What is Financial Statement Analysis? Types, Limitations, Objectives

What is Financial Statement Analysis?

Financial statement analysis is the process of examining and interpreting a company’s financial statements to assess its financial performance, position, and overall health. This analysis helps various stakeholders, including investors, creditors, analysts, and management, gain insights into a company’s strengths, weaknesses, opportunities, and risks. It involves evaluating the relationships between different financial figures and using various metrics and ratios to make informed decisions and predictions about the company’s future prospects.

Financial Statement Analysis is largely a study of the 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 series of statement

Financial Statement Analysis Definition

Objectives of Financial Statement Analysis

Financial Statement analysis can be used by different users and decision makers to achieve the following objectives:

1. Assessment of Past Performance and Current Position
2. Loan Decision by Financial Institutions and Banks
3. Prediction of Net Income and Growth Prospects
4. Prediction of Bankruptcy and Failure
5. Interpretation of Financial Statements

Assessment of Past Performance and Current Position

Past performance is often a good indicator of future performance. Therefore, an investor or creditors in interested in the trend of past sales, expenses, net income, cash flow and return on investment. These trends offer a means for judging management’s past performance and are possible indicators of future performance.

Similarly, the analysis of the current position indicates where the business stands today. For instance, the current position analysis will show the types of assets owned by a business enterprise and the different liabilities due against the enterprise. It will tell what the cash position is, how much debts the company has in relation to equity and how reasonable the inventories and receivables are.

Loan Decision by Financial Institutions and Banks

Financial statement analysis is used by financial institutions, loaning, agencies, banks, and others to make sound loan or credit decisions. In this way, they can make proper allocation of credit among the different borrowers. All lenders are primarily concerned with the repayment of loans and payment of interest on the due dates.

This requires comprehensive investigation and analysis of the financial statements submitted by the borrowers. Financial statement analysis help in determining credit risk, deciding terms and conditions of loan if sanctioned, interest rate, maturity date etc.

Prediction of Net Income and Growth Prospects

Financial Statement analysis helps in predicting the earning prospects and growth rate in the earnings which are used by investors while comparing investment alternatives and other users interested in judging the earning potential of business enterprises. Investors also consider the risk or uncertainty associated with the expected return.

The decision-makers are futuristic and are always concerned with the future financial statements which contain information on past performances analyzed and interpreted as a basis for forecasting future rates of return and for assessing risk.

Prediction of Bankruptcy and Failure

Financial statement analysis is a significant tool in predicting the bankruptcy and failure probability of business enterprises. Financial Statement analysis accomplishes this through the evaluation of solvency position.

After being aware of probable failure, mangers and investors both can take preventive measures to avoid or minimize losses. Corporate management can effect changes in operating policy, reorganise financial structure or even go for voluntary liquidation to shorten the length of time losses.

Interpretation of Financial Statements

The analysis of financial statements means a critical examination of statements for better understanding and drawing fruitful conclusions. It is only an analytical study of statements that can help draw dependable conclusions. Therefore, analysis becomes a pre-requisite for the interpretation of financial data in the form of an annual account and statement. The technique of analysis depends upon the objectives of analysis

Steps involved in Financial Statement Analysis

There are three steps involved in the financial statement analysis and they are:

• Selection: The first step involved refers to the selection of information relevant to the purpose of evaluation from the total of information contained in the financial statements
  
  
• Classification of Information: The second step involved is the classification or grouping of information in such a manner to focus on the significant relationships.
  
  
• Selection of Information: The final step is the interpretation which includes drawing of inferences and conclusions
  

Limitations of Financial Statements

The Financial Statements suffer from certain limitations, which are mentioned below :

• The financial statements do not show qualitative change which undoubtedly affects greatly the performance of an undertaking. The financial accounts do not account for events such as changes in management, labor strikes, changes in government policies affecting enterprise, etc. The financial analyst should try to assess the impact of qualitative changes on the profitability of the concerning enterprise.
  
  
• Financial statements are historical in nature. They tell nothing about the future. Since the financial analyst is concerned with analysis and interpretation for the formulation of future business policies, he should restructure the statements in such a manner, that they become more intelligible and useful for projections for the future.
  
  
• Generally, the audited Profit and Loss Account and Balance Sheet are considered dependable statements. If the analyst is compelled to use the unaudited accounting statements, he should first ascertain their truth. It is very difficult to verify the correctness of the Income Statement and Position Statement without the basic information in the form of ledger accounts and other records.
  
  
• The concept of the accounting period is not technically correct. The Profit and loss Account is prepared for an accounting year which is generally a period of one year. This gives rise to the problem of cost and income allocation. In fact, real profit or loss can be calculated only at the end with the units is closed down. The annual accounts can best be considered interim reports.
  
  
• The Profit or loss figure as shown by a Profit and Loss Account is not necessarily a correct figure which is influenced by the personal judgment of the management regarding depreciation, inventory valuation and provisions for various reserves and contingencies. The management can manipulate profit/loss figures to serve their interests. The financial analyst should see that the income has been rightly computed by following consistent accounting policies.
  
  
• The balance sheet is a static document, which means, documents showing the economic position of an enterprise on one given date. The Balance sheet is prepared on the last day of a financial year. i.e on 31st December, 31st March, or 30th June.
  
  Generally, the Balance Sheet is prepared and published very late after the close of the accounting year. The Balance sheet loses much of its significance and practical utility due to a long time gap between the close of an accounting year and the actual publication of the same. financial analysts should always bear this limitation in mind.
  
  
• Assets shown in the Balance Sheet might not be shown at their fair or current values. Goodwill is an item that is closely related to profits. If a company suffers loss continuously for the last few years, that it no more enjoys the goodwill as shown in the books of the company. But the companies continue to show goodwill at the usual figure despite continuous losses

Types of Financial Statement Analysis

In a business environment there are various parties who analyse financial for various purposes. Financial Statement Analysis are broadly classified into two categories and these two categories are further classified into two subcategories:

• On the basis of Materials Used
• On the basis of Modus Operand

On the Basis of Materials Used

On the basis of materials used, financial statement analysis can be further divided into two sub-categories, which are given below:

• External Analysis is performed by the external stakeholders of the organisation namely investors, customers, creditors, government agencies, economists, vendors, etc.
  
  These external stakeholders do not have access to internal organisational records and they relies on financial statements published in annual reports of the organisation.
  
  
• Internal Analysis is performed by the management executives of the organisation to examine financial and operating performance of the company. These are more reliable as compare to external analysis because the concerned person is given access to all the internal data and policies.

On the Basis of Modus Operand

On the basis of modus operand, financial statement analyses can be further divided into two sub categories, which are given below:

• Horizontal analysis is also known as dynamic analysis and it is that type of analysis in which financial statements of two or more consecutive accounting period are analysed. The figures of all accounting periods are written horizontally in a particular column that represents years and these figures can represent graphically also.
  
  Initial year will be taken as the base year and figures for every year is compared with that of the base year. Horizontal analysis is most applicable when an organisation examines the direction of trend for a period of several years several years. Comparative statements and trend analysis are two main techniques under horizontal analysis.
  
  
• Vertical analysis of financial analysis is also known as ‘Static Analysis’ and it is that type of analysis in which study is conducted only for one particular period. Under this analysis each item of financial statement is expressed in terms of percentage of the same item in the base year. Common size statements and ratio analysis are two important tools to perform vertical analysis.

Techniques of Financial Statement Analysis

Techniques of financial statement analysis are generally classified in to three categories:

Cross-sectional Analysis

Cross-sectional analysis or inter firm analysis is one of the most significant techniques of financial statement analysis. Under this technique, financial characteristics of a particular organisation are analysed in with the pecuniary characteristics of another organisation.

For example, if ABC Industries Ltd. has earned 20% return on investment (RoI) in the FY year 2017 and another company named XYZ Industries Limited has earned 22% (RoI). This data does not show that XYZ Industries Limited is more efficient in generating profits and under this case, we need to analyse various other components also.

Time Series Analyse

Time series analyse is also known as intra firm comparison and under this technique the relationship between two or more items of financial statements for being examined.

This comparison can be done by using, financial statement of one organisation for different period of time or financial statement of two or more organisations for a particular period of time.

Cross-sectional Cum Time Series Analysis

Cross-sectional cum time series analysis a technique that is most effective to analyse the financial statements and under this technique both the techniques cross-sectional and time series analysis, are applied together to analyse financial statements.

There are many tools or methods that are used under this technique and following are the most commonly used methods for analysing financial statement:

• Comparative financial statements: Under this method comparative financial accounts (comparative balance sheet, comparative profit and loss account and comparative cash flow statement) are prepared for a number of years. It helps in identification of loopholes and suggests corrective measures.
  
  
• Common size statements: Under this method figures of financial statements are shown in analytical percentage. The figures of all items are shown as the percentage of their relevant head (i.e. total assets and total liabilities in the balance sheet, total sales/revenue in the profit and loss account). The total percentage of each head is taken as 100.
  
  
• Fund Flow Analysis: It involves the analysis of funds flow statement which acts as additional statement to the profit and loss account and balance sheet.
  
  It shows the changes in financial position that are based on working capital and cash. It also provides information about sources of funds and their use during a particular period.
  
  
• Ratio Analysis: It is one of the most significant methods to measure the interrelationship between two or more related variables in the financial statements. Ratio analyses reduce large figures in understandable relationship.
  
  An analyst can draw meaningful conclusion by evaluating and relating various ratios. Generally ratios are categorized into three major categories namely, Liquidity Ratios, Solvency Ratios, Profitability Ratios and Activity Ratios.
  
  
• Percentage change analysis: It explains the changes in accounting figures of various variables of financial statements in percentage terms.
  
  
• Management’s Discussion and Analysis is that part of annual report which provides the overview of preceding year’s operations and company performance. Under this section management also explains their goals for the upcoming year.

Process of Financial Statement Analysis

Following is the process for conducting financial statement analysis:

Components of Financial Statement Analysis

You have studied earlier that the financial statements of an organisation are used for reporting the financial position of the company for public use. The financial statement analysis are categorised majorly into two parts:

Let us now study about these components in detail as follows:

Common Size Analysis

You have studied earlier that the traditional financial statements of an organisation are used for reporting the financial position of the company for public use. Whenever an investor intends to compare the financial statements of two organisations, there is a need for a common scale in order to match the two distinct businesses for investment purposes.

As organisations are different in size, growth, etc. comparing the traditional financial statements might lead to misleading interpretations affecting the investors.

For example, A Ltd. has liabilities worth ₹10, 00,000 while B Ltd. has liabilities worth ₹100, 00,000. Does this information from their balance sheets imply that A Ltd. is less risky than B Ltd.?

In reality, it depends in part on the size of the companies, their asset size, the industries that the two companies belong to, etc. This led to the use of common size analysis for decision-making purposes. Common size analysis is a popular method of financial statement analysis, which makes use of common size financial statements.

These financial statements display all items as percentages of a common base figure. Each item in the financial statement is reported in the form of a percentage. This percentage is arrived at by using a base figure. For example, every item on the income statement of an organisation is reported as a percentage of sales.

There are three reasons to use common-size analysis:

• Comparing financial information of an organisation from one period to the next.
  
  
• Comparing financial information of an organisation relative to its competitors.
  
  
• Comparing financial information of various companies in different parts of the world when the reporting currency is different.
  
  e.g., A Company like Uniliver plc. which has operations in several countries and the financials are in different currencies like Great British Pound (GBP), United States Dollars (USD), and Indian Rupee (INR) etc. The use of Common size analysis which translates absolute amounts in different currencies into percentages makes comparisons and financial analysis more meaningful and simpler.

The most widely used common size analysis methods are as follows:

• Horizontal Common Size Analysis
• Vertical Common Size Analysis

Although both methods are similar considering that the figures in financial statements are converted to percentages however, they differ in the base used to compute the percentages. Let us discuss the two methods in detail in the subsequent sections.

Horizontal Common Size Analysis

Horizontal common-size analysis uses one type of financial statement at a time. However, instead of using only a year’s financial statement, horizontal common analysis makes use of the same type of financial statement over several consecutive years.

Usually, three years of information is used for horizontal analyses, although it is common to extend the evaluation for measuring long-term trends in the organisation’s performance.

For instance, if an organisation performs a horizontal analysis on its income statement, it would use the income statements for 2011, 2012 and 2013. The figures in each succeeding period are expressed as a percentage of the amount in the baseline year, with the baseline amount being listed as 100%.

Consider the following illustration:

Income statement information of Dell Inc. as ended March, 2013 is as follows:

Assuming 2011 is the base year, 2012 and 2013 revenues will be calculated as follows, respectively:

Thus, the horizontal analysis of Dell’s Income Statement would be as follows:

This analysis shows that the percentages of revenue for 2012 and 2013 first increased and later decreased the 100% benchmark of 2011. The financial statement user would interpret this as an increase and later decrease in Dell Inc.’s sales performance.

Revenue for 2013 may be misleading at first glance, however, further analysis reveals that the decrease in 2013 represents only 7% fall compared to the 100% benchmark of revenue in 2011. In reality, the COGS in 2013 have come down by 11% compared to the benchmark COGS in 2011. Thus, the company is in a better position in managing its resources.

Vertical Common Size Analysis

Another type of common size analysis is the vertical analysis method. Vertical analysis refers to the proportional analysis of a financial statement, where each item on a financial statement is recorded as a percentage of another item.

This implies that each item on the income statement of an organisation is recorded as a percentage of the gross sales. On the other hand, each item on the balance sheet of an organisation is recorded as a percentage of the total assets.

For example, if the cost of goods sold has consistently been recorded as 40% of sales in the past four years for an organisation, a percentage of 48% in the fifth year would raise an alarm for further analysis. Moreover, vertical analysis is helpful for timeline analysis.

An example of vertical analysis of an income statement as follows:

Vertical analysis of a balance sheet uses the common base as the total assets of an organisation. However, for a deeper analysis, users tend to use the total of all liabilities as the base for calculating line item liabilities in a balance sheet and the total of all equity accounts as base when calculating all equity line item percentages.

This has been illustrated in the following example:

From the above analysis it can be interpreted that:

• The relative investment in fixed assets is 30% of total assets
• Total current liabilities are 20% of total liabilities and equity
• Current assets account for 20% of the total assets

Comparative Financial Statement Analysis

Comparative financial statements are those statements which provide all the desired financial information for two or more financial years. This statement is use to compare results of current financial statement with previous accounting period of the firm or with that of the competitors.

Under this method, the components of financial statement (i.e. Balance sheet and Income statement) are used for comparative purposes and all the items are presented in terms of figures and as well as in percentage.

Comparative statements determines any increase, decrease and percentage change in the corresponding amount of two or more than two years and this analysis is used by various stakeholders such as, managers, investors, creditors, analyst, etc. It reflects organisation’s ability to deal with solvency, liquidity, profitability related issues.

The methods used under the comparative statements are as follows:

Comparative Income Statement

Comparative Income Statement shows the financial performance of the firm in comparison of prior period data of the firm or of competitors. It provides information regarding expenses and income of the firm for two or more than two years.

It also provides the information about various changes in absolute figure and in the form of percentage. It provides a view of business performance over a time and supports financial manager in decision making practices.

Consider the following illustration:

Comparative Income Statement of Infosys for year ended March 31, 2017 is as follows:

Comparative Balance Sheet

Comparative Balance Sheet shows the current financial position of the firm in comparison to prior period data. Comparative balance sheet records all the items of balance sheet side by side under relevant head of three main components (i.e. Assets, Liabilities and Share capital) of balance sheet.

Generally it is presented at the end of financial year for the past 3 years data. While some firms like financial institutions use other versions which shows all the data at the month end or at the quarter end. However, in both versions it provides a clear picture of firm’s financial position to the analyst.

Consider the following illustration:

Comparative Balance Sheet of Infosys for year ended March 31, 2017 is as follows: