concept b)b) MaterialityMateriality• c)c) Accounting period conceptAccounting period concept c)c) ConsistencyConsistency• d)d) Money Measurement ConceptMoney Measurement Concept d)d) ConservatismConservatism• e)e) Cost ConceptCost Concept• f)f) Cost Attach ConceptCost Attach Concept• g)g) Dual Aspect ConceptDual Aspect Concept• h)h) Accrual conceptAccrual concept• i)i) Periodic Matching of cost and Periodic Matching of cost and • Revenue ConceptRevenue Concept• j)j) Realisation ConceptRealisation Concept• k)k) Verifiable Objective Evidence ConceptVerifiable Objective Evidence Concept

ESSENTIAL QUALITIES OF ESSENTIAL QUALITIES OF FINANCIAL STATMENTSFINANCIAL STATMENTS

• 1.1. RelevanceRelevance

• 2.2. UnderstandabilityUnderstandability : :

• 3.3. Reliability and AccuracyReliability and Accuracy

• 4.4. ComparabilityComparability

• 5.5. CompletenessCompleteness

• 6.6. TimelinessTimeliness

LIMITATIONS OF FINANCIAL LIMITATIONS OF FINANCIAL STATEMENTSSTATEMENTS

• 1.1. Lack of PrecisionLack of Precision

• 2.2. Lack of ExactnessLack of Exactness

• 3.3. Incomplete InformationIncomplete Information

• 4.4. Interim ReportsInterim Reports

• 5.5. Hiding of Real Position or Window Hiding of Real Position or Window DressingDressing

• 6.6. Lack of ComparabilityLack of Comparability

• 7.7. Historical CostsHistorical Costs

Analysis Analysis

• Analysis – To Analyse – to cut into piecesAnalysis – To Analyse – to cut into pieces• But only analyse – No – It means also But only analyse – No – It means also

Interpretation. Interpretation.

• ThusThus• Financial Statement Analysis means Financial Statement Analysis means

“Analysis, comparisons and “Analysis, comparisons and interpretation of Financial data to interpretation of Financial data to achieve the desired result”achieve the desired result”

TOOLS OF FINANCIAL TOOLS OF FINANCIAL STATEMENT ANALYSISSTATEMENT ANALYSIS

• 1.1. Comparative Statements Comparative Statements

• 2.2. Common Size StatementsCommon Size Statements

• 3.3. Trend AnalysisTrend Analysis

• 4.4. Ratio Analysis Ratio Analysis

• 5.5. Fund Flow StatementFund Flow Statement

• 6.6. Cash Flow StatementCash Flow Statement

Types of Financial Types of Financial AnalysisAnalysis

• 1.1. Intra-Firm ComparisonIntra-Firm Comparison

• 2.2. Inter-firm ComparisonInter-firm Comparison

• 3.3. Industry Average or Industry Average or Standard Standard

AnalysisAnalysis: :

• 4.4. Horizontal AnalysisHorizontal Analysis

• 5.5. Vertical AnalysisVertical Analysis

InterpretationInterpretation

• The Analysis is of no use without The Analysis is of no use without interpretation The Company has to interpret interpretation The Company has to interpret the financial statement which it has analysed. the financial statement which it has analysed.

• The Analysis is made to serve the following The Analysis is made to serve the following purpose purpose

•• 1.1. Profitability AnalysisProfitability Analysis• 2.2. Liquidity AnalysisLiquidity Analysis• 3.3. Solvency Analysis (To know the financial Solvency Analysis (To know the financial

structure)structure)

Interested Parties in Analysis of Interested Parties in Analysis of Financial Statements Financial Statements

• 1.1. Management Management • 2.2. Investors (In the form of Shareholders or Investors (In the form of Shareholders or • Debentureholders)Debentureholders)• 3.3. Banks and Financial InstitutionBanks and Financial Institution• 4.4. Trade CreditorsTrade Creditors• 5.5. Government and their AgenciesGovernment and their Agencies• 6.6. EmployeesEmployees• 7.7. CustomersCustomers• 8.8. PublicPublic• 9.9. Trade AssociationTrade Association• 10.10. Stock ExchangeStock Exchange

1. Comparative Financial 1. Comparative Financial StatementsStatements

• Comparative Financial Statements is Comparative Financial Statements is a statement of Financial Position of a a statement of Financial Position of a business designed in such a way business designed in such a way where a comparative study is where a comparative study is undertaken of different accounting undertaken of different accounting items, to measure the performance items, to measure the performance of a Business Activity.of a Business Activity.

Types of ComparisonTypes of Comparison

• There are 3 types of Comparison There are 3 types of Comparison

• 1)1) Inter Firm ComparisonInter Firm Comparison

• 2)2) Intra Firm ComparisonIntra Firm Comparison

• 3)3) Inter Period Comparison Inter Period Comparison

Merits:Merits:

• 1)1) Indicate the Direction of Indicate the Direction of Financial Financial

PositionPosition

• 2)2) Reveal Nature & Trend:Reveal Nature & Trend:

• 3)3) Identifying Trouble Spots:Identifying Trouble Spots:

•

Disadvantages:Disadvantages:

• 1)1) Misleading picture, if consistency in accounting Misleading picture, if consistency in accounting principle not followed.principle not followed.

• 2)2) Constant change in price level tender accounting Constant change in price level tender accounting statement useless for comparison.statement useless for comparison.

• 3)3) Inter firm comparison is useless, unless all the firms Inter firm comparison is useless, unless all the firms are of the same age, size and follow the same principles.are of the same age, size and follow the same principles.

• 4)4) If there exists any Abnormal Period between 2 If there exists any Abnormal Period between 2 successive accounting period then it will prove to be a successive accounting period then it will prove to be a pointless analysis.pointless analysis.

2. Common Size 2. Common Size StatementsStatements

• It is a Statement in Vertical Form in It is a Statement in Vertical Form in which every item of the Financial which every item of the Financial Statement is reduced to a common Statement is reduced to a common base. This was introduced with a base. This was introduced with a view to overcome the limitation of view to overcome the limitation of Comparative Statement.Comparative Statement.

Types of common size Types of common size statements.statements.

• (1)Common Size Balance Sheet(1)Common Size Balance Sheet

• ((2)Common Size Income 2)Common Size Income Statement:Statement:

Advantages of Common Advantages of Common Size StatementSize Statement

• 1)1) It reveals Sources and Application of Funds It reveals Sources and Application of Funds in a nutshell which help in taking decision.in a nutshell which help in taking decision.

• (2)(2) If common size statements of 2 or more If common size statements of 2 or more years are compared it indicate the changing years are compared it indicate the changing proportion of various components of Assets, proportion of various components of Assets, Liabilities, Cost, Net Sale & Profit.Liabilities, Cost, Net Sale & Profit.

• (3)(3) When Inter Firm Comparison is made with When Inter Firm Comparison is made with the help of Common size statement it helps in the help of Common size statement it helps in doing corporate evaluation and Ranking.doing corporate evaluation and Ranking.

Disadvantages of Common Disadvantages of Common Size StatementSize Statement

• (1)(1) No Established Standard Proportion:No Established Standard Proportion:• Common Size Statements are regarded as Common Size Statements are regarded as

useless as there is no established standard useless as there is no established standard proportion of an asset to the total asset or an proportion of an asset to the total asset or an item of expense to the net sales.item of expense to the net sales.

• (2)(2) Consistency Required:-Consistency Required:-• If Financial Statement of a Particular business If Financial Statement of a Particular business

organization are not prepared year after year on organization are not prepared year after year on a consistent basis comparative study of common a consistent basis comparative study of common size statement will be misleading size statement will be misleading

3. Trend Analysis3. Trend Analysis

• Trend Analysis is a statement in vertical Trend Analysis is a statement in vertical form where the earliest year is taken as form where the earliest year is taken as base year and the value of all the items base year and the value of all the items in the financial statements will be in the financial statements will be related to the base year in terms of % related to the base year in terms of % where value of each item in base year where value of each item in base year will be considered as 100. Trend % will be considered as 100. Trend % analysis move in one directions either analysis move in one directions either upward or downward progression or upward or downward progression or regression.regression.

Advantages:Advantages:

• (1)(1) Trend % indicate the increase or Trend % indicate the increase or decrease with the magnitude of change in decrease with the magnitude of change in % which is more effective than absolute % which is more effective than absolute data.data.

• Ex. If we say profit increases by Rs. Ex. If we say profit increases by Rs. 50,000/- it will be meaningless unless we 50,000/- it will be meaningless unless we find by what % the profit has increased.find by what % the profit has increased.

• (2)(2) Facilitate efficient comparative study Facilitate efficient comparative study of financial performance of financial performance

Limitations:Limitations:

• (1)(1) It will give a misleading picture if consistency in It will give a misleading picture if consistency in accounting principle is not followed.accounting principle is not followed.

• (2)(2) Constant change in price level render accounting Constant change in price level render accounting statement useless for comparison.statement useless for comparison.

• (3)(3) During inflationary period the data over a period of time During inflationary period the data over a period of time become incomparable, unless the absolute rupee data is adjusted.become incomparable, unless the absolute rupee data is adjusted.

• (4)(4) There is always the danger of selecting the base year There is always the danger of selecting the base year which may not be representative, normal & typical.which may not be representative, normal & typical.

• (5)(5) Trend % should be studied in relation with Absolute Trend % should be studied in relation with Absolute figure otherwise it give misleading picture. For ex. No. of student figure otherwise it give misleading picture. For ex. No. of student where 2, the next year they increased to 4. Now trend % show where 2, the next year they increased to 4. Now trend % show 100% increase but absolutely we get clear picture than trend %.100% increase but absolutely we get clear picture than trend %.

4. Ratio Analysis4. Ratio Analysis

• TRADITIONAL CLASSIFICATIONTRADITIONAL CLASSIFICATION• BALANCE SHEET RATIOSBALANCE SHEET RATIOS• (1)(1) Current RatioCurrent Ratio• (2)(2) Quick Ratio / Liquid Ratio / Acid Test Ratio.Quick Ratio / Liquid Ratio / Acid Test Ratio.• (3)(3) Super Quick RatioSuper Quick Ratio• (4)(4) Stock to work Capital RatioStock to work Capital Ratio

(5)(5) Capital Gearing RatioCapital Gearing Ratio• (6)(6) Debt Equity RatioDebt Equity Ratio• (7)(7) Proprietary RatioProprietary Ratio• (8)(8) Long Term Borrowing : Total AssetLong Term Borrowing : Total Asset• (9)(9) Fixed Assets : Net Worth.Fixed Assets : Net Worth.

REVENUE STATEMENT REVENUE STATEMENT RATIOSRATIOS

• Gross Profit RatioGross Profit Ratio

• Net Profit RatioNet Profit Ratio

• Operating Net Profit RatioOperating Net Profit Ratio

• Operating RatioOperating Ratio

• Operating Expenses RatioOperating Expenses Ratio

• Stock Turnover RatioStock Turnover Ratio

• Stock Holding PeriodStock Holding Period

COMBINED RATIOSCOMBINED RATIOS

• Return on Investment (ROI) or Return on Investment (ROI) or Return on Capital Employed (ROCE)Return on Capital Employed (ROCE)• Return on Proprietor / Shareholder fundReturn on Proprietor / Shareholder fund• Return on Equity shareholder fundReturn on Equity shareholder fund• Earning per shareEarning per share• Dividend per share Dividend per share • Dividend Payout RatioDividend Payout Ratio• Price Earning RatioPrice Earning Ratio• Interest Coverage RatioInterest Coverage Ratio

COMBINED RATIOSCOMBINED RATIOS

• Debt : Service Coverage RatioDebt : Service Coverage Ratio

• Debit Collection periodDebit Collection period

• Debtor Turnover RatioDebtor Turnover Ratio

• Creditor Payment PeriodCreditor Payment Period

• Creditor Turnover RatioCreditor Turnover Ratio

• Preference Dividend CoverPreference Dividend Cover

• Equity Dividend CoverEquity Dividend Cover

BASED ON FUNCTIONSBASED ON FUNCTIONS

• SOLVENCY RATIOSSOLVENCY RATIOS

• Short Term SolvencyShort Term Solvency

• Current RatioCurrent Ratio

• Quick Ratio / Liquid Ratio / Acid Test Quick Ratio / Liquid Ratio / Acid Test RatioRatio

• Super Quick RatioSuper Quick Ratio

• Stock : Working Capital Ratio.Stock : Working Capital Ratio.

Long Term Solvency / Long Term Solvency / Leverage Ratio / Leverage Ratio /

• Capital Gearing Capital Gearing

• Debt : Equity RatioDebt : Equity Ratio

• Proprietary RatioProprietary Ratio

• Long Term Borrowing: Total Assets Long Term Borrowing: Total Assets

• ( 1 – Net Worth )/ ( 1 – Net Worth )/ Total AssetsTotal Assets

• Fixed Asset : Net worthFixed Asset : Net worth

ACTIVITY RATIO / ACTIVITY RATIO / TURNOVER RATIOSTURNOVER RATIOS

• Stock Turn Over RatioStock Turn Over RatioStock Holding PeriodStock Holding PeriodDebt Collection PeriodDebt Collection PeriodDebtor Turnover RatioDebtor Turnover RatioCreditor Payment PeriodCreditor Payment PeriodCreditor Turnover RatioCreditor Turnover Ratio

PROFITABILITY RATIOPROFITABILITY RATIO

• In relation to salesIn relation to sales

• Gross Profit RatioGross Profit Ratio

• Net Profit RatioNet Profit Ratio

• Operating Net Profit RatioOperating Net Profit Ratio

• Operating RatioOperating Ratio

• Operating Expenses Ratio.Operating Expenses Ratio.

In relation to capital In relation to capital employedemployed

• Return on Interest (ROI) or Return on Return on Interest (ROI) or Return on Capital Employed (ROLE)Capital Employed (ROLE)

• Return on Proprietor / Shareholder fundsReturn on Proprietor / Shareholder funds

• Return on Equity Shareholder FundReturn on Equity Shareholder Fund

• Earning per ShareEarning per Share

• Dividend per ShareDividend per Share

• Dividend Payout RatioDividend Payout Ratio

• Price Earning RatioPrice Earning Ratio

COVERAGE RATIOSCOVERAGE RATIOS

• Interest Coverage RatioInterest Coverage Ratio

• Preference Dividend CoverPreference Dividend Cover

• Equity Dividend CoverEquity Dividend Cover

• Debt Service Coverage RatioDebt Service Coverage Ratio

•

USER BASED USER BASED CLASSIFICATIONCLASSIFICATION• FOR SHORT TERM CREDITORSFOR SHORT TERM CREDITORS• (1) (1) Current RatioCurrent Ratio• (2)(2) Quick / Liquid Ratio / Acid Test RatioQuick / Liquid Ratio / Acid Test Ratio• (3)(3) Super Quick RatioSuper Quick Ratio• (4)(4) Stock : Working Capital RatioStock : Working Capital Ratio• (5)(5) Stock Turnover RatioStock Turnover Ratio• (6)(6) Stock Holding PeriodStock Holding Period• (7)(7) Creditor Payment PeriodCreditor Payment Period

(8)(8) Creditor Turnover RatioCreditor Turnover Ratio

FOR LONG TERM FOR LONG TERM CREDITORSCREDITORS

• Capital Gearing RatioCapital Gearing Ratio

• Debit : Equity RatioDebit : Equity Ratio

• Proprietary Ratio Proprietary Ratio

• Long Term Borrowing : Total Asset Long Term Borrowing : Total Asset RatioRatio

• Fixed Asset : Net worthFixed Asset : Net worth

• Interest Coverage RatioInterest Coverage Ratio

• Debt Service Coverage RatioDebt Service Coverage Ratio

FOR SHARE HOLDERSFOR SHARE HOLDERS

• Return on Investment (ROI) or Return on Capital Return on Investment (ROI) or Return on Capital Employed (ROCE)Employed (ROCE)

• Return on Proprietary / Shareholder fundReturn on Proprietary / Shareholder fund• Return on Equity Shareholder fundReturn on Equity Shareholder fund• Earning per shareEarning per share• Dividend per shareDividend per share• Dividend payout RatioDividend payout Ratio• Price Earning RatioPrice Earning Ratio• Preference Dividend CoverPreference Dividend Cover• Equity Dividend Cover Equity Dividend Cover

FOR MANAGEMENTFOR MANAGEMENT

• Return on Investment (ROI) or Return on Return on Investment (ROI) or Return on Capital Employed (ROCE)Capital Employed (ROCE)

• Debtor Turnover RatioDebtor Turnover Ratio

• Debtor Collection PeriodDebtor Collection Period

• Creditor Payment periodCreditor Payment period

• Creditor Turnover RatioCreditor Turnover Ratio

• Stock Turnover RatioStock Turnover Ratio

• Stock Holding PeriodStock Holding Period

FOR MANAGEMENTFOR MANAGEMENT

• Gross Profit RatioGross Profit Ratio

• Net Profit RatioNet Profit Ratio

• Operating Net Profit RatioOperating Net Profit Ratio

• Operating RatioOperating Ratio

• Proprietary RatioProprietary Ratio

• Fixed Asset : Net WorthFixed Asset : Net Worth

• Long Term Borrowing : Total AssetsLong Term Borrowing : Total Assets