This document provides an overview of interpreting financial statements. It defines financial statement analysis and interpretation, and explains that analysis involves simplifying data through classification while interpretation explains the meaning and significance of the data. The document outlines objectives of analysis including assessing profitability, efficiency, and solvency, and discusses tools used like comparative statements, common size statements, ratio analysis, and trend analysis. It also covers limitations of analysis and importance of comparative statements.

1. INTERPRETATION OF
FINANCIAL STATEMENTS
Pooja Kumar
Faculty
IMS, RU

2. MEANING
• It is a systematic process of dividing the financial information into simple and valuable
elements, establishing relationships between inter-related elements and interpreting the
same to understand the working and financial position of an enterprise from its financial
statements.
• It includes analysis of Statement of Profit and Loss, Balance Sheet and Cash Flow
Statement of an enterprise.
UNDERSTANDING ANALYSIS AND INTERPRETATION
• These two terms in understanding the meaning of financial statement analysis are
complementary to each other and therefore, analysis cannot be complete without
interpretation.
• Analysis: It is concerned with simplification of financial data by proper classification of
given in the financial statement.
• Interpretation: It is concerned with explaining the meaning and significance of the
financial data.

3. DEFINITION OF FINANCIAL STATEMENT ANALYSIS
As per Myer:
Financial Statement Analysis is largely a study of
relationships among the various financial factors in
a business, as disclosed by a single set of
statements, and a study of trends of these factors,
as shown in a series of statements.

4. OBJECTIVE AND SIGNIFICANCE OF FINANCIAL ANALYSIS
• To Assess the Earning Capacity or Profitability.
• To Assess the Managerial Efficiency.
• To Assess the Short-term and Long-term Solvency of the Enterprise.
• To facilitate Inter-firm Comparison.
• To Forecast and Prepare Budgets.
• To Understand Complicated Matter by using charts, graphs and diagrams which
are easy to explain and understand.

5. USES OF FINANCIAL ANALYSIS
• Security Analysis: It is a process used by the investor to identify whether the
firm is fulfilling his expectations with regard to dividends, capital appreciation, etc.
• Credit Analysis: It is useful to know credit worthiness of client so as to take
decisions regarding whether to allow or extend credit to them or not.
• Debt Analysis: It is useful when a firm wants to know its borrowing capacity.
• Dividend Decision: It is useful in determining the rate of dividend in order to
decide how much of the earnings are to be distributed in the form of dividends
and how much is to be retained.
• General Business Analysis: It is useful in identifying the key profit drivers and
business risks in order to assess the profit potential of the firm and also assist in
future growth scenarios.

6. Parties Interested in Financial Analysis
• Management.
• Employees and Trade Unions.
• Shareholder or Owners or Investors.
• Potential Investors.
• Suppliers or Creditors.
• Bankers and Lenders.
• Researchers.
• Tax Authorities.
• Customers.

7. CLASSIFICATION OF FINANCIAL STATEMENT ANALYSIS
Financial Statement Analysis is of 4 types as follows:
External Analysis: This type of analysis is done by investors, credit
agencies, researchers, etc. who do not have access to the confidential and
complete records of an enterprise and therefore, have to depend on
information published in various statements or reports which shall
comprise of Statement of Profit and Loss, Balance Sheet, Auditor’s
Reports etc.
 Internal Analysis: This is a detailed and accurate type of analysis done
by the management of the enterprise to determine the financial position
and operational efficiency of the organization. Since, management has
access of complete information, they perform an extensive type of analysis
which is more detailed and accurate.

8. Horizontal Analysis: It is also known as Dynamic
Analysis. It is done to review and analyze financial
statement for a number of years and hence, is also
known as time series analysis. It facilitates comparison
of financial data for several years against a chosen
base year.
 Vertical Analysis: It is also known as Static Analysis.
It is done to review and analyze the financial statements
of one year only. It is useful in comparing the
performance of several companies of the same type or
divisions or departments in one enterprise.

9. DIFFERENCES BETWEEN HORIZONTAL ANALYSIS AND
VERTICAL ANALYSIS

10. INTER-FIRM AND INTRA-FIRM ANALYSIS
• Inter-firm Analysis: It facilitates a comparison of two or
more firms based on the various financial factors or
variables that will help decide the competitiveness of the
respective firms. A comparison of a single set of statements
of two or more firms is termed as Cross-sectional Analysis.
• Intra-firm Analysis: It facilitates a comparison of the
various financial variables of an enterprise over a period of
time and therefore, it is also known as Time Series Analysis
or Trend Analysis. It helps analyzing performance of an
enterprise over a period of time.

11. TOOLS OR TECHNIQUES OF FINANCIAL STATEMENT ANALYSIS
Comparative Statements:
o It means a comparative study of individual components or
elements or items of Balance Sheet and Statement of Profit or
Loss for two or more years.
o At first, the value of each component or element or item
of two or more financial years is placed alongside each other.
o After this, differences between the two amounts is
determined.
o Lastly percentage change in the amount from the base
year is ascertained.
o Such comparative statements can be Intra-Firm or Inter-
Firm Comparisons.

12. Common Size Financial Statements:
o It is a vertical analysis of Financial Statements in which
amounts of individual items of Balance Sheet or Statement of
Profit or Loss are written. These amounts are further converted
into percentages to a common base.
o These percentages can be compared with the
corresponding percentages in other periods and meaningful
conclusions can be drawn.
o Such statements may be prepared for intra-firm and inter-
firm comparison.
o Such statements may be prepared for Balance Sheet as
well as Income Statement.

13. Ratio Analysis:
o It is a study of relationship among various financial factors in a
business.
o It is a technique of analyzing the financial statements with the help
of accounting ratio.
o It is a process of determining and interpreting relationships between
items of financial statements to provide a meaningful understanding of the
financial performance and position of an enterprise.
Cash Flow Statement:
o It is a statement that shows the inflows and the outflows of Cash
and Cash Equivalents during the period.
o Inflows are those transactions that increase the Cash and Cash
Equivalents and outflows are those transactions that decrease the Cash and
Cash Equivalents.

14. Trend analysis –
• Trend analysis is also called time-series analysis.
• Trend analysis helps a firm's financial manager determine how the
firm is likely to perform over time.
• Trend analysis is based on historical data from the firm's financial
statements and forecasted data from the firm's pro forma, or
forward-looking, financial statements.

15. LIMITATIONS OF FINANCIAL STATEMENT ANALYSIS
• Historical Analysis: Financial Statements are prepared using the historical information
of the financial transactions that have already taken place.
• Price Level Changes are not considered: If there is a change in the price level,
analysis of financial statements of different accounting years become invalid as
accounting records ignore change in value of money.
• Qualitative Aspect Ignored: Financial Statements record only monetary transactions
which are quantitative in nature.
• Not free from bias: Financial statements are the outcome of accounting concepts and
conventions combined with estimates. Estimates cannot be relied upon completely as
there are chances that the amounts may fluctuate and hence, are not free from bias.
• Accounting Practices: In order to compare the profitability and the financial position of
different firms, it is necessary that these firms follow same accounting practices. If
different accounting practices are followed, inter-firm comparison is not possible.
• Window Dressing: It refers to the presentation of a better financial position than what it
actually is by way of manipulating the books of accounts. Such false representation will
provide misleading information for analysis which will result in wrong decision making.

16. Comparative Statements

17. MEANING
• It means a comparative study of components or elements or items of
Balance Sheet and Statement of Profit or Loss for two or more
years.
• At first, the value of each component or element or item of two or
more financial years is placed alongside each other.
• After this, differences between the two amounts is determined.
• Lastly percentage change in the amount from the base year is
ascertained.
• Such comparative statements can be Intra-Firm or Inter-Firm
Comparisons.

18. OBJECTIVES
• Data Presentation becomes Simple and Comparable: It is a statement with
data for two or more years in a tabular form. Such tabular representation makes
the data simple, understandable and comparable for drawing appropriate
conclusions from the complex information.
• Indicates Trend: It gives information about the changes affecting financial
position and performance of an enterprise. It helps in forecasting by the way of
indicating the trend.
• Indicates Strengths and Weaknesses: It indicates the strengths and
weaknesses of the enterprise with respect to liquidity, profitability and solvency.
• Comparison with other Firms and Industry Performance: It helps in
comparison of a enterprise’s performance with that of other enterprises or with
that of the industry.
• Forecasting and Planning: Analyzing changes and trend in the financial data
of previous years helps the management in forecasting and planning.

19. IMPORTANCE
• Shareholders: It provides meaningful information to the shareholders.
Such statements are important to the shareholders being the owners of
the company in making the timely decisions whether to hold the shares
or sell them.
• Decisions and Plans: Such statements are important to the
management of the company to take proper decisions and to formulate
plans and policies accordingly.
• Lenders: These are the funds providers in the form of loan. In order to
evaluate as to whether the loan is safe, whether any further loan is to be
made and at what rate, such statements are important information
providers to the lenders.
• Investment Decision: Such statements are important to the potential
investors to decide whether to invest in the company’s share. From such
statements they can obtain the useful information to take appropriate
investment decisions.

20. LIMITATIONS
• Historical Records
• Affected by Estimates and Personal Judgement
• Different Accounting Practices
• Qualitative Elements are ignored
• Price Level Changes are ignored
• Cannot Meet the Purpose of all Parties
• Aggregate Information

21. TYPES OF COMPARATIVE STATEMENTS
The two comparative statements are :
(i)Balance sheet, and
(ii) Income statement.

22. COMPARATIVE BALANCE SHEET
Meaning:
i. It is a statement which is used for comparing the assets, liabilities
and capital and ascertaining increase or decrease in those items.
ii. It is horizontal analysis of Balance Sheet in which each item of
assets, equity and liabilities is analyzed horizontally for two or
more accounting periods.

23. Preparation:
I. First Column: In this column, the components or elements or items of
Balance Sheet are written.
II. Second Column: In this column, the Note No. given against the line
item in Balance Sheet is written.
III. Third Column: In this column, amounts of previous year are written.
IV. Fourth Column: In this column, amounts of current year are written.
V. Fifth Column: In this column, differences i.e., increase or decrease in
amounts between the current and previous year are shown.
VI. Sixth Column: In this column, the difference of amount in column 5
(increase or decrease) is expressed as a percentage, taking column 3
(previous year’s amount) as the base.

26. GUIDELINES FOR INTERPRETATION OF COMPARATIVE BALANCE SHEET
The interpreter is expected to study the following aspects:
 Current financial position –
• For studying short -term financial position of a concern, one should see the working
capital in both the years. The excess of current assets over current liabilities will give
the figures of working capital. The increase in working capital will mean improvement
in the current financial position of the business.
• An increase in current assets is accompanied by the increase in current liabilities of the
same amount will not show any improvement in the short-term financial position. One
should study the increase or decrease in current assets and current liabilities and this
will enable him to analyze the current financial position.

27. liquidity position –
• If liquid assets like cash in hand, cash at bank, bills receivables,
debtors, etc. show an increase in the second year over the first year,
this will improve the liquidity position of the concern.
• The increase in inventory can be on account of accumulation of
stocks for want of customers, decrease in demand or inadequate
sales promotion efforts. An increase in inventory may increase
working capital of the business but it will not be good for the
business.

28. Long -term financial position –
• This can analyzed by studying the changes in fixed assets, long-term liabilities
and capital .The proper financial policy of concern will be to finance fixed
assets by the issue of either long-term securities such as debentures, bonds,
loans from financial institutions or issue of fresh share capital.
• An increase in fixed assets should be compared to the increase in long-term
loans and capital. If the increase in fixed assets is more than the increase in
long term securities then part of fixed assets has been financed from the
working capital.
• On the other hand, if the increase in long-term securities is more than the
increase in fixed assets then fixed assets have not only been financed from
long-term sources but part of working capital has also been financed from
long-term sources. A wise policy will be to finance fixed assets by raising
long-term funds.
• The nature of assets which have increased or decreased should also be studied
to form an opinion about the future production possibilities. The increase in
plant and machinery will increase production capacity of the concern.
• On the liabilities side, the increase in loaned funds will mean an increase in
interest liability whereas an increase in share capital will not increase any
liability for paying interest.

29. Profitability of the concern –
• The study of increase or decrease in retained earnings, various resources and
surpluses, etc. will enable the interpreter to see whether the profitability has
improved or not.
• An increase in the balance of Profit and Loss Account and other resources
created from profits will mean an increase in profitability to the concern.
• The decrease in such accounts may mean issue of dividend, issue of bonus
shares or deterioration in profitability of the concern.
After studying various assets and liabilities an opinion should be formed
about the financial position of the concern. One cannot say if short-term
financial position is good then long-term financial position will also be
good or vice-versa. A concluding word about the overall financial
position must be given at the end.

30. ILLUSTRATION 1

33. ILLUSTRATION 2

35. COMPARATIVE STATEMENT OF PROFIT AND LOSS
Meaning:
I. It is a horizontal analysis of Income Statement which
shows the operating results for more than one accounting
period so that changes in absolute amounts and
percentages from one period to another are known.
II. It will consist of all the items that are present in the normal
Income statement like revenue from operations, cost of
materials consumed, employee benefit expenses, etc. The
methodology or formulae used to compute all these
amounts also remains the same.

36. Preparation
I. First Column: In this column, items of revenues and expenses are
written.
II. Second Column: In this column, Note No. is given against the item in
the Statement of Profit or Loss is written.
III. Third Column: In this column, the amounts of previous year are written.
IV.Fourth Column: In this column, the amounts of current year are written.
V. Fifth Column: In this column, differences (increase or decrease) in
amounts between the current and previous period are recorded.
VI.Sixth Column: In this column, the above difference in column 5
(increase or decrease) is expressed as a percentage of column 3
(previous year’s amount).

38. GUIDELINES FOR INTERPRETATION OF INCOME STATEMENTS
Gross Profit –
• The increase or decrease in sales should be compared with the increase or
decrease in cost of goods sold. An increase in sales will not always mean an
increase in profit. The profitability will improve if increase in sales is more than
the increase in cost of goods sold.
Operational Profits –
• The operating expenses such as office and administrative expenses, selling and
distribution expenses should be deducted from gross profit to find out operating
profits.
• An increase in operating profit will result from the increase in sales position
and control of operating expenses.
• A decrease in operating profit may be due to an increase in operating expenses
or decrease in sales.
• The change in individual expenses should also be studied. Some expenses may
increase due to the expansion of business activities while others may go up due
to managerial inefficiency.

39. Overall Profitability –
• The increase or decrease in net profit will give an idea about the overall
profitability of the concern.
• Non-operating expenses such as interest paid, losses from sale of assets,
writing off of deferred expenses, payment of tax, etc. decrease the figure of
operating profit.
• When all non-operating expenses are deducted from operational profit, we get
a figure of net profit.
• Some non-operating incomes may also be there which will increase net profit.
• An increase in net profit will give an idea about the progress of the concern.
An opinion should be formed about profitability of the concern and it
should be given at the end. It should be mentioned whether the overall
profitability is good or not.

44. COMMON-SIZE STATEMENT

45. MEANING OF COMMON SIZE FINANCIAL STATEMENTS
• It is a vertical analysis of Financial Statements in which amounts of
individual items of Balance Sheet or Statement of Profit or Loss are
written. These amounts are further converted into percentages to a
common base.
• These percentages can be compared with the corresponding
percentages in other period sand meaningful conclusions can be
drawn.
• Such statements may be prepared for intra-firm and inter-firm
comparison.
• Such statements may be prepared for Balance Sheet as well as
Income Statement.

46. TYPES OF COMMON SIZE FINANCIAL STATEMENTS
The two Common-Size Statement statements are :
(i) Profit and Loss statement, and
(ii) Balance sheet.

47. COMMON-SIZE STATEMENT OF PROFIT AND LOSS
Meaning
• A Common-size Statement of Profit and Loss may be prepared for different
periods of the firm or for the same period of two firms. It shows the relative
efficiency in operating the business.
Objectives:
• To analyze change in individual items of Income Statement.
• To study the trend in different items of Incomes and Expenses.
• To assess the efficiency.

48. Preparation:
I. First Column: In this column, the items of Statement of Profit and Loss are
written.
II. Second Column: In this column, Note no. given against the item in the
Statement of Profit and Loss is written.
III. Third Column: In this column, amounts of previous year are written if the
statement is prepared for different periods of the same firm. If the statement is
prepared for two firms, amounts relating to the first firm are written.
IV. Fourth Column: In this column, amounts of current year are written if the
statement is prepared for different periods of the same firm. If the statement is
prepared for two firms, amounts relating to the other firm are written.
V. Fifth Column: In this column, percentage of different items of Statement of
Profit and Loss of the previous year to Revenue from Operations i.e., Net Sales,
is written
VI. Sixth Column: In this column, percentage relation of different items of
Statement of Profit and Loss of the Current Year to Revenue from Operations,
i.e. Net Sales is written.

50. 1

52. 2

54. COMMON-SIZE BALANCE SHEET
Meaning:
• It shows the percentage relation of each asset/liability to total assets/total
liabilities including capital i.e., equity and liabilities.
• In this statement, total assets or total equity and liabilities are taken as 100 and
all the figures are expressed as percentage of the total.
• If such statement is prepared for different periods, it helps in highlighting the
trends in different items.
• If it is prepared for different firms in an industry, it facilitates to assess the relative
financial soundness and helps in understanding their financial strategy.
Objectives:
• To analyze the changes in individual items of Balance Sheet.
• To see the trend of different items of assets, equity and liabilities.
• To assess the financial soundness and understand financial strategy.

55. Preparation:
I. First Column: In this column, items of Balance Sheet are written.
II. Second Column: In this column, Note No. given against the line
item is written.
III.Third Column: In this column, amounts of different items
(assets/liabilities) of previous year are written.
IV.Fourth Column: In this column, amounts of different items
(assets/liabilities) of current year are written.
V. Fifth Column: In this column, percentage relation of different items
of previous year’s Balance Sheet to total Equity and Liabilities/Total
Assets (taken as 100) are written.
VI.Sixth Column: In this column, percentage relation of different items
of current year’ Balance Sheet to total Equity and Liabilities/ Total
Assets (taken as 100) are written.

57. 1