UNIT II LESSON FINANCIAL STATEMENT ANALYSIS CONTENTS 4.0 4.1 4.2 4.3 4.4 4.5 4.6 4.7 4.8 4.9 Aims and Objectives Introduction Definition and Classification of Financial Statement Analysis Comparative Financial Statements Trend Percentage Analysis Let us Sum up Lesson End Activity Keywords Questions for Discussion Suggested Readings 4.0 AIMS AND OBJECTIVES In this lesson we shall discuss about financial statement analysis After going through this lesson you will be able to: Understand definition and classification of financial statement analysis Analyse comparative financial statements and trend percentage analysis 4.1 INTRODUCTION The financial statements are affording many facts though they are absolute and concrete in terms; but not in a position to interpret and analyse the stature of the enterprise To analyse and interpret, the financial statement analysis is being applied across the financial statements viz Trading, Profit & Loss Account and Balance sheet Under the financial statement analysis, the information available are grouped together in order to cull out the meaningful relationship which is already available among them; for interpretation and analysis 4.2 DEFINITION AND CLASSIFICATION OF FINANCIAL STATEMENT ANALYSIS According to Kennedy and Muller “ The analysis and interpretation of financial statements are an attempt to determine the significance and meaning of financial statement data so that the forecast may be made of the prospects for future earnings, ability to pay interest and debt maturities and profitability and sound dividend policy” 74 The entire financial statement analysis can be classified into various categories International Financial and Management Accounting Comparative financial statements Common size financial statements Trend percentages Fund flow statements Cash flow statements ⇒ Ratio analysis Comparative financial statements Comparative study of Profit & Loss Accounts and Balance sheets Comparison in between financial statements of two or more years Comparison in between the financial statements of various firms or industrial average Intra firm comparison Inter firm comparison Figure 4.1: Comparative Financial Statements 4.3 COMPARATIVE FINANCIAL STATEMENTS Objectives of comparative financial statements Changes taken place in the financial performance are taken into consideration for further analysis To reveal qualitative information about the firm in terms of solvency, liquidity profitability and so on are extracted from the analysis of financial statements With reference to yester financial data of the enterprise, the firm is facilitated to undergo for the preparation of forecasting and planning The major part of financial statement analysis is mainly focused on the comparative analysis The comparative analysis classified into four different analyses viz.: Comparative Balance sheet Comparative Profit and Loss account Common Size statement Trend percentage First we will discuss the comparative Balance sheet The first and foremost important step is to have the following information and should take preparatory steps: i While preparing the comparative statement of balance sheet, the particulars for the financial factors are required ii iii iv v The second most important for the preparation of the comparative balance sheet is yester financial data extracted from the balance sheet or balance sheets The next most important requirement to have an effective comparison with the yester financial data is current year information extracted from the balance sheet or balance sheet of the firms After having been procured the financial data pertaining to various time periods are ready for comparison; to determine or identify the level of increase or decrease taken place in the financial position of the firms To determine the level of increase or decrease in financial position, the percentage analysis to carried out in between them Illustration From the following information, Prepare comparative Balance sheet of X Ltd 31st Mar,2004 50,00,000 60,00,000 10,00,000 10,00,000 30,00,000 30,00,000 10,00,000 Particulars Equit share capital Fixed Assets Reserves and surpluses Investments Long-term loans Current assets Current liabilities 31st Mar,2005 50,00,000 72,00,000 12,00,000 10,00,000 30,00,000 21,00,000 11,00,000 Solution: The first step we have to segregate the available information into two different categories viz Assets and Liabilities Particulars 2004 (Rs) 2005 (Rs) Absolute Change (Rs) Fixed Assets 60,00,000 72,00,000 12,00,000 Investments 10,00,000 10,00,000 N.C Current assets 30,00,000 21,00,000 (9,00,000) 1,00,00,000 1,03,00,000 3,00,000 Total Assets Equity share capital 50,00,000 50,00,000 N.C Reserves & surpluses 10,00,000 12,00,000 2,00,000 Long-term loans 30,00,000 30,00,000 N.C Current liabilities % Increase % Decrease 20 - - 30 - - - 20 - - - 10,00,000 11,00,000 1,00,000 10 - 1,00,00,000 1,03,00,000 3,00,000 - N C = No change in the position during the two years From the above table, the following are basic inferences The fixed assets volume got increased 20% from the year 2004 to 2005, amounted Rs 12, 00, 000 Rs 9, 00, 000 worth of current assets decrease from the year 2004 to 2005 recorded 30% The total volume of assets recorded 3% increase from the year 2004 to 2005 It is obviously understood that 20% increase takes place on the reserves and surpluses It clearly evidenced that the current liabilities of the firm increased 10% from the year 2004 to 2005 The firm has not recorded any changes in the investments, equity share capital and long-term loans 75 Financial Statement Analysis 76 International Financial and Management Accounting The next one in the comparative financial statement analysis is that Income statement analysis Comparative (Income) financial statement analysis: This analysis is being carried out in between the income statements of the various accounting durations of the firm, with other firms in the industry and with the industrial average This will facilitate the firm to know about the stature of itself regarding the financial performance It facilitates to understand about the changes pertaining to various financial data which closely relevantly connected with the financial performance Change in the gross sales Change in the net sales Change in gross profit and net profit Change in operating profit Change in operating expenses Change in the volume of non-operating income Change in the non operating expenses The ultimate purpose of the comparative (Income) financial statement analysis is as follows: i To study the income earning and expenditure spending pattern of the firm for two or more years ii To identify the changing pattern of the income and expenditure of the firms The preparatory steps for the preparation of the comparative financial statement (Income) analysis The first and foremost important step is to have the following information and should take preparatory steps: i While preparing the comparative statement of Profit & Loss Account, the particulars for the financial factors are required ii The second most important for the preparation of the comparative Profit & Loss account is yester financial data extracted from the Profit & Loss A/c or Profit & Loss Accounts iii The next most important requirement to have an effective comparison with the yester financial data is current year information extracted from the balance sheet of the firm or of the other firms iv After having been procured the financial data pertaining to various time periods are ready for comparison; to determine or identify the level of increase or decrease taken place in the operating financial performance of the firms v To determine the level of increase or decrease in financial performance, the percentage analysis to be carried out in between them Illustration Prepare the comparative income statement from the following: Particulars Sales Cost of goods sold Operating expenses Net profit 2004 (Rs) 2,00,000 1,00,000 1,00,000 10,000 90,000 2005 (Rs) 2,50,000 1,30,000 1,20,000 10,000 1,10,000 Solution: 77 Financial Statement Analysis Comparative Income Statement Particulars Sales (-)Cost of goods sold (-)Operating expenses Net profit 2004 2005 (Rs) 2,00,000 1,00,000 1,00,000 10,000 90,000 (Rs) 2,50,000 1,30,000 1,20,000 10,000 1,10,000 Absolute Change (Rs) 50,000 30,000 20,000 N.C 20,000 % Increase % Decrease 25 30 20 22.22 - From the above table, the following inferences can be had: The firm has registered 25% increase in sales from the year 2004 to 2005 Cost of goods sold raised 30% from the year 2004 to 2005 There is no change in the level of operating expenses The firm has got 22 22% increase in the level of net profits from the year 2004 to 2005 Illustration From the following information, prepare a comparative income statement: Particulars 2001 Rs 2002 Rs 10,00,000 8,00,000 Cost of goods sold 6,00,000 4,00,000 Administration Expenses 2,00,000 1,40,000 40,000 20,000 1,20,000 1,40,000 Sales Other Income Income tax Solution: Comparative Income Statement Particulars Sales (–)Cost of goods sold (–) Administration Expenses Operating Income (+)other income Total Net Income Before tax Income tax Net Income after the tax 2001 2002 (Rs) 10,00,000 6,00,000 4,00,000 2,00,000 2,00,000 40,000 2,40,000 1,20,000 1,20,000 (Rs) 8,00,000 4,00,000 4,00,000 1,40,000 2,60,000 20,000 2,80,000 1,40,000 1,40,000 Absolute Change (Rs) (2,00,000) (2,00,000) (60,000) 60,000 (20,000) 40,000 20,000 20,000 % Increase 30 16.66 16.66 % Decrease 20 33.33 30 50 16.66 - For this problem, the inferences could be enlisted according to the comparative statement analysis on Profit & Loss Accounts of two different year viz 2001 and 2002 The next important tool of financial statement analysis is a common size statement analysis which known as predominant tool in intra firm analysis in studying the share of each component The components are translated into percentage for analysis and interpretations For profit and loss account, Net sales is considered as a base for the computation of a share of each financial factor available 78 International Financial and Management Accounting For Balance sheet, total volume of assets and liabilities are taken into consideration for the computation of a share of each financial factor available under the heading of assets and liabilities Illustration Prepare the common size statement analysis for the firm ABC ltd Liabilities Share capital Reserves and surpluses Bank overdraft Quick liabilities 1990 (Rs) 2,00,000 1,00,000 1991 (Rs) 3,00,000 2,00,000 60,000 40,000 4,00,000 2,00,000 1,00,000 8,00,000 Assets Fixed assets Stock 1990 (Rs) 2,25,000 1,29,000 1991 (Rs) 4,00,000 2,00,000 Quick assets 46,000 2,00,000 4,00,000 8.,00,000 Solution: Common size statement analysis of the Balance sheet of the firm ABC Ltd Particulars Assets Fixed assets Stock Quick assets Total Liabilities Share capital Reserves and surpluses Bank overdraft Quick liabilities Amount 1990 Rs 2,25,000 1,29,000 46,000 4,00,000 1991 Rs 4,00,000 2,00,000 2,00,000 8,00,000 2,00,000 1,00,000 60,000 40,000 4,00,000 3,00,000 2,00,000 2,00,000 1,00,000 8,00,000 % of Balance sheet total 1990 56.25 32.25 11.5 100 50 25 15 10 100 1991 50 25 25 100 37.5 25 25 12.5 100 The above illustration highlights the share of every component in the balance sheet out of the total volume of assets and liabilities This will certainly facilitate the firm to easily understand not only the share of every component but also facilitates to have a meaningful and relevant comparison with various time horizons Illustration From the following table, prepare the common size statement analysis: Sales Miscellaneous Income Materials consumed Wages Factory expenses Office expenses Interest Depreciation Profit 2000 (Rs.) 20,00,000 20,000 20,20,000 11,00,000 3,00,000 2,00,000 90,000 1,00,000 1,40,000 90,000 20,20,000 2001 (Rs.) 24,00,000 16,000 24.16,000 12,96,000 4,08,000 2,16,000 1,00,000 1,20,000 1,50,000 1,26,000 24,16,000 Solution: 79 Financial Statement Analysis Common size statements Profit & Loss Account Particulars Sales Miscellaneous Income Materials consumed Wages Factory expenses Office expenses Interest Depreciation Profit 2000 (Rs.) % Percentage 20,00,000 20,000 20,20,000 11,00,000 3,00,000 2,00,000 90,000 1,00,000 1,40,000 90,000 20,20,000 100 100.9 54.46 14.85 9.90 4.47 4.95 6.94 4.47 100.9 2001 (Rs.) 24,00,000 16,000 24.16,000 12,96,000 4,08,000 2,16,000 1,00,000 1,20,000 1,50,000 1,26,000 24,16,000 Percentage % 100 67 100.67 53.64 16.82 8.92 4.95 4.92 6.21 5.21 100.67 Check Your Progress (1) (2) (3) (4) Financial statement analysis is used for (a) Inter firm comparison only (b) Intra firm comparison only (c) Industrial average comparison (d) All of the above Intra firm analysis is (a) Within a year (b) Between the years (c) Comparison with the projected (d) (a), (b) & (c) Comparative financial statement analysis is into (a) Comparison of Income& Position statements (b) Common size statements (c) Trend percentage analysis (d) (a), (b) & (c) Main objectives of the Financial statements analysis are (a) To study the changes in the financial performance (b) To study the liquidity, solvency of the firm (c) To undergo financial planning based upon the yester financial performance (d) (a), (b) & (c) 4.4 TREND PERCENTAGE ANALYSIS The next important tools of analysis is trend percentage which plays significant role in analyzing the financial stature of the enterprise through base years’ performance ratio computation This not only reveals the trend movement of the financial performance of the enterprise but also highlights the strengths and weaknesses of the enterprise 80 The following ratio is being used to compute the trend percentage International Financial and Management Accounting = Current year × 100 Base year This trend ratio is being computed for every component for many number of years which not only facilitates comparison but also guides the firm to understand the trend path of the firm 4.5 LET US SUM UP Under the financial statement analysis, the information available are grouped together in order to cull out the meaningful relationship which is already available among them; for interpretation and analysis To reveal qualitative information about the firm in terms of solvency, liquidity profitability and so on are extracted from the analysis of financial statements Comparative (Income) financial statement analysis is being carried out in between the income statements of the various accounting durations of the firm, with other firms in the industry and with the industrial average After having been procured the financial data pertaining to various time periods are ready for comparison ; to determine or identify the level of increase or decrease taken place in the operating financial performance of the firms 4.6 LESSON END ACTIVITY In financial statement analysis, what is the basic objective of observing trends in data and ratios? Suggest some other standards of comparison 4.7 KEYWORDS Financial Statements: These refer to a set of reports and schedules which an accountant prepares at the end of a period of time for a business enterprise Financial Statement Analysis: The study of relationship among the various financial factors in business as disclosed by a single set of statements and a study of the trend of these factors as shown in a series of statements Comparative Statements: These statements provide time perspective to the various elements of financial position contained therein Common-size Statement: Those statements in which figures reported are converted into percentages to some common base Trends Ratios: Index numbers of the movements of the various financial items in the financial statements for a number of periods 4.8 QUESTIONS FOR DISCUSSION Write elaborative note on the financial statement analysis Elucidate the common size statement analysis List out the objectives of the financial statement analysis Explain the steps involved in the process of comparative statement of balance sheet Write brief note on the trend analysis Check Your Progress: Model Answers d, b, a, d 4.9 SUGGESTED READINGS R L Gupta and Radhaswamy, “Advanced Accountancy” V K Goyal, “Financial Accounting”, Excel Books, New Delhi Khan and Jain, “Management Accounting” S N Maheswari, “Management Accounting” S Bhat, “Financial Management”, Excel Books, New Delhi Prasanna Chandra, “Financial Management – Theory and Practice”, Tata McGraw Hill, New Delhi (1994) I M Pandey, “Financial Management”, Vikas Publishing, New Delhi Nitin Balwani, “Accounting & Finance for Managers”, Excel Books, New Delhi 81 Financial Statement Analysis ... Gupta and Radhaswamy, “Advanced Accountancy” V K Goyal, ? ?Financial Accounting? ??, Excel Books, New Delhi Khan and Jain, ? ?Management Accounting? ?? S N Maheswari, ? ?Management Accounting? ?? S Bhat, ? ?Financial. .. investments, equity share capital and long-term loans 75 Financial Statement Analysis 76 International Financial and Management Accounting The next one in the comparative financial statement analysis... 74 The entire financial statement analysis can be classified into various categories International Financial and Management Accounting Comparative financial statements Common size financial statements