ANALYSIS OF FINANCIAL

STATEMENTS

Prof. M .B. Thakoor

 SYNOPSIS
• 1) MEANING OF FINANCIAL STATEMENT
• 2) NATURE OF FINANCIAL STATEMENT
• 3) ESSENTIAL QUALITIES OF FINANCIAL
STATEMENT
• 4) LIMITATION OF FINANCIAL
STATEMENT
• 5) FINANCIAL STATEMENT ANALYSIS
• 6) TOOLS & TECHNIQUES OF ANALYSIS
• 7) TYPES OF COMPARISON
• 8) INTERPRETATION
 NATURE OF FINANCIAL
STATEMENT
• The data exhibited by financial statements
are affected by
• a) Recorded facts
• b) Accounting Concepts, Conventions
& Principles
• c) Personal Judgment
 Accounting Principles

•
Accounting concepts Accounting Conventions
• a) Entity Concept a) Disclosure
• b) Going Concern Concept b) Materiality
• c) Accounting period concept c) Consistency
• d) Money Measurement Concept d) Conservatism
• e) Cost Concept
• f) Cost Attach Concept
• g) Dual Aspect Concept
• h) Accrual concept
• i) Periodic Matching of cost and
• Revenue Concept
• j) Realisation Concept
• k) Verifiable Objective Evidence Concept
 ESSENTIAL QUALITIES OF
FINANCIAL STATMENTS
• 1. Relevance
• 2. Understandability :
• 3. Reliability and Accuracy
• 4. Comparability
• 5. Completeness
• 6. Timeliness
 LIMITATIONS OF FINANCIAL
STATEMENTS
• 1. Lack of Precision
• 2. Lack of Exactness
• 3. Incomplete Information
• 4. Interim Reports
• 5. Hiding of Real Position or Window Dressing
• 6. Lack of Comparability
• 7. Historical Costs
 Analysis
• Analysis – To Analyse – to cut into pieces
• But only analyse – No – It means also
Interpretation.

• Thus
• Financial Statement Analysis means
“Analysis, comparisons and interpretation
of Financial data to achieve the desired
result”
 TOOLS OF FINANCIAL
STATEMENT ANALYSIS

• 1. Comparative Statements
• 2. Common Size Statements
• 3. Trend Analysis
• 4. Ratio Analysis
• 5. Fund Flow Statement
• 6. Cash Flow Statement
Types of Financial Analysis

• 1. Intra-Firm Comparison
• 2. Inter-firm Comparison
• 3. Industry Average or Standard
Analysis:
• 4. Horizontal Analysis
• 5. Vertical Analysis
 Interpretation
• The Analysis is of no use without interpretation
The Company has to interpret the financial
statement which it has analysed.

• The Analysis is made to serve the following

purpose
•
• 1. Profitability Analysis
• 2. Liquidity Analysis
• 3. Solvency Analysis (To know the financial structure)
 Interested Parties in Analysis of
Financial Statements
• 1. Management
• 2. Investors (In the form of Shareholders or
• Debentureholders)
• 3. Banks and Financial Institution
• 4. Trade Creditors
• 5. Government and their Agencies
• 6. Employees
• 7. Customers
• 8. Public
• 9. Trade Association
• 10. Stock Exchange
 1. Comparative Financial
Statements
• Comparative Financial Statements is a
statement of Financial Position of a
business designed in such a way where a
comparative study is undertaken of
different accounting items, to measure the
performance of a Business Activity.
 Types of Comparison
• There are 3 types of Comparison
• 1) Inter Firm Comparison
• 2) Intra Firm Comparison
• 3) Inter Period Comparison
 Merits:

• 1) Indicate the Direction of Financial

Position
• 2) Reveal Nature & Trend:
• 3) Identifying Trouble Spots:
•
 Disadvantages:

• 1) Misleading picture, if consistency in accounting principle

not followed.
• 2) Constant change in price level tender accounting
statement useless for comparison.
• 3) Inter firm comparison is useless, unless all the firms are of
the same age, size and follow the same principles.
• 4) If there exists any Abnormal Period between 2 successive
accounting period then it will prove to be a pointless analysis.
2. Common Size Statements

• It is a Statement in Vertical Form in which

every item of the Financial Statement is
reduced to a common base. This was
introduced with a view to overcome the
limitation of Comparative Statement.
 Types of common size
statements.
• (1)Common Size Balance Sheet

• (2)Common Size Income Statement:

 Advantages of Common Size
Statement
• 1) It reveals Sources and Application of Funds
in a nutshell which help in taking decision.
• (2) If common size statements of 2 or more
years are compared it indicate the changing
proportion of various components of Assets,
Liabilities, Cost, Net Sale & Profit.
• (3) When Inter Firm Comparison is made with
the help of Common size statement it helps in
doing corporate evaluation and Ranking.
Disadvantages of Common Size
Statement
• (1) No Established Standard Proportion:
• Common Size Statements are regarded as useless as
there is no established standard proportion of an asset
to the total asset or an item of expense to the net sales.

• (2) Consistency Required:-

• If Financial Statement of a Particular business
organization are not prepared year after year on a
consistent basis comparative study of common size
statement will be misleading
 3. Trend Analysis
• Trend Analysis is a statement in vertical
form where the earliest year is taken as
base year and the value of all the items in
the financial statements will be related to
the base year in terms of % where value
of each item in base year will be
considered as 100. Trend % analysis move
in one directions either upward or
downward progression or regression.
 Advantages:
• (1) Trend % indicate the increase or decrease
with the magnitude of change in % which is
more effective than absolute data.
• Ex. If we say profit increases by Rs. 50,000/- it
will be meaningless unless we find by what %
the profit has increased.

• (2) Facilitate efficient comparative study of

financial performance
 Limitations:
• (1) It will give a misleading picture if consistency in
accounting principle is not followed.
• (2) Constant change in price level render accounting
statement useless for comparison.
• (3) During inflationary period the data over a period of time
become incomparable, unless the absolute rupee data is
adjusted.
• (4) There is always the danger of selecting the base year
which may not be representative, normal & typical.
• (5) Trend % should be studied in relation with Absolute
figure otherwise it give misleading picture. For ex. No. of
student where 2, the next year they increased to 4. Now trend
% show 100% increase but absolutely we get clear picture than
trend %.
 4. Ratio Analysis
• TRADITIONAL CLASSIFICATION
• BALANCE SHEET RATIOS
• (1) Current Ratio
• (2) Quick Ratio / Liquid Ratio / Acid Test Ratio.
• (3) Super Quick Ratio
• (4) Stock to work Capital Ratio
(5) Capital Gearing Ratio
• (6) Debt Equity Ratio
• (7) Proprietary Ratio
• (8) Long Term Borrowing : Total Asset
• (9) Fixed Assets : Net Worth.
REVENUE STATEMENT RATIOS

• Gross Profit Ratio

• Net Profit Ratio
• Operating Net Profit Ratio
• Operating Ratio
• Operating Expenses Ratio
• Stock Turnover Ratio
• Stock Holding Period
 COMBINED RATIOS
• Return on Investment (ROI) or
Return on Capital Employed (ROCE)
• Return on Proprietor / Shareholder fund
• Return on Equity shareholder fund
• Earning per share
• Dividend per share
• Dividend Payout Ratio
• Price Earning Ratio
• Interest Coverage Ratio
COMBINED RATIOS

• Debt : Service Coverage Ratio

• Debit Collection period
• Debtor Turnover Ratio
• Creditor Payment Period
• Creditor Turnover Ratio
• Preference Dividend Cover
• Equity Dividend Cover
BASED ON FUNCTIONS

• SOLVENCY RATIOS
• Short Term Solvency
• Current Ratio
• Quick Ratio / Liquid Ratio / Acid Test
Ratio
• Super Quick Ratio
• Stock : Working Capital Ratio.
 Long Term Solvency /
Leverage Ratio /

• Capital Gearing
• Debt : Equity Ratio
• Proprietary Ratio
• Long Term Borrowing: Total Assets
• ( 1 – Net Worth )/ Total
Assets
• Fixed Asset : Net worth
ACTIVITY RATIO / TURNOVER
RATIOS

• Stock Turn Over Ratio

Stock Holding Period
Debt Collection Period
Debtor Turnover Ratio
Creditor Payment Period
Creditor Turnover Ratio
 PROFITABILITY RATIO

• In relation to sales
• Gross Profit Ratio
• Net Profit Ratio
• Operating Net Profit Ratio
• Operating Ratio
• Operating Expenses Ratio.
In relation to capital employed

• Return on Interest (ROI) or Return on Capital

Employed (ROLE)
• Return on Proprietor / Shareholder funds
• Return on Equity Shareholder Fund
• Earning per Share
• Dividend per Share
• Dividend Payout Ratio
• Price Earning Ratio
 COVERAGE RATIOS

• Interest Coverage Ratio

• Preference Dividend Cover
• Equity Dividend Cover
• Debt Service Coverage Ratio
•
USER BASED CLASSIFICATION

• FOR SHORT TERM CREDITORS

• (1) Current Ratio
• (2) Quick / Liquid Ratio / Acid Test Ratio
• (3) Super Quick Ratio
• (4) Stock : Working Capital Ratio
• (5) Stock Turnover Ratio
• (6) Stock Holding Period
• (7) Creditor Payment Period
(8) Creditor Turnover Ratio
FOR LONG TERM CREDITORS

• Capital Gearing Ratio

• Debit : Equity Ratio
• Proprietary Ratio
• Long Term Borrowing : Total Asset Ratio
• Fixed Asset : Net worth
• Interest Coverage Ratio
• Debt Service Coverage Ratio
 FOR SHARE HOLDERS
• Return on Investment (ROI) or Return on Capital
Employed (ROCE)
• Return on Proprietary / Shareholder fund
• Return on Equity Shareholder fund
• Earning per share
• Dividend per share
• Dividend payout Ratio
• Price Earning Ratio
• Preference Dividend Cover
• Equity Dividend Cover
 FOR MANAGEMENT
• Return on Investment (ROI) or Return on
Capital Employed (ROCE)
• Debtor Turnover Ratio
• Debtor Collection Period
• Creditor Payment period
• Creditor Turnover Ratio
• Stock Turnover Ratio
• Stock Holding Period
 FOR MANAGEMENT

• Gross Profit Ratio

• Net Profit Ratio
• Operating Net Profit Ratio
• Operating Ratio
• Proprietary Ratio
• Fixed Asset : Net Worth
• Long Term Borrowing : Total Assets