Analysis Of Financial Statements.pdf

CHAPTER

8 Analysis of Financial Statements

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Introduction

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Purpose of Financial Analysis

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Main Objective of Financial Analysis

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Users of Financial Analysis

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Types of FFinancial inancial Analysis z

Horizontal Analysis

z

Vertical Analysis

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Major TTools ools of FFinancial inancial Analysis

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Comparative Financial Statements

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Trend Analysis or TTrend rend Ratios

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Common Size Statements

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Illustrations

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True or FFalse alse

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Pick up the Most Appropriate Answer

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Descriptive Questions

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Interview Questions

8.1 INTRODUCTION The basic limitation of the traditional financial statements, comprising balance sheet and profit and loss account, is they do not give all the relevant and required information for knowing the

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strength and weakness of a firm. Still, they provide extremely useful information to the extent that the balance sheet mirrors the financial position on a particular date, in terms of structure of assets, liabilities and owner’s equity, like a snap shot. The profit and loss account shows the operational results during a particular period, in terms of the revenue generated and costs incurred for achieving them. As the financial information is in absolute terms, every one may not, readily, understand them. The answer is ‘Analysis of Financial Statements’. Analysis of financial statements refers to the application of different tools to know the behaviour of the accounting information. Much can be learnt by analysing the financial statements. 8.2 PURPOSE OF FINANCIAL ANALYSIS Purpose of Financial Analysis: The purpose of financial analysis is to diagnose the information content in financial statements so as to judge the profitability, financial soundness of the firm and chalk out the ways to improve existing performance.

Every management is interested in knowing the financial strengths to make their better use and spot out the weaknesses of the firm to take suitable corrective action, in time. The term ‘Financial Analysis’ is also known as analysis and interpretation of financial statements. 8.3 MAIN OBJECTIVE OF FINANCIAL ANALYSIS Different parties are interested in the financial statements for different purposes and look to them from their own angle. The objective of the different parties is not the same. Their requirements are not uniform. So, every one is interested to use them for his own requirement. A lender is interested for repayment of the money lent and interest, assured at the time of lending. Shareholder is concerned for earnings and appreciation of the investment, he has made. It is very clear their objectives are not common so their approach and information, they look for, would be different. 8.4 USERS OF FINANCIAL ANALYSIS Financial analysis can be undertaken by the management of the firm or interested parties, outside the firm. The outsiders of the firm are owners (shareholders), creditors, intending investors and others, in particular potential lenders. Nature of Analysis: The nature of the analysis depends upon their purpose or requirement. They make the necessary analysis and take the decision, based on their assessment of the results obtained.

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Trade creditors are those who have supplied goods and services to the firm. They are interested in their timely repayment. So, before they supply or render service, they want to be sure that the firm would be in a position to pay their dues, in a short period, as assured to them. They analyse the firm’s short-term liquidity position. The term ‘liquidity’ refers to the ability of the firm to pay, as and when the demands and debts fall due for payment. Firm would be in a position to meet the current obligations, if the cash receipts match payments, in terms of time. Suppliers of long-term debt are those who provide loans for a long period. They are concerned with the firm’s long-term solvency and survival, which depends on profitability and cash generation. Before they lend, they want to assure themselves that the organisation would be able to generate adequate liquid funds to pay the loan installment and interest. They are more concerned with the future outlook, rather than the past, based on the projections of the firm. They analyse the historical data, based on the financial statements, to determine the basis and reasonableness of the projections to decide the future financial standing of the firm. Shareholders and investors invest their money in the firm’s shares to earn dividend and appreciation of share value. They are concerned with the firm’s present and future profitability. The ability of the company to pay dividends depends on the future prospects and earning capacity of the organisation. They would have more confidence in those firms, which show steady growth in earnings. They are also interested in the firm’s financial structure to the extent it influences the firm’s earning ability. Employees and Management: The importance of trust and harmonious relationship between the employees and management requires no more emphasis for accelerated growth of the firm. If the employees feel confident of more salaries, retirement benefits and fast track career growth, in future, their loyalty would be assured. Employees look for stability and profitability in financial statements. Management of the firm would be interested in every aspect of financial analysis. Management is concerned with the effective and efficient utilisation of resources, analysing the financial statements and other information available to them. Government regulates the functioning of all organisations for the benefit of public. It has to generate adequate revenue for this purpose. Collection of taxes and information for deciding future policies are based on the financial statements of the firms. It is clear that the different users need the financial statements for different purposes. Requirements of users of financial statements are different, not uniform. The aim of the financial statements is to provide the information required for their divergent needs.

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8.5 TYPES OF FINANCIAL ANALYSIS Financial analysis can be classified into two categories depending upon (i) Material used and (ii) Method of Analysis Types of Financial Analysis

Method of Analysis

Material used

External Analysis

Internal Analysis

Horizontal Analysis

Vertical Analysis

Types of Financial Analysis

(i) On the basis of Material used: According to this category, financial analysis can be of two types. They are: (A) External Analysis: Those people who do not have access to the internal records of the firm do this analysis. Basically, they are creditors, present and potential investors, credit agencies and the general public. Normally, except select employees in the firm, all others do not have access to the internal records. There is always a time lag for the publication of accounts, after their preparation. So, updated or recent information is not available for analysis. Due to this inherent limitation, this type of analysis serves a limited purpose as the analysis is based on the published financial accounts, audited or un-audited. However, of late, the position has, significantly, improved due to government regulations to make the published accounts more frequent, transparent and detailed. (B) Internal Analysis: Those persons, who have the access to the books of accounts, financial and other records of the firm, do this analysis. Basically, the employees and executives of the firm who have access to the records can do this analysis. Even, the Government agencies also can do when they have the statutory powers to access the records. This analysis would be more meaningful and useful as the analysis is made on the basis of full records and with a specific objective. The management of the firm would, invariably, adopt internal analysis for managerial purposes. (ii) Method of Analysis: Based on the method, financial analysis can be of two types. They are Horizontal analysis and Vertical Analysis. Horizontal Analysis: When financial statements of a number of years of the same firm are compared and reviewed, it is known as Horizontal Analysis. Horizontal analysis helps to observe the changes in the financial variables, across the years. For this analysis, first base or standard year is chosen as a starting point. Any year may be taken as the base year, but, generally,

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the starting or initial year is taken as the base year. All the financial figures are presented in a horizontal manner. Keeping the data of base year in the beginning, the data of the different years are kept in separate columns. The attention of the management would be focussed on those items, which have changed, significantly.

The purpose of the analysis is to identify the strengths and weaknesses of the firm. Comparison of the item, over several years, shows the development of trend. The management would be able to get insight of the strength or problem for necessary action, in time. Since this analysis is based on the data from year to year rather than on one-year data, this analysis is also termed as Dynamic analysis. Comparative financial statements use the technique of Horizontal Analysis. Based on the prevailing trend, it is possible for the firm to make a rational forecast about the future progress. Vertical Analysis: Vertical analysis refers to the study of relationship of the various items contained in the financial statement of one accounting period. For example, the ratios of different items of cost for a particular period are calculated with the sales for that period. So, sales are taken as 100 and each expense is taken as a percentage of sales, i.e. 100. Such analysis is useful in comparing the performance of several companies in the same group or industry, or divisions or departments in the same company. Vertical analysis is also known as ‘Static Analysis’. Common – size financial statements and financial ratios are the two tools employed in vertical analysis. Combined use of Horizontal and Vertical Analysis: Both analyses can be used, simultaneously. Vertical analysis can be used along with horizontal analysis to make it more effective and meaningful. Horizontal Analysis is used for comparing data of several years of one firm, while Vertical Analysis is used for comparing the relative performance of different firms in the same industry for one particular period or year. A simple sample of horizontal and vertical analysis and its comparison with the industry and its immediate competitor would be like this: Horizontal Analysis for X Ltd. g¯¤ª> q ©¤®>

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The position reveals that the financial expenses of X Ltd. have been increasing from year to year, compared to the base year 2005. The same is confirmed that the firm’s percentage of financial expenses for the year 2008 is more than the industry as well as its immediate competitor. On other hand, production and purchase departments have been improving their performance year after year, reflected in falling cost of sales. Even their cost of sales is lower than the industry and its immediate competitor for the year 2008. The efficiency of production and purchase departments is eaten by the inefficiency of finance division in X Ltd. This situation requires further investigation to improve its profitability. Despite the inefficiency of finance division, still profitability of X Ltd. is higher than the industry and equal to its immediate competitor. The profit margin to sales has been stagnant during the period 2005-08. If finance division’s performance is improved, X Ltd. can improve its profitability, further. This analysis indicates the area, where focus of action and improvement is, immediately, essential to show better results.

8.6 MAJOR TOOLS OF FINANCIAL ANALYSIS Various tools or techniques are used in the financial analysis. The main objective of any analytical method is simple presentation of data, in a relevant manner, even for a complex problem for quick understanding. Basic purpose is attention of the management should be focussed only on the problem area for solution. The most important tools for financial analysis are: (a) Comparative Financial Statements (b) Trend Analysis or Trend Ratios (c) Common Size Statements (d) Ratio Analysis (e) Fund Flow Analysis (f) Cash Flow Analysis

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8.7 COMPARATIVE FINANCIAL STATEMENTS Comparative Financial Statements indicate the direction of movement with respect to financial position and operating results of the firm. Method of Preparation: Information in the financial statements, both Profit and Loss Account and Balance Sheet, has to be grouped and placed, side-by-side, for two or more years. The next column has to show the amount of change in absolute amount and the last column as a percentage of increase or decrease. From this, it is possible to draw reasonable conclusions about the direction, progress or deterioration of operational efficiency and financial position of the business and the factors that have contributed. The importance of comparative financial statements can be understood from the requirement of the Companies Act, 1956 which makes obligatory for all companies to prepare the final accounts of the companies by presenting current year as well as previous year figures. It is obligatory under Companies Act, 1956 for all companies to prepare the final accounts of the companies by presenting current year as well as previous year figures. For comparison, figures have to be regrouped, if necessary. Illustration No. 1 From the Comparative Balance Sheet of Shyam Ltd., prepare Comparative Balance Sheet for the year 2007 and 2008. Draw tentative conclusions, after preparing ‘CBS’. [Rs. in lakhs] _®®¤¯®>

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Liabilities

Rs. 31.12.07

Rs. 31.12.08

Amount of increase or decrease in 2008

Percentage of increase or decrease in 2008 %

Capital 8% Preference Capital

400

600

1,000

1,000

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400

500

+ 100

+ 25.00

1,800

2,100

+ 300

+ 16.67

700

400

– 300

– 43.00

Sundry creditors

600

700

+ 100

+ 16.67

Bills payable

400

350

– 50

– 12.50

Taxes payable

240

116

– 124

– 50.00

Total Current liabilities

1,240

1,166

– 74

– 5.97

Total Liabilities

1,940

1,566

– 374

– 19.28

Total Capital & Liabilities

3,740

3,666

– 74

– 2.00

Equity Capital Reserve & Surplus Total Proprietors’ Funds

+ 200

+ 50.00

Secured Loans: 10% Debentures Current Liabilities:

Tentative conclusions Total fixed assets have been added during the year 2008 by Rs. 110 lakhs [i.e., about 5%] compared to 2007, for which long-term investments worth Rs. 100 lakhs have been realised. The level of current assets worth Rs. 84 lakhs has been reduced. Despite the increase in fixed assets, the total assets have been decreased by Rs.74 lakhs. It implies that there has been an addition to fixed assets with a decrease in current assets, which reflects a poor financial policy. Fixed assets are to be supported by current assets for improvement in business. The relationship between the total current assets and total current liabilities is also not satisfactory as the current ratio is around 1 in both the years. Increase in the preference share capital of Rs. 200 lakhs might have been due to the fresh issue of shares for the redemption of debentures. Reserves have gone up by 100 lakhs, which shows the improving trend in profits. The redemption of debentures has been made from the proceeds of the fresh issue of Preference Share Capital and increase in profits. 8.8 TREND ANALYSIS OR TREND RATIOS Trend Analysis is a statistical device applied in the analysis of financial statements to reveal the trend of items with the passage of time.

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Absolute figures are difficult to understand, in particular when they are big amounts. One can understand better and immediately if the statement says that there has been an increase of 10% in sales, rather than mentioning the absolute amount of sales for both the years. Absolute amounts of large numbers are substituted by percentages to show brevity and ready readability for management. Illustration No. 2 From the following data of Sathyavathi & Co, calculate the percentage, taking the year 2006 as the base. Judge which year’s performance is better, if the base year is 2006. (Rs.) >

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Tentative Conclusion: During the year 2007, sales have been up 160%, while profit has gone up by 193%. In other words, the percentage of increase in profit has been more than the % of increase in sales. So, performance of profit is better than the performance of sales. However, during the year 2008, sales have gone up by 200%, but profit also has increased only by 200%, alone. It means the performance of profit has just matched the performance of sales. Reason is lack of control on expenses during the year 2008. Expenses have gone up only by 133%, despite increase in sales by 160% during the year 2007, which indicates good control on expenses. However, during the year 2008, increase of sales and expenses are the same (200%). So, individual identification of expense is to be made for exercising effective control. Performance is judged by profitability, not sales. So, performance of the year 2007 is better than the year 2008, in terms of profitability.

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8.9 COMMON-SIZE STATEMENTS (CSS) The common-size statements, balance sheet and income statement are shown in analytical percentages. The CSS represents the relationship of different items, contained in a financial statement, with some common item by expressing each item as a percentage of the common item. The common-size statements may be prepared in the following ways: (1) The totals of assets and liabilities in the balance sheet are taken as 100. (2) The individual assets are expressed as a percentage of total assets. i.e., 100. Different liabilities are calculated in relation to total liabilities. For example, if total assets are Rs. 10 lakh and debtors value is Rs. 1, 00,000. Debtors will be 10% of total assets.

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Balance Sheets as on 31st December, 2005 and 2006

(Figures in Rs.)

Liabilities Capital

2005 3,00,000

2006 4,00,000

Assets Land

2005 50,000

2006 50,000

Reserves Secured Loans Creditors

1,50,000 50,000 1,00,000

72,500 75,000 1,37,500

Building Plant Furniture

1,50,000 1,50,000 50,000

1,35,000 1,35,000 70,000

50,000

75,000

80,000

90,000

70,000 1,00,000

1,30,000 1,50,000

6,50,000

7,60,000

Outstanding Expenses

Cash Debtors Finished stock

6,50,000

Solution:

7,60,000

COMMON SIZE INCOME STATEMENT Percentages

Amount (Rs.) Net Sales Less: Cost of goods sold Gross: Profit (1) Less: General Expenses Selling Expenses Total Operating Expenses (2) Net Profit (1 – 2)

2005

2006

2005

2006

6,00,000 5,00,000 1,00,000 10,000 15,000 25,000 75,000

5,00,000 3,75,000 1,25,000 10,000 20,000 30,000 95,000

100.00 83.33 16.67 1.67 2.50 4.17 12.50

100.00 75.00 25.00 2.00 4.00 6.00 19.00

COMMON SIZE BALANCE SHEET

Land Building Plant Furniture Total Fixed Assets (1) Cash Debtors Finished Stock Total Current Assets (2) Total Assets (1+2)

Amount (Rs.) 2005 2006 50,000 50,000 1,50,000 1,35,000 1,50,000 1,35,000 50,000 70,000 4,00,000 3,90,000 80,000 90,000 70,000 1,30,000 1,00,000 1,50,000 2,50,000 3,70,000 6,50,000 7,60,000

Percentages 2005 7.70 23.07 23.07 7.70 61.54 12.31 10.76 15.39 38.46 100

2006 6.58 17.76 17.76 9.21 51.31 11.84 17.10 19.75 48.69 100

188

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Tentative Conclusions: 1. Sales have gone down by Rs. 1,00,000. However, net profit has increased by 6.5% [12.5% (2005) to 19% (2006)]. The net increase is due to combination of reduction of cost of goods sold by 8.33% [83.33% (2005) to 75% (2006)] and increase of total operating expenses by 1.83%. This indicates that the firm has concentrated on the improvement of profitability, even at the cost of reduction in sales. 2. There has been significant improvement in reducing the cost of production in 2006, compared to 2005 as cost of sales has gone down from 83.33 (2005) to 75% (2006). 3. For further improving profitability, control on operating expenses is required. Inventory control would improve the profitability, further. 4. Finished stock % has gone up from 15.39% to 19.75%, despite fall in sales. This indicates that the firm is experiencing accumulation of stocks. Descriptive Questions 1.

What is the need of Analysis of Financial Statements? (8.1 and 8.2)

2.

What is meant by ‘Financial Analysis’? Discuss the utility and significance of the Analysis of Financial Statements to the management and others, interested in the business? (8.1 to 8.3)

3.

What are the objectives of Analysis of Financial Statements? Who are the Users of Financial Analysis? (8.3 and 8.4)

4.

Explain the different types of Financial Analysis? (8.5)

5.

Explain common-size statements? Explain the technique of preparing the common size balance sheet? (8.8)

6.

What are the major tools of Financial Analysis and explain any three of them? (8.6 to 8.8)

State whether the following Statements are True or False 1. Comparative Financial Statements indicate the direction of the movement of the firm. 2. It is not obligatory under Companies Act, 1956 for all companies to prepare the final accounts of the companies by presenting current year as well as previous year figures for comparison.

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3. External analysis is better than the internal analysis. 4. In horizontal analysis, balance sheets of different years of the same firm are kept side by side for comparison. 5. Ratio analysis is one of the major tools of Financial Analysis. 6. The traditional financial statements give all the relevant and required information to show the strength and weakness of the company. 7. The purpose of financial analysis is to diagnose the information content in financial statements so as to judge the profitability, financial soundness of the firm and chalk out the way to improve existing performance. 8. ‘Liquidity’ refers to the ability of the firm to pay, as and when the demands and debts fall due for payment. 9. Different parties need the financial statements for same purposes. 10. Horizontal Analysis is used for comparing data of several years of one firm, while Vertical Analysis is used for comparing the relative performance of different firms in the same industry for the same period.

Answers 1. True 2. False 3. False 4. True 5. True 6. False 7. True 8. True 9. False 10. True

Pick up the most appropriate answer 1.

2.

3.

Financial analysis is meant for a.

Identifying strength of firm.

b.

Identifying weakness of firm.

c.

Identifying strength and weaknesses of firm.

Financial Analysis can be made form a.

Profit and Loss Account.

b.

Balance Sheet.

c.

Items in Profit and Loss Account and Balance Sheet by establishing relationship.

Financial Analysis is meant for the following category. a.

Trade creditors.

b.

Trade creditors and suppliers of long-term debt.

c.

Investors.

d.

Management.

e.

All above categories specified in a, b, c and d.

Answers 1. (c) 2. (c) 3. (e)

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Interview Questions Q.1.

What is the basic purpose of analysis of financial statements?

Ans.

Management is interested finance. Absolute figures in Sheet- are always big and helps the management in decisions.

Q.2.

Name some of the tools available for analysis of financial statements?

Ans.

The most important tools for financial analysis are:

to know the strength and weakness of the firm, in terms of the financial statements –Profit and Loss Account and Balance difficult to understand, easily. Analysis of financial statements understanding the figures better for quicker and meaningful

(a) Comparative financial statements (b) Trend Analysis or Trend Ratios (c) Common Size statements (d) Ratio Analysis (e) Fund Flow Analysis (f) Cash Flow Analysis Q.3.

What do you understand by Trend Analysis?

Ans.

Trend Analysis helps in understanding the direction of movement of the firm, in terms of operational results and financial position.

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