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ANALYSIS OF FINANCIAL
     STATEMENTS

  Prof. M .B. Thakoor
SYNOPSIS
•   1)   MEANING OF FINANCIAL STATEMENT
•   2)   NATURE OF FINANCIAL STATEMENT
•   3)   ESSENTIAL QUALITIES OF FINANCIAL
         STATEMENT
• 4)     LIMITATION OF FINANCIAL
         STATEMENT
•   5)   FINANCIAL STATEMENT ANALYSIS
•   6)   TOOLS & TECHNIQUES OF ANALYSIS
•   7)   TYPES OF COMPARISON
•   8)   INTERPRETATION
NATURE OF FINANCIAL
           STATEMENT
• The data exhibited by financial statements
  are affected by
• a) Recorded facts
• b) Accounting Concepts, Conventions
  & Principles
• c) Personal Judgment
Accounting Principles

•
    Accounting concepts               Accounting Conventions
•   a) Entity Concept                     a)      Disclosure
•   b) Going Concern Concept              b)      Materiality
•   c) Accounting period concept          c)      Consistency
•   d) Money Measurement Concept          d)      Conservatism
•   e) Cost Concept
•   f)  Cost Attach Concept
•   g) Dual Aspect Concept
•   h) Accrual concept
•   i)  Periodic Matching of cost and
•       Revenue Concept
•   j)  Realisation Concept
•   k) Verifiable Objective Evidence Concept
ESSENTIAL QUALITIES OF
    FINANCIAL STATMENTS
• 1.   Relevance
• 2.   Understandability :
• 3.   Reliability and Accuracy
• 4.   Comparability
• 5.   Completeness
• 6.   Timeliness
LIMITATIONS OF FINANCIAL
          STATEMENTS
•   1.   Lack of Precision
•   2.   Lack of Exactness
•   3.   Incomplete Information
•   4.   Interim Reports
•   5.   Hiding of Real Position or Window Dressing
•   6.   Lack of Comparability
•   7.   Historical Costs
Analysis
• Analysis – To Analyse – to cut into pieces
• But only analyse – No – It means also
  Interpretation.

• Thus
• Financial Statement Analysis means
  “Analysis, comparisons and interpretation
  of Financial data to achieve the desired
  result”
TOOLS OF FINANCIAL
         STATEMENT ANALYSIS

•   1.   Comparative Statements
•   2.   Common Size Statements
•   3.   Trend Analysis
•   4.   Ratio Analysis
•   5.   Fund Flow Statement
•   6.   Cash Flow Statement
Types of Financial Analysis

• 1. Intra-Firm Comparison
• 2. Inter-firm Comparison
• 3. Industry Average or Standard
     Analysis:
• 4. Horizontal Analysis
• 5. Vertical Analysis
Interpretation
• The Analysis is of no use without interpretation
    The Company has to interpret the financial
    statement which it has analysed.

• The Analysis is made to serve the following
    purpose
•
•   1. Profitability Analysis
•   2. Liquidity Analysis
•   3. Solvency Analysis (To know the financial structure)
Interested Parties in Analysis of
          Financial Statements
•   1. Management
•   2. Investors (In the form of Shareholders or
•        Debentureholders)
•   3. Banks and Financial Institution
•   4. Trade Creditors
•   5. Government and their Agencies
•   6. Employees
•   7. Customers
•   8. Public
•   9. Trade Association
•   10. Stock Exchange
1. Comparative Financial
            Statements
• Comparative Financial Statements is a
 statement of Financial Position of a
 business designed in such a way where a
 comparative study is undertaken of
 different accounting items, to measure the
 performance of a Business Activity.
Types of Comparison

• There are 3 types of Comparison
• 1) Inter Firm Comparison
• 2) Intra Firm Comparison
• 3) Inter Period Comparison
Merits:

• 1) Indicate the Direction of Financial

     Position
• 2) Reveal Nature & Trend:
• 3) Identifying Trouble Spots:
•
Disadvantages:

• 1) Misleading picture, if consistency in accounting principle
    not followed.
•   2) Constant change in price level tender accounting
    statement useless for comparison.
•   3) Inter firm comparison is useless, unless all the firms are
    of the same age, size and follow the same principles.
•   4) If there exists any Abnormal Period between 2 successive
    accounting period then it will prove to be a pointless analysis.
2. Common Size Statements

• It is a Statement in Vertical Form in which
 every item of the Financial Statement is
 reduced to a common base. This was
 introduced with a view to overcome the
 limitation of Comparative Statement.
Types of common size
         statements.
• (1)Common Size Balance Sheet

• (2)Common Size Income Statement:
Advantages of Common Size
           Statement
• 1) It reveals Sources and Application of Funds
    in a nutshell which help in taking decision.
•   (2) If common size statements of 2 or more
    years are compared it indicate the changing
    proportion of various components of Assets,
    Liabilities, Cost, Net Sale & Profit.
•   (3) When Inter Firm Comparison is made with
    the help of Common size statement it helps in
    doing corporate evaluation and Ranking.
Disadvantages of Common Size
         Statement
• (1) No Established Standard Proportion:
• Common Size Statements are regarded as useless as
  there is no established standard proportion of an asset
  to the total asset or an item of expense to the net sales.

• (2) Consistency Required:-
• If Financial Statement of a Particular business
  organization are not prepared year after year on a
  consistent basis comparative study of common size
  statement will be misleading
3. Trend Analysis

• Trend Analysis is a statement in vertical
 form where the earliest year is taken as
 base year and the value of all the items in
 the financial statements will be related to
 the base year in terms of % where value
 of each item in base year will be
 considered as 100. Trend % analysis
 move in one directions either upward or
 downward progression or regression.
Advantages:
• (1) Trend % indicate the increase or decrease
    with the magnitude of change in % which is
    more effective than absolute data.
•   Ex. If we say profit increases by Rs. 50,000/- it
    will be meaningless unless we find by what %
    the profit has increased.

• (2) Facilitate efficient comparative study of
    financial performance
Limitations:
• (1) It will give a misleading picture if consistency in
    accounting principle is not followed.
•   (2) Constant change in price level render accounting
    statement useless for comparison.
•   (3) During inflationary period the data over a period of time
    become incomparable, unless the absolute rupee data is
    adjusted.
•   (4) There is always the danger of selecting the base year
    which may not be representative, normal & typical.
•   (5) Trend % should be studied in relation with Absolute
    figure otherwise it give misleading picture. For ex. No. of
    student where 2, the next year they increased to 4. Now trend
    % show 100% increase but absolutely we get clear picture
    than trend %.
4. Ratio Analysis
•   TRADITIONAL CLASSIFICATION
•   BALANCE SHEET RATIOS
•   (1) Current Ratio
•   (2) Quick Ratio / Liquid Ratio / Acid Test Ratio.
•   (3) Super Quick Ratio
•   (4) Stock to work Capital Ratio
    (5) Capital Gearing Ratio
•   (6) Debt Equity Ratio
•   (7) Proprietary Ratio
•   (8) Long Term Borrowing : Total Asset
•   (9) Fixed Assets : Net Worth.
REVENUE STATEMENT RATIOS

•   Gross Profit Ratio
•   Net Profit Ratio
•   Operating Net Profit Ratio
•   Operating Ratio
•   Operating Expenses Ratio
•   Stock Turnover Ratio
•   Stock Holding Period
COMBINED RATIOS
• Return on Investment (ROI) or
    Return on Capital Employed (ROCE)
•   Return on Proprietor / Shareholder fund
•   Return on Equity shareholder fund
•   Earning per share
•   Dividend per share
•   Dividend Payout Ratio
•   Price Earning Ratio
•   Interest Coverage Ratio
COMBINED RATIOS

• Debt : Service Coverage Ratio
• Debit Collection period
• Debtor Turnover Ratio
• Creditor Payment Period
• Creditor Turnover Ratio
• Preference Dividend Cover
• Equity Dividend Cover
BASED ON FUNCTIONS

• SOLVENCY RATIOS
• Short Term Solvency
• Current Ratio
• Quick Ratio / Liquid Ratio / Acid Test
  Ratio
• Super Quick Ratio
• Stock : Working Capital Ratio.
Long Term Solvency /
        Leverage Ratio /

• Capital Gearing
• Debt : Equity Ratio
• Proprietary Ratio
• Long Term Borrowing: Total Assets
•                   ( 1 – Net Worth )/ Total
  Assets
• Fixed Asset : Net worth
ACTIVITY RATIO / TURNOVER
          RATIOS

• Stock Turn Over Ratio
 Stock Holding Period
 Debt Collection Period
 Debtor Turnover Ratio
 Creditor Payment Period
 Creditor Turnover Ratio
PROFITABILITY RATIO

•   In relation to sales
•   Gross Profit Ratio
•   Net Profit Ratio
•   Operating Net Profit Ratio
•   Operating Ratio
•   Operating Expenses Ratio.
In relation to capital employed

• Return on Interest (ROI) or Return on Capital
    Employed (ROLE)
•   Return on Proprietor / Shareholder funds
•   Return on Equity Shareholder Fund
•   Earning per Share
•   Dividend per Share
•   Dividend Payout Ratio
•   Price Earning Ratio
COVERAGE RATIOS

•   Interest Coverage Ratio
•   Preference Dividend Cover
•   Equity Dividend Cover
•   Debt Service Coverage Ratio
•
USER BASED CLASSIFICATION

•   FOR SHORT TERM CREDITORS
•   (1)   Current Ratio
•   (2)   Quick / Liquid Ratio / Acid Test Ratio
•   (3)   Super Quick Ratio
•   (4)   Stock : Working Capital Ratio
•   (5)   Stock Turnover Ratio
•   (6)   Stock Holding Period
•   (7)   Creditor Payment Period
    (8)   Creditor Turnover Ratio
FOR LONG TERM CREDITORS

•   Capital Gearing Ratio
•   Debit : Equity Ratio
•   Proprietary Ratio
•   Long Term Borrowing : Total Asset Ratio
•   Fixed Asset : Net worth
•   Interest Coverage Ratio
•   Debt Service Coverage Ratio
FOR SHARE HOLDERS
•   Return on Investment (ROI) or Return on Capital
    Employed (ROCE)
•   Return on Proprietary / Shareholder fund
•   Return on Equity Shareholder fund
•   Earning per share
•   Dividend per share
•   Dividend payout Ratio
•   Price Earning Ratio
•   Preference Dividend Cover
•   Equity Dividend Cover
FOR MANAGEMENT

• Return on Investment (ROI) or Return on
    Capital Employed (ROCE)
•   Debtor Turnover Ratio
•   Debtor Collection Period
•   Creditor Payment period
•   Creditor Turnover Ratio
•   Stock Turnover Ratio
•   Stock Holding Period
FOR MANAGEMENT

• Gross Profit Ratio
• Net Profit Ratio
• Operating Net Profit Ratio
• Operating Ratio
• Proprietary Ratio
• Fixed Asset : Net Worth
• Long Term Borrowing : Total Assets

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Analysis of financial statements

  • 1. ANALYSIS OF FINANCIAL STATEMENTS Prof. M .B. Thakoor
  • 2. SYNOPSIS • 1) MEANING OF FINANCIAL STATEMENT • 2) NATURE OF FINANCIAL STATEMENT • 3) ESSENTIAL QUALITIES OF FINANCIAL STATEMENT • 4) LIMITATION OF FINANCIAL STATEMENT • 5) FINANCIAL STATEMENT ANALYSIS • 6) TOOLS & TECHNIQUES OF ANALYSIS • 7) TYPES OF COMPARISON • 8) INTERPRETATION
  • 3. NATURE OF FINANCIAL STATEMENT • The data exhibited by financial statements are affected by • a) Recorded facts • b) Accounting Concepts, Conventions & Principles • c) Personal Judgment
  • 4. Accounting Principles • Accounting concepts Accounting Conventions • a) Entity Concept a) Disclosure • b) Going Concern Concept b) Materiality • c) Accounting period concept c) Consistency • d) Money Measurement Concept d) Conservatism • e) Cost Concept • f) Cost Attach Concept • g) Dual Aspect Concept • h) Accrual concept • i) Periodic Matching of cost and • Revenue Concept • j) Realisation Concept • k) Verifiable Objective Evidence Concept
  • 5. ESSENTIAL QUALITIES OF FINANCIAL STATMENTS • 1. Relevance • 2. Understandability : • 3. Reliability and Accuracy • 4. Comparability • 5. Completeness • 6. Timeliness
  • 6. LIMITATIONS OF FINANCIAL STATEMENTS • 1. Lack of Precision • 2. Lack of Exactness • 3. Incomplete Information • 4. Interim Reports • 5. Hiding of Real Position or Window Dressing • 6. Lack of Comparability • 7. Historical Costs
  • 7. Analysis • Analysis – To Analyse – to cut into pieces • But only analyse – No – It means also Interpretation. • Thus • Financial Statement Analysis means “Analysis, comparisons and interpretation of Financial data to achieve the desired result”
  • 8. TOOLS OF FINANCIAL STATEMENT ANALYSIS • 1. Comparative Statements • 2. Common Size Statements • 3. Trend Analysis • 4. Ratio Analysis • 5. Fund Flow Statement • 6. Cash Flow Statement
  • 9. Types of Financial Analysis • 1. Intra-Firm Comparison • 2. Inter-firm Comparison • 3. Industry Average or Standard Analysis: • 4. Horizontal Analysis • 5. Vertical Analysis
  • 10. Interpretation • The Analysis is of no use without interpretation The Company has to interpret the financial statement which it has analysed. • The Analysis is made to serve the following purpose • • 1. Profitability Analysis • 2. Liquidity Analysis • 3. Solvency Analysis (To know the financial structure)
  • 11. Interested Parties in Analysis of Financial Statements • 1. Management • 2. Investors (In the form of Shareholders or • Debentureholders) • 3. Banks and Financial Institution • 4. Trade Creditors • 5. Government and their Agencies • 6. Employees • 7. Customers • 8. Public • 9. Trade Association • 10. Stock Exchange
  • 12. 1. Comparative Financial Statements • Comparative Financial Statements is a statement of Financial Position of a business designed in such a way where a comparative study is undertaken of different accounting items, to measure the performance of a Business Activity.
  • 13. Types of Comparison • There are 3 types of Comparison • 1) Inter Firm Comparison • 2) Intra Firm Comparison • 3) Inter Period Comparison
  • 14. Merits: • 1) Indicate the Direction of Financial Position • 2) Reveal Nature & Trend: • 3) Identifying Trouble Spots: •
  • 15. Disadvantages: • 1) Misleading picture, if consistency in accounting principle not followed. • 2) Constant change in price level tender accounting statement useless for comparison. • 3) Inter firm comparison is useless, unless all the firms are of the same age, size and follow the same principles. • 4) If there exists any Abnormal Period between 2 successive accounting period then it will prove to be a pointless analysis.
  • 16. 2. Common Size Statements • It is a Statement in Vertical Form in which every item of the Financial Statement is reduced to a common base. This was introduced with a view to overcome the limitation of Comparative Statement.
  • 17. Types of common size statements. • (1)Common Size Balance Sheet • (2)Common Size Income Statement:
  • 18. Advantages of Common Size Statement • 1) It reveals Sources and Application of Funds in a nutshell which help in taking decision. • (2) If common size statements of 2 or more years are compared it indicate the changing proportion of various components of Assets, Liabilities, Cost, Net Sale & Profit. • (3) When Inter Firm Comparison is made with the help of Common size statement it helps in doing corporate evaluation and Ranking.
  • 19. Disadvantages of Common Size Statement • (1) No Established Standard Proportion: • Common Size Statements are regarded as useless as there is no established standard proportion of an asset to the total asset or an item of expense to the net sales. • (2) Consistency Required:- • If Financial Statement of a Particular business organization are not prepared year after year on a consistent basis comparative study of common size statement will be misleading
  • 20. 3. Trend Analysis • Trend Analysis is a statement in vertical form where the earliest year is taken as base year and the value of all the items in the financial statements will be related to the base year in terms of % where value of each item in base year will be considered as 100. Trend % analysis move in one directions either upward or downward progression or regression.
  • 21. Advantages: • (1) Trend % indicate the increase or decrease with the magnitude of change in % which is more effective than absolute data. • Ex. If we say profit increases by Rs. 50,000/- it will be meaningless unless we find by what % the profit has increased. • (2) Facilitate efficient comparative study of financial performance
  • 22. Limitations: • (1) It will give a misleading picture if consistency in accounting principle is not followed. • (2) Constant change in price level render accounting statement useless for comparison. • (3) During inflationary period the data over a period of time become incomparable, unless the absolute rupee data is adjusted. • (4) There is always the danger of selecting the base year which may not be representative, normal & typical. • (5) Trend % should be studied in relation with Absolute figure otherwise it give misleading picture. For ex. No. of student where 2, the next year they increased to 4. Now trend % show 100% increase but absolutely we get clear picture than trend %.
  • 23. 4. Ratio Analysis • TRADITIONAL CLASSIFICATION • BALANCE SHEET RATIOS • (1) Current Ratio • (2) Quick Ratio / Liquid Ratio / Acid Test Ratio. • (3) Super Quick Ratio • (4) Stock to work Capital Ratio (5) Capital Gearing Ratio • (6) Debt Equity Ratio • (7) Proprietary Ratio • (8) Long Term Borrowing : Total Asset • (9) Fixed Assets : Net Worth.
  • 24. REVENUE STATEMENT RATIOS • Gross Profit Ratio • Net Profit Ratio • Operating Net Profit Ratio • Operating Ratio • Operating Expenses Ratio • Stock Turnover Ratio • Stock Holding Period
  • 25. COMBINED RATIOS • Return on Investment (ROI) or Return on Capital Employed (ROCE) • Return on Proprietor / Shareholder fund • Return on Equity shareholder fund • Earning per share • Dividend per share • Dividend Payout Ratio • Price Earning Ratio • Interest Coverage Ratio
  • 26. COMBINED RATIOS • Debt : Service Coverage Ratio • Debit Collection period • Debtor Turnover Ratio • Creditor Payment Period • Creditor Turnover Ratio • Preference Dividend Cover • Equity Dividend Cover
  • 27. BASED ON FUNCTIONS • SOLVENCY RATIOS • Short Term Solvency • Current Ratio • Quick Ratio / Liquid Ratio / Acid Test Ratio • Super Quick Ratio • Stock : Working Capital Ratio.
  • 28. Long Term Solvency / Leverage Ratio / • Capital Gearing • Debt : Equity Ratio • Proprietary Ratio • Long Term Borrowing: Total Assets • ( 1 – Net Worth )/ Total Assets • Fixed Asset : Net worth
  • 29. ACTIVITY RATIO / TURNOVER RATIOS • Stock Turn Over Ratio Stock Holding Period Debt Collection Period Debtor Turnover Ratio Creditor Payment Period Creditor Turnover Ratio
  • 30. PROFITABILITY RATIO • In relation to sales • Gross Profit Ratio • Net Profit Ratio • Operating Net Profit Ratio • Operating Ratio • Operating Expenses Ratio.
  • 31. In relation to capital employed • Return on Interest (ROI) or Return on Capital Employed (ROLE) • Return on Proprietor / Shareholder funds • Return on Equity Shareholder Fund • Earning per Share • Dividend per Share • Dividend Payout Ratio • Price Earning Ratio
  • 32. COVERAGE RATIOS • Interest Coverage Ratio • Preference Dividend Cover • Equity Dividend Cover • Debt Service Coverage Ratio •
  • 33. USER BASED CLASSIFICATION • FOR SHORT TERM CREDITORS • (1) Current Ratio • (2) Quick / Liquid Ratio / Acid Test Ratio • (3) Super Quick Ratio • (4) Stock : Working Capital Ratio • (5) Stock Turnover Ratio • (6) Stock Holding Period • (7) Creditor Payment Period (8) Creditor Turnover Ratio
  • 34. FOR LONG TERM CREDITORS • Capital Gearing Ratio • Debit : Equity Ratio • Proprietary Ratio • Long Term Borrowing : Total Asset Ratio • Fixed Asset : Net worth • Interest Coverage Ratio • Debt Service Coverage Ratio
  • 35. FOR SHARE HOLDERS • Return on Investment (ROI) or Return on Capital Employed (ROCE) • Return on Proprietary / Shareholder fund • Return on Equity Shareholder fund • Earning per share • Dividend per share • Dividend payout Ratio • Price Earning Ratio • Preference Dividend Cover • Equity Dividend Cover
  • 36. FOR MANAGEMENT • Return on Investment (ROI) or Return on Capital Employed (ROCE) • Debtor Turnover Ratio • Debtor Collection Period • Creditor Payment period • Creditor Turnover Ratio • Stock Turnover Ratio • Stock Holding Period
  • 37. FOR MANAGEMENT • Gross Profit Ratio • Net Profit Ratio • Operating Net Profit Ratio • Operating Ratio • Proprietary Ratio • Fixed Asset : Net Worth • Long Term Borrowing : Total Assets