Analysis of Financial Statements

Analysis of Financial Statements: • The process of identifying financial strengths and weaknesses of a firm by properly establishing relationships between the items of financial statements (Balance Sheet and Statement of P&L) • Involves reorganising, comparing, and interpreting financial data to extract meaningful conclusions • Also called Financial Statement Analysis or Financial Analysis Objectives of Analysis of Financial Statements: 1. Assessment of profitability: • To determine whether the business is earning satisfactory profits • To compare profitability over time and with industry peers 2. Assessment of liquidity: • To determine whether the firm can meet its short-term obligations • Important for creditors and suppliers 3. Assessment of solvency: • Long-term solvency — can the company repay long-term debts? • Important for lenders, bondholders, and debenture holders 4. Assessment of managerial efficiency: • How efficiently is management using assets, inventory, debtors, etc.? 5. Comparison: • Comparing performance across years (trend analysis) • Comparing with competitors (cross-sectional analysis) • Comparing with industry benchmarks 6. Investment decisions: • Helps investors decide whether to buy, hold, or sell shares 7. Credit decisions: • Helps banks and financial institutions decide whether to lend Limitations: • Based on historical data (past may not predict future) • Ignores non-financial factors (management quality, brand, morale) • Different accounting policies make comparison difficult • Window dressing possible

Tools/Methods of Analysis of Financial Statements: 1. Comparative Financial Statements (Horizontal Analysis): • Financial statements of two or more periods are placed side by side • Shows absolute and percentage change between periods • Identifies trends (increasing/decreasing revenues, expenses, assets, liabilities) • Also called Year-to-Year Change Analysis or Horizontal Analysis 2. Common Size Statements (Vertical Analysis): • Each item expressed as a percentage of a base figure • In P&L: each item as % of Revenue from Operations (Net Sales) • In Balance Sheet: each item as % of Total Assets (or Total Liabilities) • Allows comparison between firms of different sizes • Also called Structural Analysis or Common Size Analysis 3. Trend Analysis: • One year's figure taken as base (= 100%) • Subsequent years' figures expressed as % of base year • Identifies long-term trends in financial data • Trend = (Current Year Figure / Base Year Figure) × 100 4. Ratio Analysis: • Calculates mathematical relationships between two related items • Most widely used tool • Types: Liquidity, Solvency, Activity/Efficiency, Profitability ratios • Simplifies, summarises, and helps interpret financial statements 5. Cash Flow Statement Analysis: • Shows sources and uses of cash in three activities: (a) Operating Activities (b) Investing Activities (c) Financing Activities • Helps assess actual cash generation ability 6. Fund Flow Statement (less common now): • Shows changes in working capital between two periods

Comparative Statement (Horizontal Analysis): • Shows financial data for two or more periods side by side • Also shows absolute change (₹) and percentage change (%) • Helps identify trends and assess performance over time Formula: Absolute Change = Current Year − Previous Year Percentage Change = (Absolute Change / Previous Year) × 100 Comparative Statement of Profit and Loss for the years 2022-23 and 2023-24 Particulars | 2022-23 ₹ | 2023-24 ₹ | Change ₹ | Change % ---------------------------|-----------|-----------|----------|--------- I. Revenue from Operations | | | | Net Sales | 10,00,000 | 12,00,000 | 2,00,000 | 20.00% | | | | II. Expenses: | | | | Cost of Goods Sold | 6,00,000 | 7,20,000 | 1,20,000 | 20.00% Other Expenses | 1,50,000 | 1,80,000 | 30,000 | 20.00% Total Expenses | 7,50,000 | 9,00,000 | 1,50,000 | 20.00% | | | | III. Profit Before Tax | 2,50,000 | 3,00,000 | 50,000 | 20.00% Analysis: • Sales increased by 20% — good growth • COGS also increased by 20% — COGS/Sales ratio unchanged at 60% • Other expenses also grew by 20% — same proportion • Net profit increased by 20% — proportionate with sales • Gross profit margin unchanged: (4,00,000/10,00,000 = 40%) — consistent cost control • The company maintained its cost structure while growing revenues

Common Size Statement: • Each item in the financial statement is expressed as a percentage of a base figure • In Balance Sheet: each item as % of Total Assets (or Total Liabilities) • In P&L: each item as % of Net Revenue from Operations • Enables comparison between companies of different sizes • Also called Vertical Analysis Formula: Common Size % = (Item Amount / Total Base Amount) × 100 Total Assets = Fixed Assets + Current Assets = 6,00,000 + 5,00,000 = ₹11,00,000 Total Liabilities = Equity + Reserves + LT Borrowings + CL = 5,00,000 + 2,00,000 + 3,00,000 + 1,00,000 = ₹11,00,000 ✓ Common Size Balance Sheet Particulars | Amount ₹ | % of Total -------------------------------|------------|---------- EQUITY AND LIABILITIES: | | Equity Share Capital | 5,00,000 | 45.45% Reserves | 2,00,000 | 18.18% Long-term Borrowings | 3,00,000 | 27.27% Current Liabilities | 1,00,000 | 9.09% Total | 11,00,000 | 100.00% | | ASSETS: | | Fixed Assets | 6,00,000 | 54.55% Current Assets | 5,00,000 | 45.45% Total | 11,00,000 | 100.00% Analysis: • 45.45% of financing comes from equity (owned capital) — moderate leverage • Long-term debt is 27.27% — manageable level • 54.55% invested in fixed assets — capital-intensive business • Current assets = 45.45% — reasonable liquidity

Limitations of Financial Statement Analysis: 1. Historical data — backward looking: • Financial statements report past performance, not future prospects • Past trends may not continue in future • Decisions based on past data may not be appropriate for future 2. Price level changes (inflation): • Financial statements are based on historical cost • Inflation distorts comparisons over time • Assets purchased 10 years ago appear at original cost 3. Window dressing: • Companies may manipulate data to present a favourable picture • E.g., paying off creditors just before Balance Sheet date to show better liquidity ratio • Legitimate but misleading practices can skew analysis 4. Different accounting policies: • Companies may use different methods (e.g., FIFO vs LIFO for inventory; SLM vs WDV for depreciation) • Makes inter-firm comparison difficult even within the same industry 5. Non-financial factors ignored: • Management quality, employee morale, brand strength, customer satisfaction are not captured • These factors significantly impact performance 6. Qualitative information not included: • Pending litigations, market competition, regulatory changes not quantified 7. Single-year analysis insufficient: • One year's ratios can be misleading without trend analysis 8. Different industry characteristics: • Comparing firms across different industries is meaningless • Even within the same industry, scale and nature may differ 9. Aggregation problem: • Detailed information is summarised — individual items may be lost • Average figures may hide extreme variations 10. Technical limitations: • Ratios are tools, not conclusions • Interpretation requires expertise and judgment