Grade 12 Account Note

Financial Statement Analysis

INTRODUCTION

A joint stock company with its own legal entity performs business activities for the purpose of earning profits. There are a number of stakeholders of the company such as the shareholders, managements, creditors, employees and workers, consumers and government who are keen to know about the results of its financial activities performed during a certain period of time.

 

MEANING OF FINANCIAL STATEMENTS

Financial statements are written reports of financial affairs of a company. They report and communicate the results of its business operations for a particular period of time and its financial position at the end of that period. Financial statements are the end product or output of an accounting system designed and used in an organization. Income statement, statement of retained earnings, balance sheet and cash flow statements are the major parts of a financial statement. Just as the presence of our body reflects our health, financial statements reflect the health of a business firm. Generally financial statements are prepared periodically to show the profitability, solvency and cash flow situation. Profitability is the ability of a company to generate income, it is reflected in the company’s income statement. Solvency is the ability of a company to pay debt as they become due, it is reflected in the company’s balance sheet.

 

CONTENTS OF FINANCIAL STATEMENTS

“Nepal accounting standard, July 2002” emphasizes the preparation of financial statements by the company and offers framework for the preparation and presentation of these statements. Accordingly, the financial statements of the company contain the following:

Income statement: It tells us about the operating result of a particular accounting period, say a month or a year. The income statement contains two broad categories of items: revenues and expenses. Revenues represent the actual or expected inflow of assets, the settlement of liabilities or both. While expenses represent the utilization or consumption of assets or incurring of liabilities or both to produce the revenue inflow.

Statements of retained earning: It is also known as profit and loss appropriation account. It show how the net incomes of the period appropriated or distributed. It also shows the change in retained earning between the beginning and the end of the period.

Balance sheet: It is also known as position statement. The objectives of a balance sheet are to provide the information concerning assets owned by the company and equity interests (of both the creditor and owner) in those assets.

Cash flow statement: The statement of cash flow tells us from what kinds of activities were the cash and cash equivalents received and where those were applied. It shows the inflow and outflow over a period of time.

 

Objectives of financial statement:

Financial statements are the end results of the accounting process and they provide the profitability and solvency position of the company. The following are the main objectives of financial statements;

i)To provide the operating result of the company.
ii)To provide the financial position of the company, for the specified period of time.
iii)To provide financial information to the external as well as internal users.
iv)To reveal the history of the firm.
v)To facilitate the performance evaluation intra and inter company.
vi)To evaluate the efficiency of the management.
vii)To provide the required information to the management for future planning and decision making.

 

IMPORTANCE OF FINANCIAL STATEMENTS

Financial statements provide valuable financial information to various users for different purpose. The importance of financial statements can be pointed out as follows:

It provides the information relating profit in terms of sales and investment, earning per share, dividend per share.
It shows the Pat performance of an organization and past performance is the good indicator of future.
It makes the comparative analysis of profitability, solvency and activities of the organization.
It provides the information about solvency position of the business.
It provides the detail information about revenue expenses, income and profit.
It provides the information about profitability, solvency, activity of the management, stability and future prospect.

 

LIMITATIONS OF FINANCIAL STATEMENTS

The following are the main limitations of financial statements:

It provides the information relating to only monetary fact.

It records the financial information relating to historical in nature.

It is only interim report.

It is influenced by accounting concept.

It fails to disclose the adequate information.

It ignores the effect of price level changes.

It is prepared primarily for shareholders.

 

FINANCIAL STATEMENT ANALYSIS

The process of interpreting financial statement with specific tool and purpose is known as financial statement analysis. In other words, it can be defined as the process of knowing the strength and weakness of an organization through the meaningful search of figures contained in the financial statement. Therefore, the financial statements analysis is concerned with collecting, classifying and grouping of figures, contained in the financial statement with specific tool and purpose so that a user can get the required information such as survival, productivity, stability, profitability and growth prospect of the company. Without systematic analysis and interpretation, the figures contained in the financial statement will be the static and value of the figures will be meaningless and these figures cannot be utilized by the users effectively.

 

Objectives of financial statement analysis

The following are the important objectives of financial statements analysis:

To know about profitability: The financial statement analysis provides information about the profitability of the company in terms of sales and investment. The profitability scenario helps shareholders to decide whether to continue holding its shares and other potential investors to decide whether to invest in its shares or not.

To judge solvency: An analysis of financial statements is helpful for judging the short-term and long-term solvency of the company. The banks with such information will be in a position to decide whether it should extend loan or not.

To measure strengths and weakness: The analysis of financial statements helps to measure the financial strengths and weaknesses of the company, which is essential for deciding future course of action.

To assess managerial performance: The financial statement analysis is essential for measuring the company’s managerial performance, which is important to decide about rewarding the management or taking action against it.

To make future planning: The financial statement analysis provides relevant information about the present position of the company. The present position of the company provides guidelines for making future plans of the company by deciding what course of action should it take to achieve its objectives.

 

METHODS/TECHNIQUES OF FINANCIAL STATEMENT ANALYSIS

Financial statement analysis can be performed by employing a number of methods or techniques. The following are the important methods or techniques of financial statement analysis:

Ratio analysis: It is the analysis of interrelationship between two financial figures.

Cash flow analysis: It is the analysis of the change in the cash position during a period.

Comparative financial statements: It is the analysis of financial statements of the company for two years or of the two companies of similar type.

Trend analysis: It is the analysis of the trend of the financial ration of the company over the years.

 

Importance of financial statement analysis

The financial statement analysis is important for different reasons:

i)For decision of holding share: Financial statement provides the information about profitability in terms of share and investment. It also provides the information about earning per share, dividend per share etc. on the basis of which, an investor takes decision whether continue to hold or sale out the share.

ii)For future decision and planning: Financial statement shows the past performance of an organization and past performance is the good indicator of future. Therefore, management makes planning and takes decision for the future on the basis of past performance.

iii)For investment decision: Financial statement makes the comparative analysis of profitability, solvency and activities of the organization. On the basis of these comparative analyses an investor may take decision whether to invest or not.

iv)For assessing corporate tax: Financial statement analysis provides the detail information about revenue expenses, incomes and profit. Therefore, it will be the basis for the government to determine the corporate tax liability.

v)For credit extending decision: Financial statement provides the information about solvency position of the business. Solvency position means the ability to pay the debt. If the company possess sufficient amount of current assets, the creditor extends the credit period of loan. If not, the creditor does not extend the credit period.

vi)For forecasting the trend of stock market price: Financial statement analysis provides the information about profitability, solvency, activity of the management, stability and future prospect. On the basis of these information, stock analysis forecast the future market price of the company’s share.

 

Limitations of financial statement analysis

Financial statement analysis is very much important to the various parties as mentioned above. However it has some limitations, which are as follows:

Ignore the qualitative aspects:Financial statement is prepared by the company on the basis of financial transactions only. It does not include non-financialtransaction, which is also known as qualitative aspect like entry and exit of competitors, management employees relation, customers feedback etc. But the qualitative expects are very important for the formulation of strategies and policies of the company.

Not free from bias: Financial statement analysis is made as per the personal judgment of analyst. Therefore, the analysis is not free from the biasness of the analyst.

No possibility to adjust the effect of the price level change: Financial statement analysis is done on the basis of historical data contained by the financial statement. Therefore, there will not be any adjustment of inflation and deflation and it cannot represent the current value of the business.

No solution but identification of problems only: Financial statement analysis shows the strength and weakness of the organization or it identifies the problem only but it does not provide any guidelines for the solution of the identified problems.

Chance of wrong analysis: The accuracy of financial statement analysis mostly depends upon the accuracy of the figures contained in the financial statement. If these figures are manipulated, the analysis also will be the wrong. The decision made on the basis of such wrong analysis may mislead the users in making their decision.

 

PARTIES INTERESTED IN FINANCIAL STATEMENT ANALYSIS

Financial statement analysis is the process of knowing the strength and weakness of an organization through the meaningful search of figures contained in financial statement. It is useful for various parties to obtain the required information about the organization. Following are the parties interested in financial statement analysis.

Management: Management is interested in financial analysis for the performance evaluation of employees, implementation of planning, policies and decisions. Management makes analysis of financial statement to know the solvency positions, profitability, liquidity position and return on investment from the business.

Shareholders: Shareholders are interested in financial statement to know the profitability position in terms of sales and investment. Profitability position shows the safety to investment made by shareholder and prospective growth of an organization.

Creditors: Creditors are interested in financial statement analysis to know the solvency position of the organization. Solvency position indicates whether the firm is financially sound or solvency as far as its current obligation are concerned. On the basis of financial information, creditors know the firm’s ability to pay current obligation and they take decision about the supply of raw materials.

Investors or lenders: They analysis the financial statement to know the solvency position of the organization. On the basis of financial information, they will know whether the organization can pay interest and principal amount of loan on due date or not. In addition to this they also know about the safety of their investment.

Employees: the financial information provided by the financial statement, employees might decide whether they demand for higher wages and salaries or other benefits from the management.

Government: Government is interested in the financial statement analysis for determining the amount of tax liability.


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