CHAPTER 9

Financial Statement Analysis

LEARNING OBJECTIVES
this chapter, you should be able to
ster reading
report on intra-firm and inter-firm comparison
describe and draft
a

statement analysis for management control purposes

Derform financial financial
and nterpret common size s t a t e m e n t s of income and
prepare
position.

MEANING
important
Statement Analysis is an analysis which highlights
Financial embraces
Financial statement analysis
financial s t a t e m e n t s .
relationships in the the results of past performance
and
and interpreting
the methods used in assessing factors of interest i n
investment

a s they relate to particular

current financial position of assessing past performance
and in forecasting
decisions. It is a n important means
future performance. According
to Lev:
and planning to
is an information processing system designed
"Financial Statement Analysis selection model, bank
such a s the portfolio
data for decision making models,
provide financial management models.
decision models, and corporate
ending
ANALYSISS
OF FINANCIAL STATEMENT
OBJECTIVIES
decision makers
statement analysis is to provide
The major objectives of financial Users of financial
for u s e in decision making.
a t i o n about a business enterprise
decision-makers
concerned with evaluating the
edement information a r e the its future course.
mic situation of the firm and predicting
the different users and decision
analysis c a n be used
statement
by
ancial
ak to achieve the following objectives:
Current Position: Past
. Performance and
S s e s s m e n t of Past Therefore, a n investor
indicator of future performance.
or
is
nce often a good income, cash tlow
sales, expenses, net
and Or 1s interested in the trend of past
offer a m e a n s for judging
management's
U on investment. These trends
 226 Financial Reporting and Analysis

past performance and are possible indicators of future performance. Simil

analysis of current position indicates where the
business stands today, Fori the
the current position analysis will show the types of assets owned by by aa h
busie
enterprise. It will tell
the
tance,
enterprise and the different liabilities due against
the cash position is, how much debt the company has in relation to equity andat
and how
reasonable the inventories and receivables are.

2. Prediction of Net Income and Growth Prospects: The financial state.

analysis helps in predicting the earning prospects and growth rates in the earnine atement
which are used by investors while comparing investment alternatives and oth rnings
users interested in judging earning potential of business enterprises. nvestors ale
other
consider the risk or uncertainty associated with the expected return. The decision
also
makers are futuristic and are always concerned with the future. Financial statement
sion
ents
which contain information on past performances are analysed and interpreted as
basis for forecasting future rates of return and for assessing risk.
3. Prediction of Bankruptcy and Failure: Financial statement
analysis is
a significant tool in predicting the bankruptcy and failure probability of business
enterprises. After being aware about probable failure, both managers and investors
can take preventive measures to
avoid/minimise losses. Corporate managements
can effect
changes in operating policy, reorganise financial structure or even go for
voluntary liquidation to shorten the length of time losses.
In accounting and finance area, empirical studies conducted have
suggested a
set of financial ratios which can give
early signal corporate failure. Such a prediction
of
model based on financial statement analysis is useful to
managers, investors and
creditors. Managers may use the ratios prediction model to assess the
solvency
position of their firms and thus can take appropriate corrective actions. Investors
and shareholders can use the model to make the
optimum portfolio selection and to
bring changes in the investment strategy in accordance with their investment goals.
Similarly, creditors can apply the prediction model while evaluating the
creditworthiness of business enterprises.
Decision by Financial Institutions and Banks: Financial statement
4. Loan
analysis is used by financial institutions, loaning agencies, banks and others
make sound loan or credit decision. In this way, they can make to
proper allocation o
credit among the different borrowers. Financial statement
analysis helps 1n
determining credit risk, deCiding terms and conditions of loan if sanctioned, interest
rate, maturity date, etc.

TYPES OF FINANCIAL ANALYSIS

Financial analysis may be classified on the basis of either end-use or relative
comparison on the basis of end-users of financial information:
 Statement Analysis
Financial
227

(a)
Erternal Analysis:
E Various stakeholders who are not directly involved in
t h e b u s i n
ss usually
e s s
conduct an
analysis based on published financial results.
the direct access to business information. They
ot have

b)
Tnternal Analysis: Various insiders of companies including
1ders, and ike government and it
and agencies like panies including managers,
government and its regulatory
managers,
s h a r e h
reholders, bodies conduct detailed
Snaial analysis as they have complete access to financial information.
f i n a n
analysis as the
c i a l

On the basis of relative comparison:

o) Horizontal Analysis: It refers to the analysis of same financial information

aheriod of time.
Hence concepts like
over assets, receivables, cash, etc., are compared
o r a period of time to chart the trend. It is also known as dynamic analysis.

)Vertical Analysis: It involves the analysis of accounting/financial figures

f a single year by converting them to percentages. It defines the composition of
financial statements by expressing balance sheet total or total revenue as 100% and
expressing rest of the figures as a percentage of the same. It is also called static
analysis.

LIMITIONS OF FINANCIAL STATEMENTS

1. Excludes qualitative aspects: Though attempts are being made to ensure
complete reflection of a business' state of affairs in financial statements, qualitiative
aspects like employer-employee relations, motivation levels, managements skills,
work life balance, etc., are still not captured despite being integral to the working
of a company.

2. Lack comparable value: The difference in industry, scale and nature of

business between different companies make it difficult to compare financial data.
The results of a start up company may be very healthy with respect to its investion
and growth but the
figures may be miniscule in comparison to market players.
3. Inflation impact: Financial statement analysis is based on historical data.
y prediction or planning with respect to future makes it necessary to adjust
fents for inflation. In fact, a comparison of results of the same company over past
*
years is also incorrect without
adjusting for inflation.
Window dressing: An enterprise may fabricate result by using incorrect
valu
o n policies for inventory or depreciation and for other accounting concepts;
anal.ustments may impact liquidity figures and other vital parameters. Any
y'Sis of such results
may not be reliable.
ubjectivity
of preparation of analyst: Subjectivity of the analyst creeps in as the processes
statenrationand presentation wherever options are provided. Hence financial
statements
suffer from biasness of the preparers.
 228
Financial Reporting and
Analysis
TECHNIQUES OF FINANCIAL STATEMENT ANALYSIS
Various techniques are used in the analysis of financial data
to enm
comparative and relative importance of data presented and to evaluate
of the firm. Among the more widely used of these
phasise tthehe
the
techniques are the follo position
i) Comparative statements lowing
(ii) Common size statements
(iii) Trend analysis
(iv) Ratio analysis

Comparative statements
Comparative analysis of financial statements refers to "over the
period
comparison" of various figures to understand the
change and rate of
invloves simultanious presentation and analysis of income statements change, It
or balance
sheets of the same firm for two or more
accounting periods (intra-firm) or for different
firm over an accounting period (inter-firm). Horizontal
analysis is used for the same.
The percentage analysis of increases and decreases in
corresponding items in
comparative financial statements is called horizontal analysis. Horizontal analysis
involves the computation of amount changes and percentage changes from the
previous to the current year. The amount of each item on the most recent statement
ompared with the corresponding item on one more earlier statements. The increase
or decrease in the amount of the item is then listed, together with the per cent of
increase or decrease. When the comparison is made between two statements, the
earher statement is used as the base. If the horizontal
analysis includes three or
more statements, there are two alternatives in the selection of the base. First,the
earliest date or period may be used as the basis for comparing all later dates or

periods: or second, each statement may be compared with the immediately preceng
statement.
oss
Figure 9.1l and 9.2 present the comparative balance sheet and profit ana and
account respectively of a company with the amont of increase or decredse
percentage changes shown. The per cent change is computed as follows:

Amount of change
Percentage change Previous year amount
x 100
Financial S t a t e m e n t A n a l y s i s
229

ABC LTD. BALANCE SHEET

31st March, 2016 and 31st March 2017

Particulars
(in 000) (Increase (Decrease)
2016 2017 Amount Percentage
Equity and Liabilities

1) Shareholder's Funds 500 x ho0

(a) Share Capital 40,000 45,000 5,000 12.5040 Do

Reserves
and Surplus 19,024 20,800 1,776 9.34
b)
(2) Non-current Liabilities

(a) Long-term borrowings 10,000 11,000 1,000 10.00

-4,,0 -66.67
long-term liabilities 6,000 2,000
b) Other
-1,000 25.00
(c) Long-term provisions 4,000 3,000
(3) Current Liabilities

325 25 8.33
(a) Short-term borrowings 300
4,275 1075 33.59
(b) Trade payables 3,200
c)Other current liabilities 500 400 -100 20.00
8,576 9,300 924 10.77
(d) Short-term provisions
91,600 96,300 4700 5.13
Total

II. Assets
(1) Non-current assets
(a) Fixed assets
44,440 45,600 1160 2.61
6) Tangible assets
700 800 100 14.29
i) Intangible assets
(b) Non-current investments 500 1300 800 160.00

(2) Current assets

(a) Inventories 25,600 29,800 4,200 16.41

b) Trade receivables 12,000 -1,000 7.69

13,000
c) Cash and cash 5,200 3500 -1,700 32.69
equivalents
(d) Short-term loans and advance 1,760 2,800 1,040 39.09

(1) 5,200 100 25.00

Other current assetss 400

96,300 4,700 5.13

Total 91,600
FIG. 9.1
 Financial Reporting and
230 Analvs lysis

OF PROFIT AND LOSS

ABC LTD. STATEMENT
31st March, 2016 and
31st March, 2017

(in 000)
Particulars
2017
(Increase (Decrease)
2016 Amount
37.02.000 39,11,000o 2,09,000
Percentage
Revenue from operations
44,000 55,000 11,000
5.65
II. Other Incomes
25.00
(1 + I) 37,46,000 39,66,000 2,20,000
II. Total Revenue 5.87
IV. Expenses:
Cost of materials consumed
Purchase of Stock-in-trade 12,39,500 16,00,000 3,60,500 29.08
Changes in inventories of
finished goods, work-in-
progress and Stock-in-trade -1,00,000 -1,10,000 -10,000 10.00
Employee benefít expense 11,04,000 12,50,000 1,46,000 13.22
Financial costs 25,000 20,000 5,000 -20.00
Depreciation and amortization 50,000 51,000 1,000 2.00
expense
4,96,000 4,80,000) -16,000 -3.23
Other expenses
28,14,500o 32,91,000 4,76,500 16.93
Total Expenses
IX. Profit before tax (111-IV) 9,31,500 6,75,000 -2,56,500 -27.54

X. Tax expense:
(1) Current tax 4,65,750 3,37,500 -1,28,250 -27.54
(2) Deferred tax 0 0
-1,28,250o -27.54
XV. Profit/loss for the period 4,65,750 3,37,500
-12.83 -27.54
46.58 33.75
XVI. Earning per equity share: Basic
FIG. 9.2

cOMMON sIZE STATEMENTS

tages.
Common size statements involve expressing comparisons in per a
of
Common size statements may be prepared in order to compare perceare one
compare
or to
current period with past periods, to compare individual business Ss, financial

business with industry percentages published by trade associations ana

information services. alone.

Common size financial statements contain the percentages of a e e

is usually
without the long corresponding amount figures. The use of percentages

clear
lear

make thi:
preferable to the of absolute figures. An illustration will
profitabe
profitable?'

use
company A earns 710,000 and Company B earns 1,000, which 18 mo
re
 -ial Statement Analysis 231
F i n a n c i a S t a t e

to be company A. However, the total shareholders equity of

ie likely
The answer
answe
A i s 710,00,000
10,00,0 and company B is 10,000 the return on equity will be as
companyA :

follows:

=
Earnings
rnings
Equity
Return
on
Equity

10,000
y
Company A
A =
z 10,00, 000
= 1%

T1,000
B= o
Company z10,000
that B is more
the return on equity, it can be clearly said company
Comparing
than company A.
profitable
of business enterprises
size statements c a n make comparisons
The use of c o m m o n numbers a r e brought to c o m m o n
sizes much m o r e meaningful since the
of different to the operating and
allows an analyst compare
cent. Such statement
base, i.e., per sizes in the s a m e industry.
of may two companies of different
characteristics
financing
statements when the absolute
exercised in the u s e of c o m m o n size
Care must be substantial
can result in a very
small, because a small absolute change
figures are
to F1,000 and
if net profits last year amounted
percentage change. For example, in net profits,
increased this year to F5,000, this
would be a n increase of only 4,000
but represents a substantial increase
in percentage terms.
in vertical analysis and horizoontal
Common size statements c a n be prepared
analysis from formats, In vertical analysisForformat, a figure from a year is compared
were
selected from the same year. example, if advertising expenses
h a base expenses will be 1%
of sales.
,000 in 2016 and salesF10,00,000, the advertising is expressed in
format the amount of a n item (an account)
Or1Z0ntal analysis if sales
that same account figure for a selected base year. For example,
Sof to 150% of the
F12,00,000 in 2017, then sales increased
9 8,00,000 in 2016 and
4016 level in 2017, an increase of 5U%.
the relationship of the different
aAnalysis percentages to show uses
s
D aparts to
the total in a single statement. Vertical analysis sets a
total figure in the
me
statem total
the percentage of each component
of
equal to 100 per cent and computes
that will be total assets o r total
re, The figure to be used a s 100 per cent
abilitiee
ities and sheet and r e v e n u e o r sales in the
Case of the . in the c a s e of balanceequity capital
profit and loss account.
The same
9.3 and 99.4) has been presented with the help of following examples (see figures
and
232
Financial
Reporting and Analys
ABC LTD. STATEMENT OF PROFIT AND
nalyse
LOSS
31st March, 2016 and 31st March, 2017

Particulars (in R000)

2016
Percent(%)
(Increase (Decrease)
2017
I. Equity And Liabilities
(1) Shareholder's Funds
Percentage
(a) Share Capital 40,000 3.67
45,000
(b) Reserves and Surplus 19,024 20.77 46.78
20,800
(2) Non-current Liabilities 21.60
(a) Long-term borrowings 10,000 .92 11,000
b) Other long term iabilities 6,000 .55 11.42
2,000
(c) Long-term provisions 4,000 4.37 2.08
3,000
(3) Current Liabilities 3.12
(a) Short-term borrowings 300 0.33 325
0.34
b) Trade payables 3,200 3.4 4.275 4.44
c)Other current liabilities 500 0.55 400 0.42
(d) Short-term provisions 8,576 9.36 9,500 9.87
Total 91,600 100.00 96,300 100

II. Assets
(1) Non-current assets
(a) Fixed assets
44,440 48.52 45,600 47.35
) Tangible assets
800 0.83
(i) Intangible assets 700 0.76
1.35
(b) Non-current investments 500 0.55 1,300
(2) Current assets
29,800
30.
(a) Inventories 25,600 27.95
124
14.19 12,000
(b) Trade receivables 13,000
3.0
5.68 3,500
(c) Cash and cash equivalents 5,200 9
2,800
(d) Short-term loans and advance 1,760 1.92
500
(e) Other current assets 400 0.44
96,300
Total 91,600 100

FIG. 9.3
 ncial Statement Analysis 233
Finan

ABC LTD. STATEMENT OF PROFIT AND LOSS

31st March, 2016 and 31st March, 2017

Particulars
(in 7000) (Increase (Decrease)
2016 Percent(%) 2017 Percentage
operations 37,02,000 100.00 39,11,000 100.00
Revenue from
L
IL. Other Income 44,000 1.19 55,000 1.41

37,46,000 101.19 39,66,000 101.41

Revenue (I +11)
Total
III.
IV. Expenses:

materials
consumed:
Cost of 40.91
Purchase o f S t o c k - i n - T r a d e 12,39,500 33.48 16,00,000
in inventories of finished
Changes
work-in-progress and Stock-in-
goods, -1,10,0000 -2.81
-1,00,000 -2.70
Trade
29.82 12,50,000 31.96
Employee benefit expense 11,04,000
0.68 20,000 0.51
Financial costs 25,000
50,000 1.35 51,000 1.30
amortization expense
Depreciation and 12.27
4,96,000 13 40 4,80,000
Other expenses
76.03 32,91,000 84.15
Total Expenses 28,14,500
25.16 6,75,0000 17.26
IX.Profit before tax (III -

IV) 9,31,500
X. Tax expense:
12.58 3,37,500 8.63
(1) Current tax 4,65,750
(2) Deferred tax
12.58 3,37,500 8.63
XV. Profit/(Loss) for the period 4,65,750
XVI.Earning per equity share:
46.58 33.75
Basic
FIG. 9.4

TREND ANALYSIS
USing the previous year's data of a business enterprise, trend analysis c a n be
done over time in selected
data. In trend analysis,
observe percentage changes
years instead of between
ge changes are calculated for several successive
because, with its long run view, it may point
to S. Trend analysis is important at a trend in a particular
rat changes in the nature of the business. By looking
rising or remaining relatively
e may find whether that ratio is falling,detected
Cone o r the sign of a good
From this observation, a problem is
man
management is found.
one Trend anal
nalysis uses an index number over a period of time.
Other years
For index
are
number,
measured in
relatio ne base year is equal to 100 per cent.
ion C h a t amount. For example, an analyst may be
interested in sales and
 234
Financial Reportingg
and
earnings trends for the past five
Analysis
of years. For this purpose, sales
a
company are given to prepare further the trend and earni
analysis or percentag
Is or
percentrnings data
dat
ABC Company
Annual Performance
Year 1 Year 2 Year 3 Year 4 000)
Sales 202.0 215.0 243.0
Year 5
Net Earnings 320.0
10.9 11.7 13.5 415.0
15.4
The above data show a 18.8
fairly
from year to year can be determined healthy growth pattern but the pattern of eha
more precisely ange
To do this, a base by calculating trend
year is selected and then the data are percentagee
divided for each of ges.
years by the base year data. The resultant the other
occurring throughout the period. If year 1figures
are actually indexes of
the changes
is chosen as
year 2 through 5 will be related to the base year, all data for
year 1, which is represented as
100%.
To create the
following table, each year sales is divided- from
years 5 - by R202, the year 1 sales. year 2 through
5 are divided by Similarly, the net, earnings
for years 2 through
T10.9, the year 1 net earnings.
Annual Performance
(Percentage of Base Year)
Year 1 Year 2 Year 3 Year 4 Year 5
Sales 100 106 120 158 205
Net Earnings 100 107 xop 124 141 172
The trend percentages reveal that the
in sales for years 2 and 3, then fell growth in earnings outstripped the growth
below the sales growth in the last two
It is clear in this
analysis of years
in
comparative statements that a disproportionate increase
operating expenses emerged in year 5. One may analyse the year 4 data to
determine if net income was affected for the same reason or if the reduced growtn
was caused by other factors.

RATIO ANALYSIS
Ratio analysis is
two numbers. A ratio can be
an
important
expressing
means of
relationship Det a the een

computed from any pair of numbers. To be ust

ratio must represent a meaningful relationship, but use of ratios cannot tae the
place of studying the underlying data.
Ratios are guides or shortcuts that ition
useful in evaluating the financial other
are
and operations of a
company and iiu cumparing them to previous years
other
companies The primary purposeof ratios to ation.
investigal
areas for further
out is
pointunderstanding and
and
They should be used in connection with a general ot tne
its environment.
 / Staton
FinanciaStatement.Analysis
235

of
omparison of income statement and
comparte difficulties due to the timingbalance
tios, can c r e a
sheet numbers,
of the financial
in the form of
and
loss
loss statements. Specifically,
account covers the entire fiscal period, whereas
pront
i n t in time, the end of the
oint
po
the balance sheet
the
ra $singleent figure such
period. Ideally then, to
balance Sheet figure such ascompare an
s a
t o ra
as sales to a
income s t a t e m e n t

weusually need
reasonable
eed a reasonable measure of receivable.
average receivables for the year
sua over. However, these data are not available to the external that the
les figurhe
les figure

analyst should
cases, the analyst take the next best analyst. In
sme ca and approach,
by using an average of
beginning
some
nd eending balance sheet figures. This
approach smooths out changes
beginnning
beginning to end, but it does not eliminate problem due to
seasonal and cyclical
changes.
from De It also does not reflect changes that occur unevenly throughout the year.
This topic has been discussed in detail in chapter 10.

FINANCIAL STATEMENT VALUATION BY TYPES OF INDuSTRY

Inter company comparisons reveal that components of financial statements
wary by type of industry. A simultaneous analysis of balance sheets, statement of
Profit and Loss and cash flow statements highlights the relative importance of
iferent components depending on type of industry.

Merchandising (retail and wholesale) firms primarily sell products purchased

from other firms. As their main operation centers around trading goods, the
investmentsin Tangible Fixed Assets and Inventory (especially raw material and
wOrk-in-progress) are significantly lower than manufacturing firms.
Moreover Cash and cash equivalents' and Trade Receivables' are largely affected
due
Dy the credit policy. For some merchandising firms, cash balance may be large
to major sales in cash or through credit cards. Aternatively, if the firm otters credit
due to competitive nature of industry it may generate relatively large receivables
nce.Additionally, 'purchases of stock-in-trade' usually represent a large quantum
of total expenses.

financial statements of a manufacturing firm show substantial quantum of

fundsne in tangible fixed asset and large value of inventory (raw material,
work inVEsted nd finished goods) vis-a-vis service
sector firms or merchandising
ogrese and
firms. Consolidated company show
Statement of Profit and Loss of manufacturing
that
at
material consumed
cons of total expenses.
and purchases constitute majority
Depreciati
preciation compo in fixed assets. The length
of operating cye onent also indicates heavy investment receivables. Cash flow from
eratin and industry competition affects
trade
sting Acti ycle assets in a manufacturing
firm. Aservice highlight the significane of fixed
AA SerVice lesalso other hand generates its r e v e n u e by providing services.
As these firms
these firm on the technology-oriented, the major
comp ents of financiausually
re people-intensive and
fPonents manufacturing
picture vis-a-vs
different
ancial statements paint
a
ms. The positio in case of a service firm a s
of inventory is diametrically opposite
n
236 Financial Reporting and
Analysis sis
services cannot be stored being a human-capital based firm. In a sa

Infosys Ltd. "Employee benefit expenses" is the most of significant

a
service
co firm like
total expenses. Other major expenses include software packages,
professional charges. The company has a very sound liquidity position
ponent
cono..onent of
of
ncy and
balance in cash and cash equivalents. osition with large

REFERENCES

1. Baruch Lev. Financial Statement Analysis, New Approach, Prentice Hall, 1974. 955.

QUESTIONS
1. What do you mean by financial statement analysis? What are its purposes?
2. Discuss different types of financial analysis.
3. What is meant by horizontal and vertical analysis of financial statement? Explain givin
ng
suitable examples.
4. What are the limitations of financial statements?
5. Discuss the techniques of financial stetement analysis.
6. What are comparative statements? Substantiate with examples.
7. Explain common size percentages and how are they used.
Explain and illustrate trend analysis with suitable examples.
9. Write a note of financial statement variation by type of industry.