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Analysis of financial statements





FINANCE

INTRODUCTION:

Finance is to business what blood is to human body. Fortunately for the human

body there is mostly an automatic regulation of the quality and quantity of

blood required No such automation is available in case of business firm.

Nevertheless it is necessary that;

The firm should always have at its disposal adequate funds.

The funds should be of venous types so that the firm is able to carry on its

work smoothly without fear of losing the finds before time.

The composition of fund stream is optimum. The amount raised by way of

loans and equity capital should be mixed in the proper proportion so as to

enable the firm to have a proper advantage in respect of on equity without

taking too much risk.

The available funds are put to the best advantage from the long term point of

view.

Idleness of funds is avoided.

M. Basavaiah Institute Of Management StudiesM. Basavaiah Institute Of Management StudiesM. Basavaiah Institute Of Management StudiesM. Basavaiah Institute Of Management StudiesM. Basavaiah Institute Of Management Studies






There was a time it was thought that financial management consisted merely of

providing funds required by the various departments of the firm. This has now

changed completely and it is accepted that proper financial management

consists of a dynamic approach towards the achievement of a firm's objectives.

Meaning of Finance:

Finance is that activity which is concerned with the organization and

conservation of capital funds in meeting financial needs and objectives of a

business enterprise. In other words finance is defined as the provision of money

at the time when it is required to the business enterprise.

Objectives of Finance:

The main objective of a business is to maximize the owner's economic welfare.

The objective can be achieved by:

Profit maximization

Wealth maximization

Finance Functions:

Investment or long Term Asset Mix Decision

Financing or Capital Mix Decision







Dividend or Profit Allocation Decision

Liquidity or Short Term Asset Mix Decision

Meaning of Financial Statement:

Financial statement is an organized collection of data according to logical and

consistent accounting procedures. Its purpose is to convey an understanding of

some financial aspens of a firm.

Income Statement:







It reveals the performance of the organization in the given period of time. It

explains what has happened to business results of operations between two

balance sheet dates it is also known as profit and loss account and revenue

account.

Balance Sheet:

It shows the financial position of the enterprise as on given date and also

referred to as statement of financial position or condition, reports on a

company's assets, liabilities and net equity as of a given point in time.

Statement of Retained Earnings:

The term retained earnings means the accumulated excess of earnings over

loons and dividends. The balance shown by the income statement is transferred

to the balances sheet through this statement after making necessary

appropriation it is thus a connecting link between the balance sheet and the

income statement. It is fundamentally a display of things that have caused the

beginning of the period retained earnings balance to be changed in to the one

shown in the end of the period balance sheet. The statement is also termed as

profit and loss appropriation account in case of companies.

Statement of Changes in Financial Position:







The balance sheet shows the financial condition of the business at a particular

moments of time where the income statement discloses the results of operation

of business over a period of time. However for a better understanding of the

affairs of the business, it is essential to identify the movement of working

capital or cash in and out of the business this information is available in the

statement of changes in financial position of the business.

The statement may emphasis any of the following aspect resulting to changes in

financial position of the business.

Change in Working Capital Position

Changes in Cash Position

Changes in Overall Financial Position

Financial analysis:

Financial analysis can be defined as a study of relationship between many

factors as disclosed by the study of the trend of these factors.

Analysis of financial statements:

Introduction:







Financial analysis is the process of identifying the financial strengths and

weaknesses of the firm by property establishing relationships between the item

of the balance sheet and the profit and loss account. The financial statements

provide rich information about the operational results of a business unit and

much can be learnt from a careful examination of these statements. A forecast of

future earnings of a business can also be prepared on the basis of analysis of

financial statements.

"Financial statement analysis", According to John Myers,” is largely a study of

relationship among the various financial factors in a business as disclosed by a

single set of statements and a study of the trends of these factors as shown in a

series of statements”.

In the words W.B Meig." financial statements thus, are organized summaries of

detailed information and are thus a form of analysis. The type of statements

accountants prepare.

The way they arrange items on these statements and their standards of

disclosure are all influenced by a desire to provide information in a convenient

from”.







According to Metcalf and Titard, analyzing financial statements is “a process of

evaluating the relationship between component parts of financial statements to

obtain a better understanding of a firm's position and performance".

Objectives of analyzing financial statements

To examine the earning capacity and efficiency of various business activity

with the help of Income Statements.

To estimate about the performance efficiency and managerial ability by the

management of a business concerned.

TO determine the profitability and future prospects of the concerned.

To investigate the future potential of the concerned.

To make a comparative study of the operational efficiency of similar concern

engaged in an identical industry

TYPES OF FINANCIAL ANALYSIS







External analysis

This is an analysis based on information easily available to outsiders (Externals

for the business). Outsiders include Creditors, Supply, Investors and

Government Agencies etc. These parties do not have internal records of the

concern.

Internal analysis

This is an analysis done on the basis of information obtained from the internal

and unpublished records and books.

Horizontal analysis







It is also known as Dynamic Analysis. When financial statements for a certain

number of years are examined and analyzed. This is called Horizontal Analysis.

Vertical analysis

This is known as Static Analysis. It is made by analyzing a single set of finance

statements prepared at a particular date

DEVICES USED IN ANALYSING FINANCIAL STATEMENTS

Following are the tools and techniques of financial statement analysis:

Comparative Financial Statements

This statement is prepared for two or more years to show the absolute data of

two or more years, increase or decrease in the absolute data in value and in

terms of percentage.

Comparative Financial Statements are statements of the financial position of a

business so formulated as to focus on the elements contained therein and

provide the necessary time perspective to it. Normally, it is the balance sheet

and profit and loss account which alone are prepared in Comparative Financial

Statements.







Comparative financial statements are designed to disclose the following:

Absolute data ( Money Value)

Increase or decrease in absolute data in terms of money value

Increase or decrease in absolute data in terms of percentage

Comparisons expressed in ratios

Percentage of totals

Comparisons will have significance and will become more effective, only if the

data compared truly reflect the constancy in the application of generally

accepted accounting principles from date to date or period to period.

Common Size Statement

The common size statements are also known as component percentage or 100%

statement. Each statement is reduced to the total of 100 and each individual item

contained therein is expressed as a percentage to the total 100. Thus each

percentage shows relationship of individual item to its representative total. The

comparative financial statement and trend percentages have a shortcoming in

that they do not enable the analyst to understand the changes that have taken

from year to year in relation to total assets, total liabilities, capital or total net







sales. This defect becomes more glaring when the analysis is made through

comparison of two or more business units, with that of industry as a whole,

since there is no common base of comparison and dealing with the absolute

figures.

But when the Balance Sheet and Income Statement items are shown in

analytical percentage that each item bares to the total of appropriate item such

as Total Assets, Total liabilities, Capital and Net Sales, the common base is

provided. The statements compared in this firm, are termed as common size

statements.

Trend percentage

Trend percentage is also called as trend ratios. This method of analysis is

adapted to determine the direction upward and downward. This involves the

computation of percentage of relationship that each item in the statement bean.

The corresponding item contained in that of the base year.

The objective of trend percentage analysis is:

To know the changes in financial function and operating efficiency between

the two periods chosen.







To know the direction of changes and based upon the direction of changes,

the opinions can be formatted.

To emphasize changes in the financial data from year to year and facilitate

horizontal comparison and study of data.

Trend percentage also occupies an important place in the financial analysis.

Trend signifies a tendency and as such, the review and appraisal of tendency in

accounting variables are nothing but trend analysis. This analysis is carried out

by calculating trend ratio or by plotting the accounting data on chart.

Trend analysis of business facts is very significant from the point of view of

forecasting or budgeting. It discloses the changes in financial and operating data

between specific periods. However, a number of precautions should be taken

while using trend ratio as a tool of financial analysis.

Fund flow statements:

In every concern, the funds flow in from different sources and similarly funds

are invested in various sources of invested. The funds-flow-statement is a

report on financial operations changes, flow or movements during the period. It

is a statement which shows the sources an application of funds or it shows how

the activities of a business are financed in a particular period. In other words,







such a statement shows how the financial resources have been used during a

particular period of time. It is thus, a historical statement showing sources and

application of funds between the MO dates designed especially to analyze the

changes in the financial conditions of an enterprise. The funds-flow-statement is

a report on financial operations changes, flow or movements during the period.

It is a statement which shows the sources an application of funds or it shows

how the activities of a business are financed in a particulate period. In other

words, such a statement shows how the financial resources have been used

during a particular period of time. It is thus, a historical statement showing

sources and application of funds between the two dates designed especially to

analyze the changes in the financial conditions of an enterprise.

Objectives of funds flow statement

Funds Flow Statement is an analytical tool in the hands of financial manager.

The basic purpose of this statement is to indicate on historical basis the changes

in the working capital i.e., where funds come front and where there are used

during a given period.

The cash flow statements

The cash flow statement should report cash flows during the period classified by

operating. Investing and financing activities.







An enterprise presents its cash flow from investing and financing activities in a

manner which is most appropriate to its business. Classification by activity

provides information that allows users to assess the impact of those activities on

financial position of the enterprise and the amount of its cash and cash

equivalents this information may also be used to evaluate the relationships

among those activities. A single transaction may include cash flows that are

classified differently.

RATIO ANALYSIS:

Ratio is simply one number expressed in terms of another. The ratio analysis is

the most powerful tool of financial statement analysis. A ratio is a statistical

yardstick by means of which relationship between various figures can be

measured.

Meaning:

An analysis of financial statement with the help of the ratio may be tuned as

ratio analysis. It implies the process of computing. Determining and presenting

the relationship of items or group of items of financial statements. Alexander

wall is considered to be the pioneer of' ratio analysis. He presented after a

serious thinking a detailed system of ratio analysis is 1909







He explained that the work of interpretation can be made easier by establishing

quantitative relationship; between the facts given in financial statements.

Significance of ratio analysis:

Ratio analysis simplifies, summarizes and systematizes a long way of figures

in establishing the inter-relationship that exists between various segments of

a business.

As a tool ratio analysis are of special significance as they locus on facts on

comparative basis and facilitate drawing conclusions relating to the

performance of a firm.

Ratio analysis can be considered an instrument for diagnosing the financial

health of an enterprise.

Ratio analysis is relevant in evaluating the performance of rum on

determining the important aspects of a business such as liquidity, Solvency,

operational efficiency, overall profitability, capital gearing etc.

Ratio analysis helps in investment decisions to make profitable investments.

Limitations of Ratio Analysis:







Ratios by themselves do not convey anything specifically. They acquire

more value only when they are studied along with other ratios.

Ratio analysis facilitates wholly quantitative analysis only. The qualitative

factors which are so important for successful running of the organization are

completely ignored.

Ratio analysis focuses on the accounting data sum of which at times turnout

to be mere estimates such as life of assets, proper rate of depreciation,

provision for doubtful debts etc.

It should be remembered that ratio analysis helps in providing only a part of

information needed in the process of decision making.

Ratio analysis, considered as a powerful tool in the hands of management

becomes a weak tool of financial analysis due to the serious limitations of

the statistical concepts such as determination of proper standards for

comparison, absence of the homogeneity of the data and danger of fallacious

conclusions.

Classification of ratio:

Liquidity or Short Term Solvency Analysis







Profitability Analysis

Stability ratio

Turnover ratio

Liquidity or short term solvency analysis:

Liquidity or short term solvency analysis, aims to determine the ability of a

business to meet its financial obligations during the short-term and to maintain

its short term debt paying ability. The main aim of liquidity analysis is for a

company to have adequate funds to pay bills when they are due on to meet

unexpected needs or cash. Liquidity analysis mainly focuses on balance sheet

relationships that indicate the ability of a business to liquidate current and non-

current liabilities. The ratios that evaluate liquidity relate to working capital.

The comparisons and ratios related to evaluating liquidity or short term

solvency are as follows:







Types of liquidity Ratio

Working Capital Position:

The working capital of a business is the excess of current Wets over current

liabilities. This is computed by subtracting current liabilities form the current

assets.

Working Capital = Current Assets - Current Liabilities

Current Ratio:

Current ratio is sometimes referred to as working capital ratio; current ratio

expresses the relationship of current assets to current liabilities, and it is widely







used as a broad indicator of a company's liquidity and short term debt paying

ability.

Current ratio = Current assets

Current liabilities

Acid test Ratio or Quick Ratio:

The quick ratio is designed to inventory should be removed from current assets

when computing the acid test ratio.

Quick Ratio = Current Assets - Inventory

Current Liabilities

Cash Ratio:

The ratio relates cash and marketable securities to current liabilities. The Cash

Ratio is computed as follows:







Cash ratio = Cash + Marketable Securities

Current Liabilities

Profitability Ratios:

Types of profitability Ratio

Net profit ratio;







It is also known as net margin. This measures the relationship between net

profits and sales of a firm. Depending on the concept of net profit employed.

This ratio can be computed.

Net Profit Ratio=Earnings after interest and taxes (EAT)/ Net sales

Earning' per share:

This helps in determining the market price of equity shares of the company and

estimating the company's capacity to pay dividend to its equity shareholders.

Earnings per share = Net profit after tax

Numbers of equity shares

Price earnings ratio:

This ratio indicates the market value of every rupee earning in the firm and is

compared with industry average.

Price earnings ratio=Market value per share

Earnings per share

Turnover ratios:







These ratios are very important for a concern to judge how well facilities at the

disposal of the concern are being used or to measure the effectiveness with

which a concern uses its resources at its disposal.

Types of Turnover Ratio

Debtors turnover ratio:

The relationship between credit sale and accounts receivables may be stated as

the receivable turnovers.







Receivable turnover determines the liquidity of one item of current assets and

finds out how faster debts are being collected it is computed by dividing net

credit sales by the average net accounts. Receivables turnover is as follows:

Debtors’ turnover ratio = Net credit sales

Average debtors

Sales to capital employed:

This ratio shows the efficiency of capital employed in the business by

computing how many times capital employed is tamed over in a mated Period.

Sales to capital employed = Sales

Capital employed

Working capital turnover ratio:

This ratio shows the number of times working capital is turned over in a stated

period.

Working capital turnover ratio = Sales

Net working capital







Stability ratios:

These ratios help in ascertaining the long term solvency of a firm ninth depends

on firm adequate resources to meet its long term funds requirements,

appropriate debt equity mix to raise long term and earnings to pay interest and

installments of long term loans in time.







Fixed assets ratio:

This ratio explains whether the firm has raised adequate long term funds to

meet its fixed assets requirements and is calculated as follows.

Fixed assets ratio = Fixed assets

Capital employed

Ratio of current assets to fixed assets:

This ratio is explained as

Ratio of current assets to fixed assets = Current assets

Fixed assets Debt equity ratio:

It measures the extent of equity covering the debt. This ratio is calculated to

measure the relative proportions of relative proportions of outsider's funds and

share holders' funds invested in the company.

Debt equity ratio = long term funds

Share holders' funds







Proprietary ratio:

A variant of debt to equity ratio is the Proprietary ratio which shaves the

relationship between shareholders’ funds and the total tangible assets

Proprietary ratio = Shareholders funds

Total tangible assets


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