Kennedy and Muller, has explained that The analysis and interpretation of financial statements are an attempt to determine the significance and meaning of financial statements data so that the forecast may be made of the prospects for future earnings, ability to pay interest and debt maturines (both current and long term) and profitability and sound dividend policy. T.S.Reddy and Y. Hari Prasad Reddy (2009), have stated that “The statement disclosing status of investments is known as balance sheet and the statement showing the result is known as profit and loss account”. Peeler J. Patsula (2006), he define that a sound business analysis tells others a lot about good sense and understanding of the difficulties that a company will face. We have to make sure that people know exactly how we arrived to the final financial positions. We have to show the calculation but we have to avoid anything that is too mathematical. A business performance analysis indicates the further growth and the expansion. It gives a physiological advantage to the employees and also a planning advantage. I.M.Pandey (2007), had stated that the financial statements contain information about the financial consequences and sources and uses of financial resources, one should be able to say whether the financial condition of a firm is good or bad; whether it is improving or deteriorating. One can relate the financial variables given in financial statements in a meaningful way which will suggest the actions which one may have to initiate to improve the firm’s financial condition. Jae K.Shim & Joel G.Siegel (1999), had explained that the financial statement of an enterprise present the raw data of its assets, liabilities and equities in the balance sheet and its revenue and expenses in the income statement. Without subjecting these to data analysis, many fallacious conclusions might be drawn concerning the financial condition of the enterprise. Financial statement analysis is undertaken by creditors, investors and other financial statement users in order to determine the credit worthiness and earning potential of an entity. Susan Ward (2008), emphasis that financial analysis using ratios between key values help investors cope with the massive amount of numbers in company financial statements. For example, they can compute the percentage of net profit a company is generating on the funds it has deployed. All other things remaining the same, a company that earns a higher percentage of profit compared to other companies is a better investment option. Jonas Elmerraji (2005), tries to say that ratios can be an invaluable tool for making an investment decision. Even so, many new investors would rather leave their decisions to fate than 17 try to deal with the intimidation of financial ratios. The truth is that ratios aren’t that intimidating, even if you don’t have a degree in business or finance. Using ratios to make informed decisions about an investment makes a lot of sense, once you know how use them. Chidambaram Rameshkumar & Dr. N. Anbumani (2006), he argue that Ratio Analysis enables the business owner/manager to spot trends in a business and to compare its performance 16 and condition with the average performance of similar businesses in the same industry. To do this compare your ratios with the average of businesses similar to yours and compare your own ratios for several successive years, watching especially for any unfavorable trends that may be starting. Ratio analysis may provide the all-important early warning indications that allow you to solve your business problems before your business is destroyed by them. M Y Khan & P K Jain (2011), have explained that the financial statements provide a summarized view of the financial position and operations of a firm. Therefore, much can be learnt about a firm from a careful examination of its financial statements as invaluable documents / performance reports. The analysis of financial statements is, thus, an important aid to financial analysis. Elizabeth Duncan and Elliott (2004), had stated that the paper in the title of efficiency, customer service and financing performance among Australian financial institutions showed that all financial performance measures as interest margin, return on assets, and capital adequacy are positively correlated with customer service quality scores. Carlos Correia (2007), had explained that any analysis of the firm, whether by management, investors, or other interested parties, must include an examination of the company’s financial data. The most obvious and readily available source of this information is the firm’s annual report. The financial statements shall, in conformity with generally accepted accounting practice, fairly present the state of the affairs of the company and the results of operations for the financial year. Greninger et al. (1996), identified and refined financial ratios using a Delphi study in the areas of liquidity, savings, asset allocation, inflation protection, tax burden, housing expenses and, insolvency. Based on the Delphi findings, they proposed a profile of financial well-being for the typical family and individual. Rachchh Minaxi A (2011), have suggested that the financial statement analysis involves analyzing the financial statements to extract information that can facilitate decision making. It is the process of evaluating the relationship between component parts of the financial statements to obtain a better understanding of an entity’s position and performance. Salmi, T. and T. Martikainen (1994), in his “A review of the theoretical and empirical basis of financial ratio analysis”, has suggested that A systematic framework of financial statement analysis along with the observed separate research trends might be useful for furthering the development of research. If the research results in financial ratio analysis are to be useful for the decision makers, the results must be theoretically consistent and empirically generalizable. John J.Wild, K.R.Subramanyam & Robert F.Halsey (2006), have said that the financial statement analysis is the application of analytical tools and techniques to general-purpose financial statements and related data to derive estimates and inferences useful in business analysis. Financial statement analysis reduces reliance on hunches, guesses, and intuition for business decisions. It decreases the uncertainty of business analysis.
The term analysis is methodical classification of data given in the financial statements. Financial analysis is the process of identifying the financial strength and weakness of tiles Finn by property establishing relationship between the item of balance sheet & profit & loss account. Financial analysis can be undertaken by the firm or by outside parties, firm’s owner, creditors, investors and other. Actually the nature of analysis depends upon the parties. According to Finney and Miller “Financial analysis consists in separating facts according to some definite plan, arranging them in groups according to certain circumstances, and then presenting them in a convenient and easily read and understandable form.” According to John N. Myres “Financial statement analysis 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.”
A 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 aspects of a business firm. It may show a position at a moment of time as in the case of a balance sheet, or may reveal a series of activities over a given period of time, as in the case of an income statement. Thus, the term financial statement generally refers to the basis statements; Balance sheet Income statement Cash flow statement Statement of change in equity Notes, comprising of a summary of significant accounting policies and other explanatory notes
The balance sheet is also called the statement of financial position. This statement accounted for the assets which the company controls and the ways these assets are financed. The balance sheet is based on the accounting equation:
An income statement is also known as the statement of earnings. This statement measures the financial performance of a firm and indicates the flow of sales, expenses and earnings for a given period.
This statement reports on the cash receipt and cash paid that is the cash inflow and outflow separately for operating, investing and financing activities. Similarly, only actual cash inflows and outflows from cash items is reported in the statement.
This statement is useful as it reports the changes in equity during a company financial year. The statement gives a detail of the balance at the beginning and explained the changes that occurred during the year.
Here information concerning the preparation and the specific accounting policies adopted in the financial statement are provided. Therefore it provides additional information which does not appear in the financial statement but is important for a fair presentation.
Financial statements are used by a diverse group of parties, both inside and outside a business. Generally, these users are: Internal Users: are owners, managers, employees and other parties who are directly connected with a company. Owners and managers require financial statements to make important business decisions that affect its continued operations. Financial analysis are then performed on these statements to provide management with a more detailed understanding of the figures. These statements are also used as part of management’s report to its stockholders, as it form part of its Annual Report. Employees also need these reports in making collective bargaining agreements (CBA) with the management, in the case of labor unions or for individuals in discussing their compensation, promotion and rankings. External Users: are potential investors, banks, government agencies and other parties who are outside the business but need financial information about the business for a diverse number of reasons. Prospective investors make use of financial statements to assess the viability of investing in a business. Financial analysis are often used by investors and is prepared by professionals (Financial Analysts), thus providing them with the basis in making investment decisions. Financial institutions (banks and other lending companies) use them to decide whether to grant a company with fresh working capital or extend debt securities (such as a long-term bank loan or debentures) to finance expansion and other significant expenditures. Government entities (Tax Authorities) need financial statements to ascertain the propriety and accuracy of taxes and other duties declared and paid by a company. Media and the general public are also interested in financial statements for a variety of reasons
The purpose of analysis of financial statements depends upon the need of a person who analysis these statements. These needs may be:- To know the earning capacity or profitability. To know the solvency. To know the financial strength. To make comparative study with other firms. To know the capability of payment of interest & dividend. To know the trend of business.
Planning and Control are the two most important ingredients to a Successful Business. A Business Plan takes most of the guess work out of Business Strategy and Control through solid financial analysis. Financial Data provides a way to gauge where you are in your Strategic Plan, telling you where changes in your Plan are necessary. Because of this, Financial Data Analysis and Management are vitally important to running a successful business.
Investors are generally considered one of the primary users of financial statements. They use the financial statements to determine the current profitability of the firm and attempt to predict its future profitability. Their interest is in the future growth of a company’s stock price and/or the likelihood of the company paying dividends to the owner.
In the ongoing relationship between suppliers and a firms financial statement can play several roles consider the relationship between a firm and the suppliers to its loan capital. e.g a bank in the initial loan granting stage of the relationship, financial statement typically are an important items.
The demand by these bodies can arise in diverse set of areas such as revenue raising e.g for income tax, sales tax, value added tax collection. Govt. intervention e.g determines whether to provide a govt. backed loan agreement to a financially distressed firm.
They are the part of the organization and feel that their effort contributed to the firm profit they would there for prefers to give bonuses and salary increase this also increase expenses of the firm.
The set of party that demand for financial analysis information of corporation is open ended. Diverse party such as academic, environmental protection organization, and other special interest lobbying groups approach cooperation for detail relating to their financial and other affairs.
Various ministries and department have interest in the firm’s payments of taxes. Also sees the enactment of law for the industry and the provision of social service to the public. The govt. may also want to ensure that the firm complies with the law on for example wages payments and employees benefit.
Different types of financial statements analysis can be made on the basis of:
On this basis, the financial analysis can be external and internal analysis: External Analysis: It is made by those persons who are not connected with the enterprise. They do not have access to the enterprise. They do not have access to the detailed record of the company and have to depend mostly on published Statements. Such type of analysis is made by investors, credit agencies, governmental agencies and research scholars. Internal Analysis: The internal analysis is made by those persons who have access to the books of accounts. They are members of the organization. Analysis of financial statements or other financial data for managerial purpose is the internal type of analysis. The internal analyst can give more reliable result than the external analyst because every type of information is at his disposal.
On this basis the analysis can be long-term and short-term analysis. Long-term Analysis: This analysis is made in order to study the long-term financial stability, solvency and liquidity as well as profitability and earning capacity of a business concern. The purpose of making such type of analysis is to know whether in the long-run the concern will be able to earn a minimum amount which will be sufficient to maintain a reasonable rate of return on the investment so as to provide the funds required for modernization, growth and development of the business and to meet its costs of capital. Short-term Analysis: This is made to determine the short-term solvency, stability and liquidity as well as earning capacity of the business. The purpose of this analysis is to know whether in the short run a business concern will have adequate funds of readily available to meet its short-term requirements and sufficient borrowing capacity to meet contingencies in the near future. This analysis is made with reference to items of current assets and current liabilities (working capital analysis).
On this basis, the analysis may be horizontal analysis and vertical analysis. Horizontal (or Dynamic) Analysis: This analysis is made to review and analyze financial statements of a number of years and, therefore, based on financial data taken from several years. This is very useful for long-term trend analysis and planning. Comparative financial statement is an example of this type of analysis. Vertical (or Static) Analysis: This analysis is made to review and analyze the financial statements of one particular year only. Ratio analysis of the financial year relating to a particular accounting year is an example of this type of analysis.
The following techniques can be used in connection with analysis and interpretation of financial statements:
The comparative financial statements are statements of the financial position at different periods of time. The elements of financial position are shown in a comparative form so as to give an idea of financial position at two or more periods. The statements of two or more periods are prepared to show absolute data of two or more years, increases or decreases in absolute data in value and in terms of percentages. The two comparative statements are: Comparative Balance Sheet: the comparative balance sheet analysis is the study of the trend of the same items, group of items and computed items in two or more balance sheets of the same business enterprise on different dates. Comparative Income Statement: the comparative income statement gives the results of the operations of a business. It gives an idea of the progress of a business over a period of time.
Trend analysis is an important tool of horizontal financial analysis. This analysis enables to know the changes in the financial function and operating efficiency between the time period chosen. By studying the trends of each item we can know the direction of changes and based upon the direction of changes, the opinions can be formed. These trend ratios may be compared with industry in order to know the strong or weak points of a concern.
Common size financial statements are those in which figures reported are converted to some common base. Vertical analysis is required for an interpretation of underlying causes of changes over a period of time. For this, items in the financial statements are presented as percentages or ratios to total of the items and a common base for comparison is provided. Common size statements may be used for Common Size Balance Sheet: a statement in which balance sheet items are expressed as the ratio of each asset to total assets and the ratio of each liability is expressed as a ratio of total liabilities. Common Size Income Statement: the items in income statement can be shown as percentages of sales to show the relation of each item to sales. A significant relationship can be established.
This statement is prepared in order to reveal clearly the various sources where from the funds are procured to finance the activities of a business concern during the accounting period and also brings to highlight the uses to which these funds are put during the said period.
This statement is prepared to know clearly the various items of inflow and outflow of cash. It is an essential tool for short-term financial analysis and is very helpful in the evaluation of current liquidity of a business concern. It helps the business executives of a business in the efficient cash management and internal financial management.
This statement is prepared to know the net change in working capital of the business between two specified dates. It is prepared from current assets and current liabilities of the said dates to show the net increase or decrease in working capital.
It is done to develop meaningful relationship between individual items or group of items usually shown in the periodical financial statements published by the concern. An accounting ratio shows the relationship between the two inter-related accounting figures as gross profit to sales, current assets to current liabilities, loaned capital to owned capital etc. Ratios should not be calculated between the two unrelated figures as it will not serve any useful purpose. According to K. Shastry (1995), a powerful tool for assessments and evaluation of business enterprises is “Financial Ratio Analysis”. He defines financial ratio analysis as the systematic presentation of ratios, both from the internal and external financial reports, so as to summarize key relationships and results in order to appraise financial performance of the company.
ROI indicates the efficiency of the concern which depends upon the working operations of the concern. Net Profit Ratio and Capital Turnover Ratio, as often called is usually computed on the basis of the chart represented by DU Pont. Thus it is known as “DU Pont Chart.” This system of control was applied for the first time by DU Pont Company of the United States of America. The DU Pont chart helps to the management to identify the areas of problems for the variations in the return on investment so that actions may initiated to improve the performance. The following chart can explain the ROI effect by a number of factors.
Though analysis of financial statement is essential to obtain relevant information for making several decisions and formulating corporate plans and policies, it should be carefully performed as it suffers from a number of the following limitations:
The accuracy of financial information largely depends on how accurately financial statements are prepared. If their preparation is wrong, the information obtained from their analysis will also be wrong which may mislead the user in making decisions.
Since financial statements are prepared by using historical financial data, therefore, the information derived from such statements may not be effective in corporate planning, if the previous situation does not prevail.
Then financial statement analysis provides only quantitative information about the company’s financial affairs. However, it fails to provide qualitative information such as management labor relation, customer’s satisfaction, and management skills and so on which are also equally important for decision making.
The financial statements are based on historical data. Therefore comparative analysis of financial statements of different years cannot be done as inflation distorts the view presented by the statements of different years.
The skills used in the analysis without adequate knowledge of the subject matter may lead to negative direction. Similarly, biased attitude of the analyst may also lead to wrong judgement and conclusion.
In financial accounting the cost is not available as an aid in determining prices of the product services production order and product line.
It does not provide for a proper control of materials and suppliers, wages. Labors and overheads.
It does not provided the complete analysis of losses due to defective material, idle time, plant and equipment. In other words no distinction is made between avoidable and unavoidable wastage.
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