Study Material & Notes for the Chapter 11
Financial Statements Analysis & Tools
I. FINANCIAL STATEMENT ANALYSIS
i. Meaning of Financial Statement Analysis
- Financial statement analysis is a judgemental process which aims to estimate current and past financial positions and the results of the operation of an enterprise, with primary objective of determining the best possible estimates and predictions about the future conditions.
- It essentially involves regrouping and analysis of information provided by financial statements to establish relationships and throw light on the points of strengths and weaknesses of a business enterprise, which can be useful in decision-making involving comparison with other firms (cross sectional analysis) and with firms’ own performance, over a time period (time series analysis).
- The term ‘financial analyses includes both ‘analysis and interpretation’. The term analysis means simplification of financial data by methodical classification given in the financial statements. Interpretation means explaining the meaning and significance of the data.
ii. Objectives of Financial Statements Analysis
- To assess the current profitability and operational efficiency of the firm as a whole as well as its different departments so as to judge the financial health of the firm.
- To ascertain the relative importance of the different components of the financial position of the firm
- To identify the reasons for change in the profitability/ financial position of the firm.
- To judge the ability of the firm to repay its debt and assessing the short-term as well as the long-term liquidity position of the firm.
iii. Significance/Importance/Uses of Financial Statements Analysis
- Investors: Shareholders or proprietors of the business are interested in the well-being of the business. They like to know the earning capacity of the business and its prospects of future growth.
- Management: The management is interested in the financial position and performance of the enterprise as a whole and of its various divisions. It helps them in preparing budgets and assessing the performance of various departmental heads.
- Trade Unions: They are interested in financial statements for negotiating the wages or salaries or bonus agreement with the management.
- Lenders: Lenders to the business like debenture holders, suppliers of loans and lease are interested to know short term as well as long term solvency position of the entity.
- Tax Authorities: Tax authorities are interested in financial statements for determining the tax liability.
- Suppliers/Creditors: The suppliers and other creditors are interested to know solvency of the business i.e. the ability of the company to meet the debts as and when they fall due.
- Researchers: They are interested in financial statements for undertaking research work in business affairs and practices.
- Employees: They are interested to know the growth of profit. As a result of which they can demand better remuneration and congenial working environment.
- Government: Government and its regulatory agencies need financial information to regulate the activities of the enterprises/ industries and determine taxation policy. They suggest measures to formulate policies and regulations.
- Stock Exchange: The stock exchange members take interest in financial statements for the purpose of analysis because they provide useful financial information about companies.
iv. Limitations of Financial Statements Analysis
- Limitations of Financial Statements: Financial analysis is based on financial statements, however, financial statements itself suffer from certain limitations, for example, (a) sometimes the information given in financial statements are incomplete and not authentic, (b) financial Statements are based on accounting concepts and conventions. As such, the utility of financial analysis is decreased due to the shortcomings of financial statements.
- Affected by Window Dressing: Some firms resort to window-dressing their financial statements to cover up bad financial position on the eve of accounting date. For example, they may not record the purchases made at the end of the year or they may overvalue their closing stock. In such cases, the results obtained by analysis of financial statements will be misleading.
- Subjectivity: If two firms adopt different accounting policies, the comparison between the two will be unreliable. For example, one firm may provide depreciation on original cost method, whereas the other firm may adopt the written-down value method for providing the depreciation. Similarly, the method of valuation of closing stock may also differ from one firm to another. The results obtained from the comparison of the financial statements of such firms may give misleading picture.
- Difficulty in Forecasting: Financial statements are a record of past events and historical facts. In the fast changing and developing modern business, the analysis of past information may not be of much use in future forecasting. Continuous changes take place in the demand of the product, policies adopted by the firm, the position of competition etc. As such, no estimate based on the analysis of historical facts can be made for future.
- Lack of Qualitative Analysis: Financial statements record only those events and transactions which can be expressed in terms of money. Qualitative aspects of business units are omitted from the books at all as these cannot be expressed in monetary terms. Thus, changes in management, reputation of the business, cordial management-labour relations, firm’s ability to develop new products, efficiency of management, satisfaction of firm’s customers etc. which have a vital bearing on the profitability of the company are all ignored and omitted from being recorded because all of these are qualitative in nature.