Introduction
Financial statements are an important source of information for evaluating the performance and prospects of a firm. If properly analyzed and interpreted, financial statements can provide valuable insights into a firm's performance. Analysis of financial statements is of interest to lenders (short term as well as long term), investors, security analysts, managers, and others. Financial statement analysis may be done for a variety of purposes, which may range from a simple analysis of the short-term liquidity position of the firm to a comprehensive assessment of the strengths and weaknesses of the firm in various areas. It is helpful in assessing corporate excellence, judging creditworthiness, forecasting bond ratings, evaluating intrinsic value of equity shares, predicting bankruptcy, and assessing market risk.
FINANCIAL STATEMENTS
Managers, shareholders, creditors and other interested groups seek answers to the following questions about a firm: What is the financial position of firm at a given point of time? How has the firm performed financially over a given period of time? What have been the sources and uses of cash over a given period? To answer these questions, the accountant prepares two principal statements, the balance sheet and the profit and loss account, and an ancillary statement, the cash flow statement.
BALANCE SHEET
The balance sheet shows the financial condition of a business at a given point of time. As per the Companies Act, the balance sheet of a company shall be in either the account (horizontal) form or the report (vertical) form. Exhibit 2.1 shows the balance sheet of Horizon Limited as on March 31, 2005 cast in the account as well as the report form. While the report form is most commonly used by companies, it is more convenient to explain the contents of the balance sheet of Horizon Limited, cast in the account form, as given Exhibit 2.2. Structure of Balance Sheet as per the Companies Act
Liabilities.
Liabilities defined very broadly represent what the business entity owes others. The Companies Act classifies them as share capital, reserves and surplus, secured loans, unsecured loans, current liabilities and provisions
Share Capital:
This is divided into two types: equity capital and preference capital. The first represents the contribution of equity shareholders who are the owners to the firm. Equity capital, being risk capital, carries no fixed rate of dividend. Preference capital represents the contribution of preference shareholders and the dividend rate payable on it is fixed.
Reserves and Surplus:
Reserves and surplus are profits, which have been retained in the firm. There are two types of reserves: revenue reserves and capital reserves. Revenue reserves represent accumulated retained earning from the profits of normal business operations. These are held in various forms: general reserve, investment allowance reserve, capital redemption reserves, dividend equalization reserve, and so on. Capital reserves arise out gains, which are not related to normal business operations. Examples of such gains are the premium on issue of shares or gain on revaluation of assets. Surplus is the balance in the profit and loss account, which has not been appropriated to any particular reserve account. Note that reserves and surplus along with equity capital represent owners' equity or net worth.
Secured Loans:
These are the borrowings of the firm against which specific collateral have been provided. The important components of secured loans are: debentures, loans from financial institutions, and loans from commercial banks. Unsecured Loans. These are the borrowing of the firm against which no specific security has been provided. The major components of unsecured loans are: fixed deposits, loans and advances from promoters, inter-corporate borrowings, and unsecured loans from banks.
Current liabilities and Provisions:
Current liabilities and provisions, as per the classification under the companies Act, consist of the amounts due to the suppliers of goods and services bought on credit, advance payments received, accrued expenses, unclaimed dividend, provisions for taxes, dividends, and so on. Current liabilities for managerial purposes (as distinct from their definition in the Companies Act) are obligations, which are expected to mature in the next twelve months. So defined, they include current liabilities and provisions as per the classification under the Companies Act plus loans (secured and unsecured) which are repayable within one year from the date of the balance sheet.
Assets:
Broadly speaking, assets represent resources, which are of some value to the firm. They have been acquired at a specific monetary cost by the firm for the conduct of its operations. Assets are classified under the Companies Act as fixed assets, investments, current assets, loans and advances, miscellaneous expenditure and losses.
Fixed Assets:
These assets have two characteristics: they are acquired for use over relatively long periods for carrying on the operations of the firm and they are ordinarily not meant for resale. Examples of fixed assets are land, buildings, plant, machinery, patents, and copyrights.
Investments:
These are financial securities owned by the firm. Some investments represent long-term commitment of funds (usually these are the equity shares of other firms held for income and control purposes). Other investments are likely to be short term in nature such as holdings of units in mutual fund schemes and may rightly be classified under current assets for managerial purposes. (Under the requirements of the Companies Act, however, short term holding of financial securities also has to be shown under investments and not under current assets.)
Current Assets, Loans and Advances:
This category consists of cash and other assets, which get converted into cash during the operating cycle of the firm. Current assets are held for a short period of time as against fixed assets, which are held for relatively longer periods. The major components of current assets are: cash, sundry debtors, inventories, loans and advances, and prepaid expenses. Cash denotes funds readily disbursal by the firm. The bulk of it is usually in the form of bank balances and the rest is currency held by the firm. Sundry debtors (also called accounts receivable) represent the amounts owned to the firm by its customers who have bought goods and services on credit. Sundry debtors are shown in the balance sheet at the amount owed, less an allowance for bad debts. Inventories (also called stocks) consist of raw materials, work-in-process, finished goods, and stores and spares. They are usually reported at the lower of the cost or market value. Loans and advances are the amounts loaned to employees, advances given to suppliers and contractors, advance tax paid, and deposits made with governmental and other agencies. They are shown at the actual amount. Prepaid expenses are expenditures incurred for services to be rendered in the future. These are shown at the cost of unexpired service.
Miscellaneous Expenditures and Losses:
This category consists of two items: (i) miscellaneous expenditures and (ii) losses. Miscellaneous expenditures represent certain outlays such as preliminary expenses and developmental expenses, which have not been written off. From the accounting point of view, a loss represents a decrease in owners' equity. Hence, when a loss occurs, the owners' equity should be reduced by that amount. However, as per company law requirements, the share capital (representing owners' equity) cannot be reduced when a loss occurs. So the share capital is kept intact on the left hand side (the liabilities side) of the balance sheet and the loss is shown on the right hand side (the assets side) of the balance sheet.
PROFIT AND LOSS ACCOUNT
The Companies Act has prescribed a standard form for the balance sheet, but none for the profit and loss account. However, the Companies Act does require that the information provided should be adequate to reflect a true and fair picture of the operations of the company for the accounting period. The Companies Act has also specified that the profit and loss account must show specific information as required by Schedule IV. The profit and loss account, like the balance sheet, may be presented in the account form or the report form. Typically, companies employ the report form. The report form statement may be a single-step statement or a multi-step statement. In a
single step statement, all revenue items are recorded first, then the expense items are show and finally the net profit is given. While a single step profit and loss account aggregates all revenues and expenses, a multi-step profit and loss account provides disaggregated information. Further, instead of showing only the final profit measure, viz., the profit after tax figure, it presents profit measures at intermediate stages as well.
Net sales
Cost of goods sold
Gross profit
Operating expenses
Operating profit
Non-operating surplus/deficit
Profit before interest and tax
Interest
Profit before tax
Tax
Profit after tax.
FINANCIAL STATEMENTS ANALYSIS
Financial Statements Analysis (FSA) refers to the process of the critical examination of the financial information contained in the financial statements in order to understand and make decisions regarding the operations of the firm. The FSA is basically a study of the relationship among various financial facts and figures given in a set of financial statements. The basic financial statements i.e. the Balance Sheet and the Income Statement, already discussed in the preceding lesson contain a whole lot of historical data. The complex figures as given in these financial statements are dissected/broken up into simple and valuables elements and significant relationships are established between the elements of the same statement or different financial
statements. This process of dissection, establishing relationships and interpretation thereof to understand the working and financial position of a firm is called the FSA. Thus, FSA is the process of establishing and identifying the financial weaknesses and strength of the firm. It is indicative of two aspects of a firm i.e. the profitability and the financial position and it is what is known as the objectives of the FSA.
Objectives of the FSA:
Broadly, the objective of the FSA is to understand the information contained in financial statements with a view to know the weaknesses and strength of the firm and to make a forecast about the future prospects of the firm and thereby enabling the financial analyst to take different decisions regarding the operations of the firm. The objectives of the FSA can be identified as:
To assess the present profitability and operating efficiency of the firm as a whole as well as for its different departments and segments.
To find out the relative importance of different components of the financial position of the firm.
To identify the reasons for change in the profitability/financial position of the firm, and
To assess the short term as well as the long term liquidity position of the firm.
Types of Financial Analysis
Financial analysis can be classified into different categories depending upon
(1) The material used, and (2) The operating method of analysis.
1. On the Basis of Material Used: Under this category the financial analysis can be of two types: a) External Analysis; b) Internal Analysis
a. External Analysis:
The outsiders to the business carry out this kind of analysis, which includes investors, credit agencies, government agencies and other creditors who have no access to the internal records of the company. In recent times this analysis has gathered momentum towards better corporate governance and government regulations for more detailed disclosure of information by the companies in their financial statements.
b. Internal Analysis:
In contrast to the above this analysis is done by those who have access to the books of accounts and other information related to the business. The analysis is done depending upon the objective to be achieved through this analysis.
2. On the basis of operating method
In this case too, the financial analysis can be of two types: a) Horizontal Analysis; b) Vertical Analysis
a Horizontal Analysis:
Under this financial statements for a number of years are reviewed and analyzed. The current year’s figures are compared with standard or base year.
b Vertical Analysis:
Under this type of analysis a study is made of the quantitative relationship of the various items in financial statements on a particular date. For example, the ratios of different items of costs for a particular period may be calculated with the sales for that period. These types of financial analysis are useful in comparing the performance of several companies in the same group, or divisions or departments in the same company. In addition to above, the FSA for a firm can be undertaken in different ways. There is 'the best' technique of the FSA, which can be applied to all the firms under all the situations. The type of the FSA undertaken depends upon the person doing the FSA and the purpose of which the FSA has been undertaken. Different persons/parties may undertake the FSA for different purposes. The persons/parties, who are usually interested in the FSA, may be the shareholders, the creditors, the financial institutions, the investors and the management itself. The FSA can be classified into different categories as follows: a) Internal and External FSA; b) Dynamic and Static FSA
Internal and External FSA:
The FSA is said to be internal when it is done by a person who has access to the books of the account and other related information of the firm. This type of FSA is conducted for measuring the operational and managerial efficiency at different hierarchy levels of the firm. This type of analysis is quite comprehensive and reliable. In order to undertake internal FSA, either an employee of the same firm or an outside agency may be entrusted with the responsibility. External FSA, on the other hand, is one, which is conducted by an outsider without having any access to the basic accounting record of the firm. These outsiders may be the creditors, the investors, the shareholders, the credit rating agencies etc. The external FSA is dependent on the published financial data of the firm and consequently can serve only a limited purpose.
Dynamic and Static FSA:
The FSA is said to be dynamic if it covers a period of several years. Financial data/information for different years is incorporated in the FSA to assess the progress of the firm. This type of FSA is also called the horizontal analysis. The dynamic FSA is useful for long-term trend analysis and planning. In dynamic FSA, the figures/data for a year are placed and compared with the figures/data for several other years and changes from 1 year to another are identified. Since, the dynamic analysis covers a period of more than 1 year (may be up to 5 years or 10 years), is given a considerable insight into areas of financial weaknesses and strength of the firm. On the other hand, the static FSA covers a period of 1 year only and the analysis is made on the basis of only one set of financial statements. So, it is study in terms of information at a particular date only. It is also called vertical FSA. Implicitly, the static FSA fails to incorporate the periodic changes and therefore, may not be very conducive to a proper understanding of the financial position of the firm. It may be noted that both the dynamic and static FSA should be conducted simultaneously as both are indispensable for understanding the profitability and financial position of the firm. On the basis of the above discussion, it can be said that FSA is investigative and thought provoking. The basic objective of FSA is financial planning and forecasting on the basis of meaningful interpretation of the financial information. It is a forward looking exercise. Since, decisions are going to be taken on the basis of the FSA, the analyst must be careful, precise, analytical, objective and intelligent enough to undertake the FSA in a systematic way.
METHODICAL PRESENTATION TO FSA
The financial statements usually present the financial data in a traditional form. However, in order to make meaningful and convenient analysis, the presentation of data may be modified and suitably rearranged. In the modified form, the items of a statement are presented in a vertical form and in a particular sequence only. However, it must be noted that this modified form of the financial statements is only a matter of convenience and not a compulsory requirement and therefore, there is no standard form of methodical presentation. The FSA can be undertaken even without such modification but not so conveniently. In methodical presentation, the financial information can be presented even side by side for inter-firm comparison or for dynamic FSA. A set of methodical presentations of the Income Statement and the B/S are given in the Table 2.1 and Table 2.2 respectively. kindly click the table