chapter-04-analysis-of-financial-statements

Financial analysis is the process of evaluating a firm’s financial strengths and weaknesses by analyzing its balance sheet and profit and loss statement.
It is useful for various users such as finance managers, top management, trade payables, lenders, investors, labor unions, and others.
Finance managers use financial analysis to make rational decisions for the firm, study accounting data, determine the continuity of operating policies, and evaluate the efficiency of operations.
Lenders analyze the firm’s long-term solvency and survival by evaluating its profitability, ability to generate cash, and capital structure relationships.
Investors are interested in the firm’s earnings, present and future profitability, and capital structure. They also evaluate the efficiency of the management.
Labor unions analyze the financial statements to assess whether the firm can afford a wage increase and absorb it through increased productivity or by raising prices.

The analysis of financial statements aims to understand the information contained within, highlighting the strengths and weaknesses of the firm.
It serves to assess the current profitability and operational efficiency of the firm and its departments, providing insights into the firm’s financial health.
It helps identify the reasons for changes in the profitability/financial position of the firm and judge the firm’s ability to repay debt and assess short-term and long-term liquidity.
The analysis identifies the relative importance of different components of the firm’s financial position and can reveal the economic concentration and financial policies of various firms.
It provides a basis for governmental actions such as licensing, controls, price fixing, profit ceiling, dividend freeze, tax subsidies, and other concessions to the corporate sector.

Comparative Statements: A form of financial analysis that compares the profitability and financial position of a firm for different periods of time to give an idea about the position of two or more periods. Also known as ‘horizontal analysis’.
Common Size Statements: A type of financial analysis that indicates the relationship of different items of a financial statement with a common item by expressing each item as a percentage of that common item. Also known as ‘vertical analysis’.
Trend Analysis: A technique of studying the operational results and financial position over a series of years to observe the percentage changes over time in the selected data.
Ratio Analysis: A technique that measures the comparative significance of the individual items of the income and position statements of a firm to assess the profitability, solvency and efficiency of an enterprise.
Cash Flow Analysis: The analysis of actual movement of cash into and out of an organisation, summarising the causes for the changes in cash position of a business enterprise between dates of two balance sheets. Also known as ‘cash flow statement’.

The text provides financial information for two years.
There are different components of revenue, costs, and expenses.
The revenue from operations is 40,00,000 in 2016 and 35,00,000 in 2017.
Other income and employee benefit expenses remain the same for both years.
Cost of material consumed, other expenses, and depreciation and amortization change between the two years.
The profit is 20,09,000 in 2016 and 14,27,000 in 2017.
The text also includes instructions to prepare a comparative balance sheet, but no balance sheet data is provided for that task.

The text provides a Common Size Statement of Profit and Loss for the year ended March 31, 2016 and March 31, 2017.
Revenue from operations, other income, employee benefit expenses, and other expenses are presented as a percentage of revenue from operations for both years.
The income tax is presented as a percentage of profit before tax for both years.
The Common Size Statement of Profit and Loss is used to compare the performance of different companies or the same company over different periods.
The text also includes 3 multiple-choice questions and 6 true or false questions related to financial statements, financial analysis, and the common size statement.

Financial analysis is limited by the information available in financial statements, which can be affected by price level changes, window dressing, and changes in accounting policies.
Financial analysis may be misleading without understanding the changes in accounting procedures followed by a firm.
Financial analysis is based solely on monetary information, ignoring non-monetary aspects.
The preparation of financial statements on the basis of accounting concepts may not reflect the current position of the company.
Financial analysis does not consider price level changes and is limited to studying reports of the company.