Analysis and Interpretation of Financial Statements

In this article we will discuss about:- 1. Introduction to Analysis and Interpretation of Financial Statements 2. Types of Financial Analysis 3. Preliminaries Required 4. Objectives 5. Importance 6. Techniques.

Introduction to Analysis and Interpretation of Financial Statements:

Analysis and interpretation of financial statements are an attempt to determine the significance and meaning of the financial statement data so that a forecast may be made of the prospects for future earnings, ability to pay interest, debt maturities, both current as well as long term, and profitability of sound dividend policy.

The main function of financial analysis is the pinpointing of the strength and weaknesses of a business undertaking by regrouping and analysis of figures contained in financial statements, by making comparisons of various components and by examining their content. The analysis and interpretation of financial statements represent the last of the four major steps of accounting.

The first three steps involving the work of the accountant in the accumulation and summarisation of financial and operating data as well as in the construction of financial statements are:

(i) Analysis of each transaction to determine the accounts to be debited and credited and the measurement and variation of each transaction to determine the amounts involved.

(ii) Recording of the information in the journals, summarisation in ledgers and preparation of a worksheet.

(iii) Preparation of financial statements.

The fourth step of accounting, the analysis and interpretation of financial statements, results in the presentation of information that aids the business managers, investors and creditors.

Interpretation of financial statements involves many processes like arrangement, analysis, establishing relationship between available facts and drawing conclusions on that basis.

Types of Financial Analysis:

The process of analysis may partake the varying types. Normally, it is classified into different categories on the basis of information used and on the basis of modus operandi.

(a) On the basis of Information Used:

(i) External analysis.

(ii) Internal analysis.

External analysis is an analysis based on information easily available to outsiders (externals) for the business. Outsiders include creditors, suppliers, investors, and government agencies regulating the business in a normal way.

These parties do not have access to the internal records (information) of the concern and generally obtain data for analysis from the published financial statements. Thus an analysis done by outsiders is known as external analysis.

Internal analysis is an analysis done on the basis of information obtained from the internal and unpublished records and books. While conducting this analysis, the analyst is a part of the enterprise he is analysing. Analysis for managerial purposes is the internal type of analysis and is conducted by executives and employees of the enterprise as well as governmental and court agencies which may have major regulatory and other jurisdiction over the business.

(b) On the basis of Modus Operandi:

(i) Horizontal analysis.

(ii) Vertical analysis.

Horizontal analysis is also known as ‘dynamic analysis’ or ‘trend analysis’. This analysis is done by analysing the statements over a period of time. Under this analysis, we try to examine as to what has been the periodical trend of various items shown in the statement. The horizontal analysis consists of a study of the behaviour of each of the entities in the statement.

Vertical analysis is also known as ‘static analysis’ or ‘structural analysis’. It is made by analysing a single set of financial statement prepared at a particular date. Under such a type of analysis, quantitative relationship is established between the different items shown in a particular statement. Common size statements are the form of vertical analysis. Thus vertical analysis is the study of quantitative relationship existing among the items of a particular data.

Preliminaries Required for Analysis and Interpretation of Financial Statements:

The following procedures are required to be completed for making an analysis and interpretation of financial statements:

(i) Data should be presented in some logical way.

(ii) Data should be analysed for preparing comparative statements.

(iii) All data shown in financial statements should be studied just to understand their significance.

(iv) The objective and extent of analysis and interpretation should be determined.

(v) Facts disclosed by the analysis should be interpreted taking into account economic facts.

(vi) Interpreted data and information should be in a report form.

Objectives of Analysis and Interpretation of Financial Statements:

The following are the some of the common objects of interpretation:

(i) To investigate the future potential of the concern.

(ii) To determine the profitability and future prospects of the concern.

(iii) To make comparative study of operational efficiency of similar concerns.

(iv) To examine the earning capacity and efficiency of various business activities with the help of income statements.

(v) To estimate about the performance efficiency and managerial ability.

(vi) To determine short term and long term solvency of the business concerns.

(vii) To enquire about the financial position and ability to pay of the concerns.

Importance of Analysis and Interpretation of Financial Statements:

The following factors have increased the importance of the analysis and interpretation of financial statements:

(i) Decision taken on the basis of intuition may be wrong and defective on the other hand. Analysis and interpretation are based on some logical and scientific methods and hence decisions taken on that basis seldom prove to be misleading and wrong.

(ii) The user as individual has a very limited personal experience. He can only understand the complexities of business and mutual relationship by observation and external experience. Thus it becomes necessary that financial statements in an implicit form should be analysed in an intelligible way.

(iii) Decision or conclusions based on scientific analysis and interpretation are relative and easily to be read and understood by other people.

(iv) Even to verify and examine the correctness and accuracy of the decisions already taken on the basis of intuition, analysis and interpretation are essential.

Techniques of Analysis and Interpretation:

The most important techniques of analysis and interpretation are:

1. Ratio Analysis

2. Fund Flow Analysis

3. Cash Flow Analysis.

1. Ratio Analysis:

Two individual items on the statements can be compared with one another and the relationship is expressed as a ratio. Ratios are computed for items on the same financial statement or on different statements. These ratios are compared with those of prior years and with those of other companies to make them more meaningful.

A ratio is a simple mathematical expression. Ratio may be expressed by a number of ways. It is a number expressed in terms of another number. It i s a statistical yard stick that provides a measure of relationship between two figures.

2. Fund Flow Analysis:

Funds Flow Analysis has been the salient feature of the evolution of accounting theory and practice. The financial statement of a business provides only some information about financial activities of a business in a limited manner. The income statement deals solely with operations and the balance sheet shows the changes in the assets and liabilities.

In fact, these statements are substantially an analysis of static aspects of financial statements. Under this context, it is imperative to study and to analyse the fund movements in the business concern. Such a study or analysis may be undertaken by using another tool of financial analysis, which is called ‘Statement of Sources, and Uses of Funds’ or simply ‘Fund Statement’ or Fund Flow Analysis.

This statement is also called by other several names and they are:

(a) Application of Funds Statement.

(b) Statement of Sources and Applications of Funds.

(c) Statement of Funds Supplied and Applied.

(d) Where Got and Where Gone Statement.

(e) Statement of Resources Provided and Applied.

(f) Fund Movement Statement.

(g) Inflow-Outflow of Fund Statement.

Fund statement is a new contribution of science of accounting but has become the doyen of tools of Financial Analysis.

3. Cash Flow Analysis:

Fund Flow Statement fails to convey the quantum of inflow of cash and outflow of cash. When we say cash, we refer to the cash as well as the bank balances of the company at the end of the accounting period as reflected in the Balance Sheet of the company. Cash is a current asset like inventory and Accounts Receivables. Cash reflects its liquidity position.

The term cash can be viewed in two senses. In a narrow sense, it includes actual cash in the form of notes and coins and bank drafts held by a firm and the deposits withdrawable on demand the company has held in commercial banks. But in a broader sense, it also includes what are called ‘marketable securities’ which are those securities which can be immediately sold or converted into cash if required.

Cash flow statement is a statement of cash flow and cash flow signifies the movements of cash in and out of a business concern. Inflow of cash is known as sources of cash and outflow of cash is called uses of cash. This statement also depicts factors for such inflow and outflow of cash.

Thus cash flow statement is a statement designed to highlight upon the causes which bring changes in cash position between two Balance Sheets dates. It virtually takes the nature and character of cash receipts and cash payments though the basic information used in the preparation of this statement differs from that which is used in recording cash receipts and cash payments.

This is particularly useful to the management, credit grantors, investors and others. As regards the management, it is helpful in budgeting cash requirements.