Unit 4: Financial Statement Analysis - Subjective Questions

Financial Statement Analysis refers to the process of examining, evaluating, and interpreting the information contained in financial statements to assess the financial health, performance, and future prospects of a business enterprise.

Meaning:

• It involves the systematic study of the relationships between various items in the financial statements such as the Balance Sheet, Income Statement (Statement of Profit and Loss), and Cash Flow Statement.
• The raw data in financial statements is often complex and voluminous; analysis converts this data into meaningful information.
• It uses various tools and techniques like ratio analysis, comparative statements, common-size statements, and trend analysis.

Key aspects:

• Rearrangement of data into a comprehensible form.
• Comparison with past performance, industry standards, or competitors.
• Interpretation to draw conclusions about profitability, liquidity, solvency, and efficiency.

In essence, financial statement analysis bridges the gap between raw accounting figures and the decision-making needs of various stakeholders.

The primary objectives of Financial Statement Analysis are:

• Assessing Profitability: To evaluate the earning capacity and profitability of the business over a period.
• Judging Liquidity Position: To determine the short-term financial strength and the ability to meet current obligations.
• Evaluating Solvency: To assess the long-term financial soundness and the firm's ability to pay long-term debts.
• Measuring Operational Efficiency: To gauge how effectively resources and assets are being utilised.
• Facilitating Comparison: To compare performance over time (intra-firm) and with other firms (inter-firm).
• Forecasting and Planning: To help management in budgeting and forecasting future performance.
• Assisting Decision-Making: To provide relevant information to stakeholders for investment, lending, and other decisions.
• Identifying Trends: To recognise growth patterns and warning signs in the financial data.

Overall, the analysis aims to convert raw financial data into useful information for decision-making.

Different stakeholders analyse financial statements for different purposes:

• Shareholders/Investors: Interested in profitability, dividends, and capital appreciation. They assess the safety and growth of their investment.
• Lenders/Creditors (Long-term): Concerned with solvency and the firm's ability to repay principal and interest on long-term loans.
• Suppliers/Trade Creditors (Short-term): Focused on liquidity and the ability to pay short-term dues.
• Management: Uses analysis for planning, control, and decision-making to improve operational efficiency.
• Employees & Trade Unions: Interested in profitability and stability for job security, wages, and bonuses.
• Government & Regulatory Authorities: Concerned with tax compliance, regulation, and policy formulation.
• Customers: Interested in the continuity and stability of the enterprise for uninterrupted supply.
• Researchers & Analysts: Use data for studies, ratings, and recommendations.
• Public/Society: Interested in the firm's contribution to the economy and employment.

Each group emphasises different aspects such as liquidity, solvency, or profitability based on its objectives.

Both are lenders, but their analytical focus differs significantly:

Short-term Creditors (e.g., trade creditors, suppliers, bankers granting working capital):

• Primarily interested in the liquidity of the firm.
• Focus on the firm's ability to meet current/short-term obligations.
• Analyse current ratio, quick ratio, and working capital.
• Time horizon is short (typically within a year).

Long-term Creditors (e.g., debenture holders, financial institutions granting term loans):

• Primarily interested in the solvency of the firm.
• Focus on the firm's ability to pay interest regularly and repay principal at maturity.
• Analyse debt-equity ratio, interest coverage ratio, and profitability.
• Time horizon is long (several years).

Summary Table:

Thus, short-term creditors emphasise immediate paying capacity while long-term creditors emphasise sustained earning capacity and capital structure.

The major techniques (tools) used for analysing financial statements are:

• Comparative Statements (Horizontal Analysis): Financial data of two or more periods is presented side by side to study changes in absolute and percentage terms.
• Common-Size Statements (Vertical Analysis): Each item is expressed as a percentage of a common base (e.g., total assets or net sales) to study the internal structure.
• Trend Analysis: Data over several years is studied by taking a base year (100%) to observe the direction of movement.
• Ratio Analysis: Relationships between different items are expressed as ratios to assess liquidity, solvency, profitability, and efficiency.
• Cash Flow Analysis: Study of inflows and outflows of cash to understand liquidity and cash management.
• Fund Flow Analysis: Study of the movement of funds (working capital) between two balance sheet dates.

Broad classification:

• Horizontal Analysis (comparison across time periods).
• Vertical Analysis (comparison within a single period).

These techniques help convert financial data into meaningful, comparable, and interpretable information.

Horizontal Analysis (also called dynamic analysis or time-series analysis) refers to the comparison of financial data of a company over several periods to identify changes and trends.

Features:

• Involves comparison of the same item across different accounting periods.
• Changes are expressed in absolute amounts as well as percentages.
• Requires at least two periods of data.
• Commonly presented through Comparative Financial Statements and Trend Analysis.

Formula for percentage change:

Usefulness:

• Reveals the direction, speed, and magnitude of changes.
• Helps identify growth trends and problem areas.
• Facilitates intra-firm comparison over time.
• Aids in forecasting and planning.

For example, if sales rose from to , the increase is or .

Common Size Analysis (also called Vertical Analysis) is a technique in which each item of a financial statement is expressed as a percentage of a common base figure.

Base figures used:

• For Common-Size Income Statement: Net Sales (Revenue from Operations) is taken as .
• For Common-Size Balance Sheet: Total Assets (or Total Equity and Liabilities) is taken as .

Formula:

Preparation Steps:

• Select the appropriate base (sales or total assets).
• Express each line item as a percentage of that base.
• Present percentages for two or more periods or firms for comparison.

Usefulness:

• Shows the relative proportion of each item.
• Enables inter-firm comparison irrespective of size.
• Highlights structural changes in cost, assets, or capital.

For example, if cost of goods sold is and sales are , COGS is of sales.

Both are widely used tools but differ in approach:

Summary:

• Horizontal analysis answers how items changed over time.
• Vertical analysis answers what proportion each item bears to the whole.

Both complement each other in giving a complete picture of financial performance and position.

Trend Analysis is a form of horizontal analysis in which financial data over a number of years is studied by selecting a base year and expressing figures of subsequent years as a percentage of the base year figure.

Steps:

• Select a base year and assign it a value of .
• Calculate trend percentages for other years using:
  

Example:

Here, sales show a rising trend, growing to of the base year by 2023.

Usefulness:

• Reveals the direction and pace of change over many years.
• Helps in forecasting future performance.
• Useful for identifying long-term patterns.

Limitation: Choice of an abnormal base year can distort the analysis.

Despite its usefulness, financial statement analysis suffers from several limitations:

• Based on Historical Data: It relies on past figures which may not reflect future conditions.
• Ignores Price Level Changes: Inflation and changing prices are generally not adjusted, distorting comparisons.
• Affected by Accounting Policies: Different methods of depreciation, inventory valuation, etc., reduce comparability between firms.
• Qualitative Aspects Ignored: Non-monetary factors like management quality, employee morale, and reputation are not captured.
• Window Dressing: Financial statements may be manipulated to present a favourable picture.
• Personal Bias: Interpretation depends on the analyst's judgment and may be subjective.
• Not a Substitute for Judgment: Tools only aid decisions; they do not make decisions.
• Interim Reports: Financial statements are interim and cannot show the true final position.

Hence, analysis should be used with caution and supplemented with other information.

Both are important stakeholders but their needs differ:

Investors (Shareholders):

• Interested in return on investment (dividends and capital gains).
• Focus on profitability ratios, EPS, dividend payout, and price-earnings ratio.
• Assess the safety and growth of their invested capital.
• Their outlook is largely external and investment-oriented.

Management:

• Uses analysis for internal control and decision-making.
• Focus on all aspects: profitability, liquidity, solvency, and operational efficiency.
• Uses information for planning, budgeting, and performance evaluation.
• Has access to detailed internal data beyond published statements.

Comparison Table:

Thus, investors focus narrowly on returns while management takes a comprehensive operational view.

Comparative Income Statement:

Calculations (example):

Interpretation:

• Revenue grew by while COGS rose only , indicating better cost control.
• Gross profit improved by , showing improved efficiency.
• Operating profit rose by , reflecting an overall strong performance in Year 2.

Total Assets = Total Equity and Liabilities = (taken as ).

Common-Size Balance Sheet:

Formula used:

Interpretation:

• 60% of funds are invested in fixed assets, indicating a capital-intensive structure.
• Owned funds (50%) exceed long-term debt (30%), showing a sound capital structure.
• Current liabilities (20%) are lower than current assets (40%), reflecting satisfactory liquidity.

Comparative Financial Statements present financial data of two or more periods side by side. Their advantages include:

• Facilitates Comparison: Data of different periods can be easily compared to observe changes.
• Shows Trends: Reveals the direction of movement in items like sales, profit, and expenses.
• Reveals Absolute and Relative Changes: Presents both amount and percentage changes for clarity.
• Aids Decision-Making: Helps management and other stakeholders make informed decisions.
• Identifies Strengths and Weaknesses: Highlights areas of improvement and concern.
• Useful for Forecasting: Past trends serve as a basis for future planning and budgeting.
• Simple to Understand: Presents complex data in an easily interpretable format.

Example: By comparing sales of two years, one can immediately see whether the business is growing, stagnant, or declining, and by how much.

Thus, comparative statements convert static data into a dynamic and comparable form for effective analysis.

Both are tools of analysis but differ in purpose and presentation:

Summary:

• Comparative statements emphasise how figures changed across periods.
• Common-size statements emphasise the relative weight of each item.

Using both together provides a comprehensive analytical view.

Government and regulatory bodies are important external stakeholders. They use financial statement analysis for the following purposes:

• Taxation: To verify reported income and ensure correct assessment of income tax, GST, and other levies.
• Regulation and Compliance: To ensure companies comply with statutory requirements (Companies Act, SEBI regulations, etc.).
• Policy Formulation: To gather data for framing economic and industrial policies.
• Price Control: To regulate prices in essential industries by studying cost and profit structures.
• Grant of Subsidies/Incentives: To decide eligibility for financial assistance and subsidies.
• National Income Estimation: Aggregate corporate data contributes to macroeconomic statistics.
• Detecting Malpractices: To identify tax evasion, fraud, and irregularities.

Example: Tax authorities analyse the profit and loss account to confirm whether the taxable income declared is accurate.

Thus, the government uses analysis primarily for revenue, regulation, and policy purposes.

Employees and their representatives (trade unions) are internal stakeholders whose interests are closely tied to the firm's financial performance.

Their interests include:

• Job Security: A financially sound and profitable firm assures continuity of employment.
• Wage and Bonus Negotiations: Profitability figures form the basis for demanding higher wages, bonuses, and incentives.
• Working Conditions and Welfare: A prosperous firm can offer better welfare facilities and benefits.
• Growth Opportunities: Financial strength indicates scope for promotions and career growth.
• Assessing Stability: Analysis of solvency and liquidity reveals the long-term viability of the enterprise.

How they use analysis:

• Study profitability trends to justify wage demands.
• Examine overall stability to gauge job safety.

Example: If profits show a rising trend, unions may negotiate for higher bonuses, whereas declining profits may raise concerns about retrenchment.

Thus, employees analyse financial statements mainly to protect and enhance their economic and employment interests.

Financial statement analysis can be classified as follows:

A. On the Basis of Material Used:

• External Analysis: Conducted by outsiders (investors, creditors, government) who rely only on published financial statements. It is limited in scope due to restricted access to data.
• Internal Analysis: Conducted by insiders (management, employees) who have access to detailed internal records. It is more comprehensive and accurate.

B. On the Basis of Modus Operandi (Method):

• Horizontal Analysis (Dynamic): Compares data over several periods to identify trends. Uses comparative statements and trend analysis.
• Vertical Analysis (Static): Studies the relationship of items within a single period by expressing them as a percentage of a common base. Uses common-size statements and ratios.

Summary Table:

These classifications help select the appropriate technique based on the user's position and objective.

The process of analysing financial statements typically involves the following steps:

• Determining the Objective: Clearly defining the purpose of analysis (e.g., assessing liquidity, profitability, or solvency).
• Collecting Relevant Data: Gathering the required financial statements and related information.
• Rearranging and Regrouping Data: Simplifying and reclassifying the data into a suitable, comparable form.
• Selecting Appropriate Tools: Choosing the right technique (comparative statements, common-size, ratios, trend, cash flow analysis) as per the objective.
• Analysing the Data: Applying the chosen tools to compute changes, percentages, and ratios.
• Interpreting the Results: Drawing meaningful conclusions about performance and position.
• Presenting the Findings: Communicating results through reports, charts, and tables.
• Making Recommendations: Suggesting appropriate decisions or corrective actions.

Note: The choice of tools and depth of analysis depends on the user and objective.

This systematic procedure ensures that raw financial data is transformed into useful, decision-oriented information.

Comparative Balance Sheet:

Sample calculation:

Interpretation:

• Both fixed and current assets grew by , indicating balanced expansion.
• Share capital rose by , showing additional owner financing.
• Current liabilities increased by , which should be monitored against current asset growth to maintain liquidity.
• Overall, the firm shows healthy growth in size and resources during Year 2.