Unit 4: Financial Statement Analysis

Financial statement analysis is the process of examining a firm's published financial statements to judge its past performance, present condition, and future prospects. It converts the raw figures of the Balance Sheet, Statement of Profit and Loss, and Cash Flow Statement into ratios, trends, and proportions that support economic decisions.

• Raw material: the three core statements — Balance Sheet (position on a date), Statement of Profit and Loss (performance over a period), and Cash Flow Statement (movement of cash) — supplemented by notes and the auditor's report.
• Comparability convention: figures are read against a benchmark — the firm's own past (time series), a competitor, or an industry average — since an absolute number alone carries little meaning.
• Going-concern assumption: analysis presumes the entity will continue operating, so assets are read at book value and trends are projected forward.
• Accrual basis: revenues and expenses are matched to the period earned or incurred, not when cash moves, which is why profit and cash differ.
• Consistency: the same accounting policies must be applied period to period, otherwise trend figures are distorted and must be restated before comparison.

II. Objectives of Analysis

Purpose and Principle

Analysis exists to reduce the information gap between a business and the outsiders who must decide whether to lend to, invest in, or trade with it.

A. Objectives of Analysis

The central aim is to translate reported data into judgements about profitability, liquidity, solvency, and efficiency.

• Assessing profitability: measure the firm's earning capacity through margins and return ratios — e.g. Net Profit Ratio = (Net Profit ÷ Revenue) × 100 shows how much of each rupee of sales survives as profit.
• Assessing liquidity: judge the ability to meet short-term obligations, tested by the Current Ratio = Current Assets ÷ Current Liabilities, where a value near 2:1 is conventionally comfortable.
• Assessing long-term solvency: evaluate capacity to service debt and survive downturns, via Debt-Equity = Long-term Debt ÷ Shareholders' Funds.
• Measuring operational efficiency: relate outputs to the resources used, e.g. Inventory Turnover = Cost of Goods Sold ÷ Average Inventory, higher values signalling faster stock movement.
• Facilitating comparison: enable intra-firm (year on year), inter-firm (rival to rival), and cross-sectional (against industry norms) evaluation.
• Forecasting and planning: use established trends to project future earnings and cash needs, feeding budgets and capital decisions.
• Detecting weaknesses: locate problem areas — a rising receivables period or falling margin — early enough to correct them.

III. Various Stakeholders and their Interests

Definition

Stakeholders are the parties whose economic interests are affected by the firm; each reads the same statements through the lens of a distinct decision.

A. Various Stakeholders and their Interests

Different users pursue different questions, so no single ratio serves all.

• Shareholders and investors: care about return and safety of capital.
  • Existing owners: track Earnings Per Share = (Net Profit − Preference Dividend) ÷ No. of Equity Shares and dividend payout.
  • Prospective investors: weigh Price-Earnings and growth trends before buying.
• Lenders and creditors: focus on repayment capacity.
  • Long-term lenders (debenture holders, banks): examine Interest Coverage = EBIT ÷ Interest and Debt-Equity.
  • Short-term/trade creditors: watch liquidity ratios and the Quick Ratio = (Current Assets − Inventory) ÷ Current Liabilities.
• Management: uses analysis internally for control, pricing, and performance appraisal across every ratio class.
• Employees and unions: interested in stability and profitability that underpin wages, bonuses, and job security.
• Government and tax authorities: verify taxable income, compliance, and industry-level data for policy.
• Customers: assess the supplier's continuity, relevant for warranties and long-term contracts.
• Public and researchers: gauge the firm's contribution to employment and the local economy.

IV. Techniques of Financial Statement Analysis

Purpose and Principle

A technique is the method by which raw statements are rearranged so that relationships become visible; the choice depends on whether the analyst compares across time, within one statement, or between line items.

A. Techniques of Financial Statement Analysis

The recognised tools fall into comparative, proportional, and relational families.

• Comparative statements (horizontal): place two or more periods side by side and show absolute and percentage change; the basis of horizontal analysis.
• Common size statements (vertical): express every item as a percentage of a common base within a single period.
• Trend analysis: select a base year as 100 and index later years to it, revealing direction over a long run.
• Ratio analysis: compute arithmetical relationships between two figures — liquidity, solvency, activity, and profitability ratios.
• Cash flow analysis: trace the sources and uses of cash across operating, investing, and financing activities.
• Fund flow analysis: track changes in working capital between two balance sheet dates.

Two contrasting directions of reading underlie these tools:

1. Horizontal (dynamic): compares the same item across successive periods; answers "how has it changed over time?"
2. Vertical (static): compares items within one period against a base; answers "what share of the whole is this?"

V. Horizontal Analysis

Definition

Horizontal analysis, also called comparative or dynamic analysis, measures the change in each financial statement item over two or more periods in both absolute and percentage terms.

A. Method and Formula

The technique fixes an earlier period as the reference and expresses movement relative to it.

Absolute Change = Current Year Figure − Base Year Figure
Percentage Change = (Absolute Change ÷ Base Year Figure) × 100

• Base year figure: the earliest period in the comparison, used as denominator.
• Current year figure: the later period being evaluated.
• Sign convention: a positive result is growth, a negative result is decline; a zero or negative base makes the percentage meaningless and is left blank.

B. Worked Illustration

A short comparison shows how the percentages expose direction.

• Reading: revenue rose 25% but cost rose faster at 33.3%, so profit grew only 10% — a margin squeeze invisible in the absolute figures alone.

C. Trend Analysis Extension

When more than two periods exist, horizontal analysis becomes trend analysis.

• Indexing: set base year = 100 and compute Trend % = (Year Figure ÷ Base Year Figure) × 100 for each later year.
• Use: a smooth rising index confirms consistent growth; erratic values flag instability.

D. Applications and Limitations

The technique is powerful for direction but weak on context.

• Applications: highlights growth rates, spots deteriorating items, supports year-on-year performance review.
• Limitations: a distorted or abnormal base year skews every later percentage; ignores inflation unless figures are restated; does not show the relative size of an item within its statement.

VI. Common Size Analysis

Definition

Common size analysis, also called vertical analysis, restates every item of a statement as a percentage of a common base figure, converting rupee amounts into structural proportions.

A. Method and Formula

Each statement has its own natural base, which becomes 100%.

Common Size % = (Individual Item ÷ Base Figure) × 100

• Income statement base: Net Revenue from Operations = 100%, so each expense and profit is shown as a share of sales.
• Balance sheet base: Total Assets (or Total Equity and Liabilities) = 100%, so each asset and source of funds is a share of the total.
• Interpretation: the size of the firm is removed, letting a small and a large company be compared on structure alone.

B. Worked Illustration

Expressing the income statement vertically reveals cost structure.

• Reading: 64 paise of every sales rupee is consumed by cost of goods; if the industry norm is 55%, the firm is cost-heavy regardless of its absolute size.

C. Applications and Limitations

Vertical analysis excels at structure but not at movement.

• Applications: enables inter-firm comparison across sizes, exposes shifts in cost or asset composition, standardises statements for benchmarking.
• Limitations: a single year's percentages show no trend; a change in the base figure alters every proportion; qualitative factors and price-level changes stay hidden.

D. Contrast with Horizontal Analysis

The two proportional techniques answer opposite questions and are usually used together.

1. Horizontal: same item, many periods; denominator is a base year; reveals growth or decline over time.
2. Common size: many items, one period; denominator is a base figure within the statement; reveals internal composition and relative weight.

• Combined use: horizontal shows that costs are rising, common size shows whether they are rising as a share of sales — together they diagnose both direction and structure.