Analysis of Financial Statements - Accounting for decision making

1. FINANCIAL
STATEMENTS
MODULE - 1

2. RATIO ANALYSIS
▸ Ratios are mathematical comparisons of financial statements. The
relationships between the financial statements help investors, creditors,
and internal company management understand how well a business is
performing and areas that need improvement.
▸ Ratios are the most common and widespread tool used to analyse a
business' financial standing. Ratios are easy to understand and simple to
compute. They can also be used to compare different companies in
different industries. Ratios don't take into consideration the size of a
company or the industry. Ratios are just a raw computation of financial
position and performance.
▸ Financial ratios are often divided up into seven main categories: liquidity,
solvency, efficiency, profitability, market prospect, investment leverage,
and coverage.

3. TYPES OF RATIOS
▸ Liquidity Ratios: These ratios show the cash levels of a company and the ability to
turn other assets into cash to pay off liabilities and other current obligations. Assets
like accounts receivable, trading securities, and inventory are relatively easy for
many companies to convert into cash in the short term. Thus, all of these assets go
into the liquidity calculation of a company.
▸ Financial Leverage Ratios: Financial leverage ratios, sometimes called equity or
debt ratios, measure the value of equity in a company by analysing its overall debt
picture. These ratios either compare debt or equity to assets as well as shares
outstanding to measure the true value of the equity in a business. In other words,
the financial leverage ratios measure the overall debt load of a company and
compare it with the assets or equity. This shows how much of the company assets
belong to the shareholders rather than creditors. When shareholders own a majority
of the assets, the company is said to be less leveraged. When creditors own a
majority of the assets, the company is considered highly leveraged. All of these
measurements are important for investors to understand how risky the capital
structure of a company and if it is worth investing in.

4. ▸ Efficiency Ratios: Efficiency ratios also called activity ratios measure
how well companies utilise their assets to generate income.
Efficiency ratios often look at the time it takes companies to collect
cash from customer or the time it takes companies to convert
inventory into cash—in other words, make sales. These ratios are
used by management to help improve the company as well as
outside investors and creditors looking at the operations of
profitability of the company.
▸ Profitability Ratios: Profitability ratios compare income statements to
show a company's ability to generate profits from its operations.
Profitability ratios focus on a company's return on investment in
inventory and other assets. These ratios basically show how well
companies can achieve profits from their operations. Investors and
creditors can use profitability ratios to judge a company's return on
investment based on its relative level of resources and assets.

5. DU PONT ANALYSIS
▸ The Dupont analysis also called the Dupont model is a financial ratio based on
the return on equity ratio that is used to analyse a company's ability to increase
its return on equity. In other words, this model breaks down the return on equity
ratio to explain how companies can increase their return for investors.
▸ The Dupont analysis looks at three main components of the ROE ratio:
▸ Profit Margin
▸ Total Asset Turnover
▸ Financial Leverage
▸ Based on these three performance measures, the model concludes that a
company can raise its ROE by maintaining a high profit margin, increasing asset
turnover, or leveraging assets more effectively.
▸ The Dupont Corporation developed this analysis in the 1920s.

6. ANALYSIS OF DUPONT MODEL
This model was developed to analyse ROE and the effects different business performance
measures have on this ratio. So investors are not looking for large or small output numbers from
this model. Instead, they are looking to analyse what is causing the current ROE. For instance, if
investors are unsatisfied with a low ROE, the management can use this formula to pinpoint the
problem area whether it is a lower profit margin, asset turnover, or poor financial leveraging.
Once the problem area is found, management can attempt to correct it or address it with
shareholders. Some normal operations lower ROE naturally and are not a reason for investors to
be alarmed. For instance, accelerated depreciation artificially lowers ROE in the beginning
periods. This paper entry can be pointed out with the Dupont analysis and shouldn't sway an
investor's opinion of the company.

7. IMPORTANCE OF RATIOS
▸Analysing Financial Statements: Ratio analysis is an important technique of financial statement analysis.
Accounting ratios are useful for understanding the financial position of the company. Different users such as
investors, management. bankers and creditors use the ratio to analyse the financial situation of the company
for their decision making purpose.
▸Judging Efficiency: Accounting ratios are important for judging the company's efficiency in terms of its
operations and management. They help judge how well the company has been able to utilise its assets and
earn profits.
▸Locating Weakness: Accounting ratios can also be used in locating weakness of the company's operations
even though its overall performance may be quite good. Management can then pay attention to the weakness
and take remedial measures to overcome them.
▸Formulating Plans: Although accounting ratios are used to analyse the company's past financial
performance, they can also be used to establish future trends of its financial performance. As a result, they
help formulate the company's future plans.
▸Comparing Performance: It is essential for a company to know how well it is performing over the years and
as compared to the other firms of the similar nature. Besides, it is also important to know how well its different
divisions are performing among themselves in different years. Ratio analysis facilitates such comparison.

8. LIMITATIONS OF RATIOS
▸ Ratios are tools of quantitative analysis, which ignore qualitative
points of view.
▸ Ratios are generally distorted by inflation.
▸ Ratios give false result, if they are calculated from incorrect
accounting data.
▸ Ratios are calculated on the basis of past data. Therefore, they
do not provide complete information for future forecasting.
▸ Ratios may be misleading, if they are based on false or window-
dressed accounting information.

9. COMMON SIZE STATEMENT
▸ Common-size financial statements present the financial statement
amounts as a percentage of a base number. For example, the
common-size income statement will report the revenue and expense
amounts as percentages of net sales. The common-size balance sheet
will report each asset, liability, and owner equity amount as a
percentage of total assets.
▸ Common-size financial statements allow you to compare the financial
statements of large companies with the financial statements of smaller
companies, because you are comparing percentages instead of
dollars. For example, a small retailer can compare her cost of goods
sold (perhaps 78%) to a much larger retailer's cost of goods sold
(perhaps 80%). Similarly, one company's inventory might be 33% (of
total assets) while a competitor's might be 28%.
▸ Common-size financial statements are related to a technique known as
vertical analysis.

10. ADVANTAGES
▸ Easy to Understand: Common-size Statement helps the users of financial
statement to make clear about the ratio or percentage of each individual item to
total assets/liabilities of a firm. For example, if an analyst wants to know the
working capital position he may ascertain the percentage of each individual
component of current assets against total assets of a firm and also the percentage
share of each individual component of current liabilities.
▸ Helpful for Time Series Analysis: A Common-Size Statement helps an analyst to
find out a trend relating to percentage share of each asset in total assets and
percentage share of each liability in total liabilities.
▸ Comparison at a Glance: An analyst can compare the financial performances at a
glance since percentage of increase or decrease of each individual component of
cost, assets, liabilities etc. are available and he can easily ascertain his required
ratio.
▸ Helpful in analysing Structural Composition: A Common-Size Statement helps the
analyst to ascertain the structural relations of various components of
cost/expenses/assets/liabilities etc. to the required total of assets/liabilities and
capital.

11. LIMITATIONS OF COMMON SIZE
STATEMENT▸ Standard Ratio: Common-Size Statement does not help to take decisions since there is no standard
ratio/percentage regarding the change of percentage in the various component of assets, liabilities, sales etc.
▸ Change in Price-level: Common-Size statement does not recognise the change in price level i.e. inflationary
effect. So, it supplies misleading information since it is based on historical cost.
▸ Following Consistency: If consistency in the accounting principle, concepts, conventions is not maintained
then Common Size Statement becomes useless.
▸ Seasonal Fluctuation: Common-Size Statement fails to convey proper records during seasonal fluctuations in
various components of sales, assets, liabilities etc. E.g. sales and closing stock significantly vary. Thus, the
statement fails to supply the real information to the users of financial statements.
▸ Window Dressing: Effect of window dressing in financial statements cannot be ignored and Common-Size
Statements fail to supply the real positions of sales, assets, liabilities etc. due to the evil effects of window
dressing appearing in the financial statements.
▸ Qualitative Element: Common-Size Statement fails to recognise the qualitative elements, e.g. quality of
works, customer relations etc. while measuring the performance of a firm although the same should not be
ignored.
▸ Liquidity and Solvency Position: Liquidity and solvency position cannot be measured by Common-Size
Statement. It considers the percentage of increase or decrease in various components of sales, assets,
liabilities etc. In other words it does not help to ascertain the Current Ratio, Liquid Ratio, Debt Equity Capital
Ratio, Capital Gearing Ratio etc. which are applied in testing liquidity and solvency position of a firm.

12. COMPARATIVE FINANCIAL STATEMENTS
▸A set of comparative financial statements presents a
company’s financial performance for two or more
consecutive periods in side-by-side columns. The
presentation is also referred to as the comparative format
because it allows users to easily compare performance
results from one period to the next without having to look at
multiple financial statements. Both periods’ statements are
shown on a single report.

13. ADVANTAGES OF COMPARATIVE
FINANCIAL STATEMENTS▸ Comparison: The comparative statements show the figures of various firms or
number of years side by side i.e. both for inter-firm comparison and intra-firm
comparison.
▸ Horizontal Analysis: The variables are arranged horizontally for the purpose of
analysis and interpretations of data taken from financial statements for
assessing profitability, overall efficiency and financial position of a firm.
▸ Trend Analysis: The comparative financial statement helps to ascertain the
‘trend’ relating to sales, cost of goods sold, operating expenses etc. so that a
proper comparison can easily be made which helps the analyst to understand
the overall performance of a firm.
▸ Trend and Directions: The comparative financial statement provides necessary
information for comparison of trends in related items e.g. the analyst can
compare the trend of sales with the trend of accounts receivable which gives
very useful information. A 20% increase in accounts receivable and an
increase of sales by only 10% warrants investigation into the reasons for this
difference in the rate of increase.

14. LIMITATIONS OF COMPARATIVE
FINANCIAL STATEMENTS▸Inter-firm Comparison: Inter firm comparison will only be effective if both the firms
follow the same accounting principles, method of valuations of stocks, assets etc.
i.e. all the accounting concepts and conventions, which in real world situation, are
not identically followed by both the firms e.g. Firm A follows the FIFO method of
valuing stock whereas Firm B follows LIFO method for the same.
▸Inflationary Effect: Comparative financial statements do not recognise the change
in prices level and, as such, it will be of no use.
▸Ascertaining Correct Trend: It is very difficult to ascertain the correct trend if there
is a structural changes in a firm which are frequently happened.
▸Supply Misleading Information: Sometimes a comparative financial statement
provides meaningless information, e.g. if a negative amount comes in base year,
and a positive amount in the next year, it is not possible to find out the change in
percentage.
▸Uniformity in Principle: There must be a consistency while following accounting
principles, concepts and convention. But in practice, this is not done and as such,
multi-year analysis becomes useless.

15. TREND ANALYSIS
▸Trend analysis is one of the tools for the analysis of the
company’s monetary statements for the investment
purposes. Investors use this analysis tool a lot in order to
determine the financial position of the business. In a trend
analysis, the financial statements of the company are
compared with each other for the several years after
converting them in the percentage. In the trend analysis, the
sales of each year from the 2008 to 2011 will be converted
into percentage form in order to compare them with each
other.

16. ADVANTAGES OF TREND ANALYSIS
STATEMENTS▸Possibility of making Inter-firm Comparison: Trend analysis helps the analyst to make a
proper comparison between the two or more firms over a period of time. It can also be
compared with industry average. That is, it helps to understand the strength or weakness
of a particular firm in comparison with other related firm in the industry.
▸Usefulness: Trend analysis (in terms of percentage) is found to be more effective in
comparison with the absolutes figures/data on the basis of which the management can
take the decisions.
▸Useful for Comparative Analysis: Trend analyses is very useful for comparative analysis
of date in order to measure the financial performances of firm over a period of time and
which helps the management to take decisions for the future i.e. it helps to predict the
future.
▸Measuring Liquidity and Solvency: Trend analysis helps the analyst/and the management
to understand the short-term liquidity position as well as the long-term solvency position
of a firm over the years with the help of related financial Trend ratios.
▸Measuring Profitability Position: Trend analysis also helps to measure the profitability
positions of an enterprise or a firm over the years with the help of some related financial
trend ratios (e.g. Operating Ratio, Net Profit Ratio, Gross Profit Ratio etc.).

17. LIMITATIONS OF TREND ANALYSIS
STATEMENTS▸ Selection of Base Year: It is not so easy to select the base year.
Usually, a normal year is taken as the base year. But it is very
difficult to select such a base year for the propose of
ascertaining the trend. Otherwise, comparison or trend analyses
will be of no value.
▸ Consistency: It is also very difficult to follow a consistent
accounting principle and policy particularly when the trends of
business accounting are constantly changing.
▸ Useless in Inflationary Situations: Analysis of trend percentage is
useless at the time of price-level change (i.e. in inflation). Trends
of data which are taken for comparison will present a misleading
result.

18. THANK
YOU
BY:
AISHWARYA MAHADEVAN
M15DM02