Techniques of Financial Statement Analysis

201_ Financial Management
UNIT2:
Techniques of Financial Statement
Analysis: Introduction, Objectives
of financial statement analysis,
various techniques of analysis viz
Common Size Statements,
Comparative Statements, Trend
Analysis, Ratio Analysis, Funds Flow
Statement & Cash Flow Statement

Financial statement analysis involves gaining an
understanding of an organization's financial situation by
reviewing its financial reports. The results can be used to
make investment and lending decisions. This review
involves identifying the following items for a company's
financial statements over a series of reporting periods:
Trends. Create trend lines for key items in the financial
statements over multiple time periods, to see how
the company is performing. Typical trend lines are
for revenue, the gross margin, net profits, cash,
accounts receivable, and debt.
Techniques of Financial Statement
Analysis: Introduction

Proportion analysis. An array of ratios are available for discerning
the relationship between the size of various accounts in the
financial statements. For example, one can calculate a
company's quick ratio to estimate its ability to pay its immediate
liabilities, or its debt to equity ratio to see if it has taken on too
much debt. These analyses are frequently between the revenues
and expenses listed on the income statement and the assets,
liabilities, and equity accounts listed on the balance sheet.
Financial statement analysis is an exceptionally powerful tool for a
variety of users of financial statements, each having different
objectives in learning about the financial circumstances of the
entity.

(i) Knowing Profitability of Business: Financial statements are required to ascertain
whether the enterprise is earning adequate profit and to know whether the profits
have increased or decreased as compared to the previous year(s), so that
corrective steps can be taken well in advance.
(ii) Knowing the Solvency of the Business: Financial statements help to analyse the
position of the business as regards to the capacity of the entity to repay its short as
well as long term liabilities.
(iii) Judging the Growth of the Business: Through comparison of data of two or more
years of business entity, we can draw a meaningful conclusion as regard to
growth of the business. For example, increase in sales with simultaneous increase in
the profits of the business, indicates a healthy sign for the growth of the business.
(iv) Judging Financial Strength of Business: Financial statements help the entity in
determining solvency of the business and help to answer various aspects viz.,
whether it is capable to purchase assets from its own resources and/or whether
the entity can repay its outside liabilities as and when they become due.
Objectives of financial statement analysis

(v) Making Comparison and Selection of Appropriate Policy: To make a
comparative study of the profitability of the entity with other entities
engaged in the same trade, financial statements help the
management to adopt sound business policy by making intra firm
comparison.
(vi) Forecasting and Preparing Budgets: Financial statement provides
information regarding the weak-spots of the business so that the
management can take corrective measures to remove these short
comings. Financial statements help the management to make forecast
and prepare budgets.
(vii) Communicating with Different Parties: Financial statements are
prepared by the entities to communicate with different parties about
their financial position. Hence, it can be concluded that understanding
the basic financial statements is a necessary step towards the
successful management of a commercial enterprise.
Objectives of financial statement analysis

(i) Manipulation or Window Dressing: Some business enterprises resort to manipulate
the information contained in the financial statements so as to cover up their bad
or weak financial position. Thus, the analysis based on such financial statements
may be misleading due to window dressing.
(ii) Use of Diverse Procedures: There may be more than one way of treating a
particular item and when two different business enterprises adopt different
accounting policies, it becomes very difficult to make a comparison between
such enterprises. For example, depreciation can be charged under straight line
method or written down value method. However, results provided by comparing
the financial statements of such business enterprises would be misleading.
(iii) Qualitative Aspect Ignored: The financial statements incorporate the information
which can be expressed in monetary terms. Thus, they fail to assimilate the
transactions which cannot be converted into monetary terms. For example, a
conflict between the marketing manager and sales manager cannot be
recorded in the books of accounts due to its non-monetary nature, but it will
certainly affect the functioning of the activities adversely and consequently, the
profits may suffer.
Limitations of Financial Statements

(iv) Historical: Financial statements are historical in nature as they record past events
and facts. Due to continuous changes in the demand of the product, policies of
the firm or government etc, analysis based on past information does not serve any
useful purpose and gives only postmortem report.
(v) Price Level Changes: Figures contained in financial statements do not show the
effects of changes in the price level, i.e. price index in one year may differ from
price index in other years. As a result, misleading picture may be obtained by
making a comparison of figures of past year with current year figures.
(vi) Subjectivity & Personal Bias: Conclusions drawn from the analysis of figures given
in financial statements depend upon the personal ability and knowledge of an
analyst. For example, the term ‘Net profit’ may be interpreted by an analyst as net
profit before tax, while another analyst may take it as net profit after tax.
(vii) Lack of Regular Data/Information: Analysis of financial statements of a single
year has limited uses. The analysis assumes importance only when compared with
financial statements, relating to different years or different firm.
Limitations of Financial Statements

The various parties interested in the analysis of financial statements are :
(i)Investors : Shareholders or proprietors of the business are interested in
the well being of the business. They like to know the earning capacity
of the business and its prospects of future growth.
(ii)Management : The management is interested in the financial position
and performance of the enterprise as a whole and of its various
divisions. It helps them in preparing budgets and assessing
theperformance of various departmental heads.
(iii)Trade unions : They are interested in financial statements
fornegotiating the wages or salaries or bonus agreement with
themanagement.
(iv)Lenders : Lenders to the business like debenture holders, suppliersof
loans and lease are interested to know short term as well as longterm
solvency position of the entity.
Users of Financial Statement Analysis

(v)Suppliers and trade creditors : The suppliers and other creditors are
interested to know about the solvency of the business i.e. the abilityof the
company to meet the debts as and when they fall due.
(vi)Tax authorities : Tax authorities are interested in financial statements for
determining the tax liability.
(vii)Researchers : They are interested in financial statements in undertaking
research work in business affairs and practices.
(viii)Employees : They are interested to know the growth of profit. As result of
which they can demand better remuneration and congenial working
environment.
(ix)Government and their agencies : They need financial information to
regulate the activities of the enterprises/industries and determine taxation
policy. They suggest measures to formulate policies and and regulations.
(x)Stock exchange : The stock exchange members take interest in financial
statements for the purpose of analysis because they provide useful
financial information about companies.
Users of Financial Statement Analysis

a) Comparative Statement or Comparative Financial
and Operating Statements.
b) Common Size Statements.
c) Trend Ratios or Trend Analysis.
d) Average Analysis.
e) Statement of Changes in Working Capital.
f) Fund Flow Analysis.
g) Cash Flow Analysis.
h) Ratio Analysis.
i) Cost Volume Profit Analysis
TECHNIQUES AND TOOLS OF
FINANCIAL STATEMENT ANALYSIS

While financial statement analysis is an excellent tool, there
are several issues to be aware of that can interfere with the
interpretation of the analysis results. These issues are:
Comparability between periods. The company preparing the
financial statements may have changed the accounts in
which it stores financial information, so that results may
differ from period to period. For example, an expense may
appear in the cost of goods sold in one period, and in
administrative expenses in another period.
Problems with Financial Statement Analysis

Comparability between companies. An analyst frequently
compares the financial ratios of different companies in order to
see how they match up against each other. However, each
company may aggregate financial information differently, so
that the results of their ratios are not really comparable. This can
lead an analyst to draw incorrect conclusions about the results of
a company in comparison to its competitors.
Operational information. Financial analysis only reviews a
company's financial information, not its operational information,
so you cannot see a variety of key indicators of future
performance, such as the size of the order backlog, or changes
in warranty claims. Thus, financial analysis only presents part of
the total picture.
Problems with Financial Statement Analysis

When financial statements figures for two or more years are placed
side-by-side to facilitate comparison, these are called
'Comparative Financial Statements.'
Such statements not only show the absolute figures of various years
but also provide for columns to indicate the increase or
decrease in these figures from one year to another.
'In addition, these statements may also show the change from one
year to another in percentage form.
Because of the utmost usefulness of the comparative statements,
the Companies Act, 1956 has provided that the Profit & Loss
Account and Balance Sheet of a Company must show the
figures of the previous year also with the figures of the current
year.
COMPARATIVE STATEMENT

To Make the Data Simpler and More Understandable: When data
for a number of years are put side-by-side in a comparative
'form it becomes easier to understand them and the conclusions
regarding the profitability and financial position of the concern
can be drawn very easily.
To Indicate the Trend: This helps in indicating the trend of change
by putting the figures of production, sales, expenses, profits etc.
for number of year’s side-by-side.
To Indicate the Strong Points and Weak Points of the Concern: It
may also indicate the strong points and weak points of the firm.
Management can then investigate and find out the reasons for
the weak areas and can take corrective measures.
Purpose or Importance of Comparative
Statements

To Compare the Firm's Performance with the Average Performance of the
Industry: Comparative financial statements help a business unit to
compare its' performance with the average performance of the
industry.
To Help in Forecasting: Comparative study of the changes in the key
figures over a period helps the management in forecasting the
profitability and financial soundness of the business.
Purpose or Importance of Comparative Statements
Limitations of Comparative Statements
•These statements do not present the change in various items in
relation to total assets, total liabilities or net sales.
•These statements are not useful in comparing financial statements
of two or more business because there is no common base

In practical life any financial statement can be
prepared as comparative statement but such
analysis is more popular in the case of balance sheet
and income statements. Thus most important
comparative statements are:
 Comparative Balance Sheet
 Comparative profit &Loss Account
Constructing Comparative
Statements

The Comparative Balance Sheet as on two or more different dates
can be prepared to increase or decrease in various assets,
liabilities and capital. Such a Comparative Sheet is very useful in
studying the trends in a business enterprise.
Method of Preparing Comparative Balance Sheet: The form of
comparative balance sheet consists of four columns. In the first
column the data for previous year is shown and in the second
column the data for current year is shown. In the third column
the increases or decreases in absolute data is shown in terms of
rupee amounts. Fourth column shows the percentage of
increase or decrease in absolute data.
The preparation of comparative balance sheet has been
explained in the following example: •
Comparative Balance Sheet:

Liabilities 2017 2018 Assets 2017 2018
Current 2,00,000 4,00,000 Fixed Assets 12,00,000 18,00,000
Liabilities Less: Accumulated
Reserves 3,00,000 2,00,000 Depreciation 2,00,000 3,00,000
12% Loan 5,00,000 8,00,000 Current Assets 10,00,000 15,00,000
Share capital 5,00,000 10,00,000 5,00,000 9,00,000
15,00,000 24,00,000 15,00,000 24,00,000
Illustration 1: From, the following Balance Sheets of Bhati Chemicals Ltd. as
on 31st December, 2017 and 31st December, 2018 prepare a Comparative
Balance Sheet and comment upon the changes:
BALANCE SHEETS
As on 31st December, 2017 and 2018

Particulars 2017 2018 Increase or decrease
over2017
% Increase or decrease
over2017
Fixed Assets 12,00,000 18,00,000 +6,00,000 + 50
Less: Accumulated
Depreciation
2,00,000 3,00,000 +1,00,000 +50
Net Fixed assets (A) 10,00,000 15,00,000 +5,00,000 +50
Working capital :-
Current assets (1) 5,00,000 9,00,000 +4,00,000 +80
Current Liabilities (2) 2,00,000 4,00,000 +2,00,000 +100
Working capital ((B) (1-2) 3,00,000 5,00,000 +2,00,000 +66.67
Capital Employed (A+B) 13,00,000 20,00,000 +7,00,000 +53.85
Less:- 12% Loan 5,00,000 8,00,000 +3,00,000 +60
Shareholder’s fund 8,00,000 12,00,000 +4,00,000 +50
Represented By:
Share capital 5,00,000 10,00,000 +5,00,000 +100
+ Reserves 10,00,000 2,00,000 -1,00,000 -33.33
Shareholder’s Fund 8,00,000 12,00,000 +4,00,000 +50

Comments: The analysis of the above Comparative Balance Sheets
gives the following conclusions:
 Total fixed assets have increased by Rs. 6, 00,000, i.e. 50% increase.
 Purchase of fixed assets was financed partly by the issue of shares for Rs. 5,
00,000 and partly by increase in loan.
 Share Capital has increased by Rs. 5, 00,000, i.e. 100% increase. It has
strengthened the financial position of the company.
 Reserves have decreased by Rs. 1, 00,000 i.e. 33.33% decrease, which reflects
loss in the business during the current year.
 Current liabilities have increased by Rs. 2, 00,000, i.e. 100% increase, but current
assets have also increased by Rs. 4, 00,000, i.e., 80% increase. It has resulted in
increase in the working capital of the firm by Rs. 2, 00,000 which has been
financed by increase in loan.
 12% loan has increased by Rs. 3, 00,000 (60%). Out of it Rs. 1, 00,000 has been
used for purchase of fixed assets and the balance Rs. 2,00,000 has been used as
working capital.

Method of Preparing Comparative Profit &Loss account: The
form of comparative profit and loss account (income
statement) also consists of four columns. In the first column
the data for previous year is shown and in the second
column the data for current year is shown. In the third
column the increase or decrease in absolute data is
shown in terms of rupee amounts. Fourth column shows
the increase or decrease in various items in the form of
percentages. The preparation of Comparative Income
Statement has been explained in the following illustrations:
Method of Preparing Comparative Profit
&Loss account

Illustration 2: From the following Profit & Loss Account of
Hindustan Trading Co. for the year ending 31st Dec.,2015and
2016 you are required to prepare a comparative Profit & Loss
Account and give your comments.
Particulars 2015 2016 Particulars 2015 2016
To Cost of goods sold 420,000 5,60,000 By sales 6,0 0,000 7,20,000
To administrative 50,000 66,000 By Dividend 30,000 90,000
expenses Received
To selling and 25,000 23,000
Distribution expenses
To Interest on 12,000 12,000
Debentures
To loss on sale of plant 6,000 4,000
To provision for income 40,000 48,000
tax
To net Profit 77,000 97,000
6,30,000 8,10,000 6,30,000 8,10,000

Solution: Comparative Profit & Loss account
For the year ended 31st Dec 2015 and 2016
Particulars 2015(Rs.) 2016 (Rs.)
Absolute
Increase/
Decrease(Rs.)
Percentage
Increase/
Decrease (%)
Sales 6,00,000 7,20,000 +120,000 +20
Less: Cost of Goods Sold 4,20,000 5,60,000 +140,000 +33.33
Gross Profit(A) 1,80,000 1,60,000 -20,000 -11.11
Less :Operating expenses
Administrative expenses 50,000 66,000 +16,000 +32
Selling & distribution expenses 25,000 23,000 -2,000 -8
Total Operating expenses (B) 75,000 89,000 +14,000 +18.67
Operating profit (A-B) 105,000 71,000 -34,000 -32.38

Add: Dividend Received 30,000 90,000 +60,000 +200
Total Income (C) 135,000 161,000 +26,000 +19.26
Less: other expenses:
Interest on debentures 12,000 12,000 - -
Loss on sale of plant 6,000 4,000 -2,000 -33.33
Total other expenses (D) 18,000 16,000 -2,000 -11.11
Income before tax (C - D) 117,000 145,000 +28,000 +23.93
Less Provision for Tax 40,000 48,000 +8,000 +12
Income After tax 77,000 97,000 +20,000 +25.97

Comments: The analysis of the above comparative Profit & Loss Account
gives the following information:
In 2016, sales have increased by Rs. 1, 20,000 (20%), but cost of goods sold
has also spurted by Rs. 1,40,000 (33.33%), as a result of which the gross
profit has declined by Rs. 20,000 (11.11 %). This means that there is a
larger increase in cost of sales as compared to sales. This should be a
cause of concern and the management should thoroughly investigate
the causes of increase in cost of sales.
Operating expenses have increased by Rs. 14,000 (18.67%). Administrative
expenses, included in operating expenses have alone increased
'heavily and this must be a cause of concern. Selling expenses have
tome down by 8% in spite of increase in sales. This is a favorable sign.
Increase in cost of sales and administrative expenses have led to a fall in
operating profits by Rs. 34,000 (32.38%).
Despite decrease in operating profits, the total income has increased by
Rs. 26,000 (19.26%). This is due to Rs. 60,000 (200%) increase in non-
operating income (dividend).

Common size statement that gives only the vertical
percentages or ratios for financing data without
giving rupee value are known as common size
statements. A comparison of two years figures of a
concern is easily made under the companies Act.
Companies must show in their profit and loss account
and balance sheet the corresponding figures for the
previous year. Sometimes however the figures do not
signify anything as the head of items are regrouped
and are incomparable. For a valid comparison, the
previous heads should be strictly compared.
COMMON SIZE STATEMENT

Advantages of Common Size Statement
1. Common size analysis reveals the sources of capital and all other
sources of funds and the distribution or application of the total funds in
the asset of a business enterprise.
2. Comparison of common size statement over a number of years will
clearly indicate the changing proportion of the various components
of asset, liabilities, costs, net sales and profits.
3. Comparison of common size statement of two or more enterprises in
the same industry or that of an enterprise with the industry as a whole
will assist corporate evaluation and ranking.
Limitations of Common Size Statement
1. These statements show percentage of each item to total sum but do
not show variations in the individual items from period to period.
2. Common size statement is regarded by many as useless as there is no
established standard proportion of each item to total.

In common size statements individual figure are
converted in to percentage to some common
base.
In balance sheet, the total of assets or liabilities is
assumed to be equal to 100 and all the figures are
expressed as percentage of this total.
In profit and loss account, sales figure is taken as 100
and all other figure are expressed as percentage of
sales.
Constructing Common Size Statement

Liabilities 2017(Rs.) 2018(Rs.) Assets 2017(Rs.) 2018(Rs.)
Equity share 6,00,000 6,00,000 Land & Building 8,00,000 7,50,000
capital
General reserve 6,80,000 10,00,000 Plant & 3,00,000 5,00,000
Machinery
10% Debenture 3,00,000 3,00,000 Furniture 1,00,000 1,06,250
Bills Payable 84,000 1,40,000 Stock 4,50,000 6,25,000
Creditors 3,28,000 4,50,000 Sundry Debtors 2,55,000 4,10,000
Outstanding 8,000 10,000 Cash 95,000 1,08,750
Expenses
20,00,000 25,00,000 2000,000 2500,000
Illustration 3: Prepare a common size balance sheet from the following Balance
sheet of Aroma Industries and interpret the same.
Balance Sheet
As on 31st December 2017 and 2018

Particulars 31st December 2007 31st December 2008
Amount (Rs) % Amount (Rs) %
Fixed Assets:
Land & Building 8,00,000 40 7,50,000 30
Plant & Machinery 3,00,000 15 5,00,000 20
Furniture 1,00,000 5 1,06,250 4.25
Total Fixed Assets (A) 12,00,000 60 13,56,250 54.25
Current Assets
Stock 4,50,000 22.50 6,25,000 25
Sundry Debtors 2,55,000 12.75 4,10,000 16.40
Cash 95,000 4.75 1,08,750 4.35
Total Current Assets (B) 8,00,000 40 11,43,750 45.75
Total Assets (A+B) 20,00,000 100 25,00,000 100
Liabilities and Capital
Owner’s Equity
Equity share capital 6,00,000 30 6,00,000 24
General reserve 6,80,000 34 10,00,000 40
Total Owners Equity( C) 12,80,000 64 16,00,000 64
Long Term Borrowings
10% Debenture 3,00,000 15 3,00,000 12
Current Liabilities
Bills payable 84,000 4.20 1,40,000 5.60
Creditors 3,28,000 16.40 4,50,000 18
Outstanding expenses 8,000 .40 10,000 .40
Total Current Liabilities(E) 4,20,000 21 6,00,000 24
Total liabilities and Capital(C+D+E) 20,00,000 100 25,00,000 100

Working Notes: All the % will be calculated on basis of total of
Balance sheet. Hence in 2017 % will be based on Rs. 20,
00,000 and in 2018 % will be based on 25, 00,000
Interpretation:
in 2017, current assets were 40% of Total assets. In 2018, these
have increased to 45.75%.
Current liabilities have also increased from 21% to 24%. Because
of greater increase in current assets than in current liabilities,
the position of working capital has improved.
The percentage of fixed assets has come down from 60% to
54.25% .owners equity has remained constant.

Illustration 4: Prepare a common size Income Statement
from the following Income statement of M/S Bhati Traders
and interpret the same.
Particulars 31st Dec 2017 31st Dec 2018
Gross Sales 10,30,000 12,42,000
Less: Sales returns 30,000 42,000
Net Sales 10,00,000 12,00,000
Less: Cost of goods sold 6,00,000 6,60,000
Gross profit 4,00,000 5,40,000
Less: Operating expenses
Administrative expenses 85,000 1,14,000
Selling expenses 2,00,000 1,93,200
Total operating expenses 2,85,000 3,07,200
Income from operations 1,15,000 2,32,800
Add: Non-operating Income 24,000 34,200
Total Income 1,39,000 2,67,000
Less: Non-operating expenses 36,000 53,280
Net Profit 1,03,000 2,13,720

COMMON SIZE INCOME STATEMENT
Particulars 31st December 2017 31stDecember2018
Amount (Rs) % Amount (Rs) %
Gross Sales 10,30,000 103 12,42,000 103.50
Less: Sales returns 30,000 3 42,000 3.50
Net Sales 10,00,000 100 12,00,000 100
Less: Cost of goods sold 6,00,000 60 ,60,000 55
Gross profit 4,00,000 40 5,40,000 45
Less: Operating expenses
Administrative expenses 85,000 8.50 1,14,000 9.50
Selling expenses 2,00,000 20 1,93,200 16.10
Total operating Expenses 2,85,000 28.50 3,07,200 25.60
Income from operations 1,15,000 11.50 2,32,800 19.40
Add: Non-operating Income 24,000 2.40 34,200 2.85
Total Income 1,39,000 13.90 2,67,000 22.25
Less: Non-operating expenses 36,000 3.60 53,280 4.44
Net Profit 1,03,000 10.30 2,13,720 17.81
Working Notes: All the %
will be calculated on the
basis of net sales
Interpretation:
i) Cost of goods sold has
reduced by 5% in 2018. This
is due to reduction in cost
of raw material. As a result
of reduction the gross
profit has increased from
40% to 45%.
•Operating expenses have
been decreased by 2.9%
due to this reduction and
reduction in cost if goods
sold; income from
operation has increased
from 11.50% to 19.40%

FIVE MARKS QUESTIONS
1) Define Financial management and its objectives?
2) Financial management means maximization of economic welfare of its
shareholders.
3) Compare and contrast profit maximization and wealth maximization?
4) Critically examined wealth maximization is superior to profit maximisation.
5) What is financial management?
6) Define financial management. Explain its significance.
7) Explain the various areas of financial management.
8) Analyse the nature of financial management.
9) Describe the evolution of financial management.
10) Financial management – is it a science or an art.
11)What are key areas of financial management.
12) Explain the role of financial manager in the current scenario.

Techniques of Financial Statement Analysis

Techniques of Financial Statement Analysis

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Techniques of Financial Statement Analysis