Financial analysis/Analysis of Financial Statements
Financial analysis (also referred to as financial statement analysis or accounting analysis or Analysis
of finance) refers to an assessment of the viability, stability and profitability of a business, sub-business
or project.
It is performed by professionals who prepare reports using ratios that make use of information taken
from financial statements and other reports. These reports are usually presented to top management as one
of their bases in making business decisions.

Continue or discontinue its main operation or part of its business;

Make or purchase certain materials in the manufacture of its product;

Acquire or rent/lease certain machineries and equipment in the production of its goods;

Issue stocks or negotiate for a bank loan to increase its working capital;

Make decisions regarding investing or lending capital;

Other decisions that allow management to make an informed selection on various alternatives in the
conduct of its business.
Significance of Financial Analysis
Financial analysts often assess the following elements of a firm:
1. Profitability - its ability to earn income and sustain growth in both the short- and long-term. A
company's degree of profitability is usually based on the income statement, which reports on the
company's results of operations;
2. Solvency - its ability to pay its obligation to creditors and other third parties in the long-term;
3. Liquidity - its ability to maintain positive cash flow, while satisfying immediate obligations;
Both 2 and 3 are based on the company's balance sheet, which indicates the financial condition of a
business as of a given point in time.
4. Stability - the firm's ability to remain in business in the long run, without having to sustain significant
losses in the conduct of its business. Assessing a company's stability requires the use of both the income
statement and the balance sheet, as well as other financial and non-financial indicators. etc.
Types And Methods Of Financial Analysis
Before we know the types and methods or techniques of financial analysis, first we should know the
meaning of financial analysis. Well financial analysis is a process of ascertaining the financial strength
and weakness of the firm by properly establishing relationships between the items of balance sheet and
income statement. The information provided in the financial statements are not sufficient to evaluate the
profitability and financial soundness of the business firm. So it requires further analysis and interpretation
to draw meaningful conclusion which helps management to take appropriate decisions.
Types of financial analysis
There are various types of users like investors, creditors, customers, financial institutions, employees,
potential investors, government and general public analyze the financial reports in different angles for
different purposes. However all kinds of analysis can be classified on the basis of their users and the
method of operations followed in the analysis.
Here is a chart which describes it better.
External Analysis
The name itself suggests that this type of analysis is done by the outsiders who do not have access to the
detailed accounting information of the business firm. For this type of analysis external users like
investors, creditors, credit agencies, general public etc. mostly rely on the published financial statements.
Internal Analysis
This analysis is performed by the executives and employees of the business firm. They have full access to
all internal accounting records of the business concern. They do all these analysis only for the
management of the business enterprises.
On the basis of method of operations followed in the analysis we can again categorize analysis in to
dynamic
or
horizontal
analysis
and
static
or
vertical
analysis.
Dynamic
Analysis
In this analysis the financial data of the company is compared for several years. A base year which is
normally the beginning year is chosen and the financial data of various years are compared with the
standard or the base year. Dynamic analysis helps the management and other users to find out the trend of
items of financial statements that have changed significantly during the period. Comparison of an item
over several periods with the base year may show a trend developing. Comparative statements and trend
percentages
are
two
tools
used
in
dynamic
analysis.
Static
Analysis
Static analysis refers to study of relationships of various items in the financial statement of one financial
year only. In static analysis items of financial statement of a year are compared with the base selected
from the same year's statement. Common-size financial statements and financial ratios are two tools used
in static or vertical analysis. As items for one time period are taken for analysis in static analysis so it is
not conducive for proper analysis of financial statements. However it may be analyzed with dynamic
analysis
to
make
it
more
meaningful
and
effective.
Number of methods or devices are used for analysis of financial statements. Here I am giving a list of it.
In this post I will discuss about the first three methods and the rest methods will be discussed in the next
posts
1.
Comparative Statements
2.
Trend Analysis
3.
Common-size Statements
4.
Ratio Analysis
5.
Funds flow Analysis
6.
Cash flow Analysis
7.
Cost-volume-profit Analysis
Comparative Statements
Under comparative statement, financial statements like balance sheet and income statement are prepared
in comparative form for financial analysis. The items of financial statements are shown in a comparative
form to give an idea of financial position of the business at two or more periods. As the items are shown
in a comparative form so the analysts are able to draw useful conclusion. out of it. For example when
sales figure of current period is compared with the previous periods then the analysts will be able to study
the trend of sales over different period of time.
The two comparative statements are

Comparative balance sheet and

Comparative income statement
In comparative balance sheet items of two or more balance sheets of the same business concern are shown
on different dates. Changes in items between two or more balance sheets make analysts to draw
conclusions about the progress of the concern. Comparative balance sheet helps to study the aspects such
as current financial and liquidity position, long term financial position and the profitability of the concern.
Current financial position of the concern can be known from the changes in working capital of the
business firm. Working capital is the excess of current assets over current liabilities. An increase in
working capital shows the improvement of current financial position. But if the increase of working
capital were mainly for the increase of inventory due to accumulation of stock for want of customers,
decrease in demand or inadequate sales promotion then it is not a good financial position of the business.
Liquid assets like cash, bank, bills receivables, debtors etc. show an increase in the current year than the
previous years then it will improve the liquidity position of the business concern.
The long term financial position of the business can be known from the changes in fixed assets, long term
liabilities and capital. A good financial policy will be to finance the fixed assets by the issue of either long
term securities such as debentures, bonds, loan from financial institutions or issue of fresh share capital.
An increase in fixed assets should be compared to the increase in long term loan and cap[ital. If increase
in fixed assets is more than the increase in long term loans then part of fixed assets has been financed
from working capital. On the other hand if the increase in long term loan is more than the increase in
fixed assets then the fixed assets have not only been financed from the long term sources but part of
working capital has also been financed from long term sources. A wise policy will be to finance fixed
assets by raising long term funds.
The profitability of the business concern can be studied from the comparative balance sheet. An increase
in the balance of profit and loss account and other resources created from profit will mean an increase in
profitability of the concern. The decrease in such accounts represents deterioration in profitability of the
concern.
Here
is
an
example
of
comparative
balance
sheet.
In the above comparative balance sheet during the year 2010 there has been an increase in fixed assets of
75000 while long term liabilities to outsiders have increased by 117000 and share capital has increased by
150000. So here it tells that the fixed assets have been purchased from long term sources of finance
thereby
not
affecting
the
working
capital
of
the
business.
The current assets have increased by 142000 and cash and bank have increased by 50000. On the other
hand the stock has increased by 60000 and the current liabilities have increased only by 42000. This
position says that the long term finances have been utilized by the firm to improve its liquidity position.
reserves and surpluses have decreased by 50000 which depicts that the business concern has used its
reserves
and
surpluses
for
the
payment
of
dividends
to
shareholders.
So from the above interpretation it can be called that the overall financial position of the company is
good.
The income statement is prepared to ascertain the operational result of the business concern. Comparative
income statement is prepared to analyze the profitability of the business. It shows the progress of the
business
concern
over
a
period
of
time.
The profitability and progress of the business concern can be determined from the study of following
aspects
of
the
comparative
income
statement
An increase in sales increases the profit of the business but it is not always true. If the cost of goods sold
increases more than the increase in sales then it will not improve the profitability of the business. So the
increase or decrease of sales should be compared to the increase or decrease of cost of goods sold to
determine
the
actual
profitability
of
the
business
concern.
Increase in sales and control of operating expenses will increase the operating profit of the business
concern. Operating profit is the gross profit less operating expenses like administrative and selling and
distribution expenses. Change in a particular expense may be due to lack of managerial efficiency or due
to
expansion
of
the
business.
An increase or decrease in the net profit shows the overall profitability of the business concern. Net profit
is the operational profit less all non operating expenses like interest paid, loss from sale of old assets,
deferred expenses written off etc. There may be some non operating incomes which will increase the net
profit
of
the
business
concern.
Here
is
an
example
of
the
comparative
income
statement
In the above comparative income statement the sales has increased by 13.41% where as cost of goods sold
has increased by 10.42% resulting in increase in gross profit by 17.65%. Total operating expenses has
increased by 7.53% but the increase of gross profit is sufficient to compensate the increase of operating
expenses so there has been an increase in operational profit of Rs. 46000. There is an increase in net profit
by Rs.36000. So it may be stated that the overall profitability of the business is good. There has been a
progress in the business.
Trend Percentages Analysis
From the name of the analysis it is clear that here financial statements are analyzed on the basis of trends
of figures in the statements. In trend analysis percentage of each item of statement is calculated in relation
to the same item in the base year. Here the information for number of years is taken and generally the
beginning year is taken as the base year. The base year should be a normal year. The figure of the base
year is taken as 100 and trend percentages for other years are calculated on the basis of base year. Down
or upward trends of figures of items are seen in this analysis. For example if current assets figure for the
year 2005 to 2010 to be studied then current assets of 2005 is taken as 100 and percentage of current
assets for other years will be calculated in relation to the base year.
The interpretation of trend analysis should be done properly. The mere increase or decrease in trend
percentages may provides misleading information if studied in isolation. An increase of current assets by
25% may be good for the concern but if at the same time current liabilities also increases by 25% then this
increase will not be favorable. Similarly the increase of sales may not improve the profitability if the cost
of production also increases equivalently.
Trend Percentages
(Base Year 2005 = 100)
From the above trend percentages sales have continuously increased in all the years up to 2009
.The sales percentage has increased to 200% in year 2009 as compared to 100% in 2005. So during the
five years sales have been doubled. So the increase in sales is quite satisfactory.
The percentage of cost of goods sold have also increased from 100% in year 2005 to 150% in year 2009.
But as compared to increase in sales percentage it is quite less. So cost control has been done efficiently
resulting in improvement of profitability of the business.
The net profit percentage has increased to 233.33% in year 2009. In five years the increase in profit
percentage is more than the increase of sales percentage. It suggests a good control of operating and non
operating expenses.
Common-size Statement
In common-size statements, balance sheet and income statement the figures are shown in percentages.
The figures of these statements are expressed as percentages of total assets, total liabilities and total sales.
Total assets are taken as 100 and different assets are shown as percentage of total assets. Similarly total
liabilities are taken as 100 and different liabilities are expressed as a percentage of of total liabilities. Here
every item of the statements is expressed as a percentage of the total 100.
Common-size
Balance
Sheet
In common-size balance sheet the total assets and liabilities are taken as 100 and each asset and liability is
expressed as a percentage of the total 100. Common-size balance sheet can be used to compare companies
of
different
sizes.
Here is an example of a common-size balance sheet to compare the financial position of two companies.
Common-size Balance Sheet
Year ending 31st march, 2010
If we analyze the financing of two companies, then we can say that xyz ltd. has been financed more out of
its own fund in caparison to abc ltd. In case of xyz ltd. out of total investments 64.03% is the proprietor's
fund where as it is 60.68% for abc ltd.
If we analyze the working capitals of two companies, then we can say that abc ltd. is in much better
position then the xyz ltd. In case of xyz ltd. the percentage of its current liabilities 17.38 % is more than
its current assets 13.57%. So this company is suffering from shortage of working capital. In case of abc
ltd. its percentage of current assets 14.72% is more than its current liabilities 13.11%. So this company's
working capital position is better than the xyz ltd.
Common-size Income Statement
In common-size income statement the items in the income statement are shown in relation to sales. Each
item in the statement is expressed as a percentage of sales. An increase or decrease in sales will directly
affect the selling expenses not the administrative and financial expenses. But if the sales volume increases
considerably then it may increase the administrative and financial expenses to certain extent. So a
relationship is set between sales and other items to evaluate the operational activities of the business
concern.
Here is an example of a common-size income statement
Common-size Income Statement
year ending 31st March 2010
In the above common-size income statement sales and gross profit have increased in absolute figures in
year 2010 but the percentage of gross profit to sales has decreased in 2010. The cost of sales as a
percentage of sales has decreased the profitability from 43.33% to 36.00%.
Both operating and non operating expenses has slightly decreased in 2010.
Net profits have gone down both in absolute figures and percentage in 2010 as compared to 2009.
The overall profitability has decreased in 2010 due to rise in cost of sales. The management should take
immediate actions to control the cost of sales. Financial statement information is used by both external
and internal users, including investors, creditors, managers, and executives. These users must analyze the
information in order to make business decisions, so understanding financial statements is of great
importance. Several methods of performing financial statement analysis exist. This article discusses two
of these methods: horizontal analysis and vertical analysis.
Horizontal Analysis
Methods of financial statement analysis generally involve comparing certain information. The horizontal
analysis compares specific items over a number of accounting periods. For example, accounts payable
may be compared over a period of months within a fiscal year, or revenue may be compared over a period
of several years. These comparisons are performed in one of two different ways.
Absolute Dollars
One method of performing a horizontal financial statement analysis compares the absolute dollar amounts
of certain items over a period of time. For example, this method would compare the actual dollar amount
of operating expenses over a period of several accounting periods. This method is valuable when trying to
determine whether a company is conservative or excessive in spending on certain items. This method also
aids in determining the effects of outside influences on the company, such as increasing gas prices or a
reduction in the cost of materials.
Percentage
The other method of performing horizontal financial statement analysis compares the percentage
difference in certain items over a period of time. The dollar amount of the change is converted to a
percentage change. For example, a change in operating expenses from $1,000 in period one to $1,050 in
period two would be reported as a 5% increase. This method is particularly useful when comparing small
companies to large companies.
Vertical Analysis
The vertical analysis compares each separate figure to one specific figure in the financial statement. The
comparison is reported as a percentage. This method compares several items to one certain item in the
same accounting period. Users often expand upon vertical analysis by comparing the analyses of several
periods to one another. This can reveal trends that may be helpful in decision making. An explanation of
Vertical analysis of the income statement and vertical analysis of the balance sheet follows.
Income Statement
Performing vertical analysis of the income statement involves comparing each income statement item to
sales. Each item is then reported as a percentage of sales. For example, if sales equals $10,000 and
operating expenses equals $1,000, then operating expenses would be reported as 10% of sales.
Balance Sheet
Performing vertical analysis of the balance sheet involves comparing each balance sheet item to total
assets. Each item is then reported as a percentage of total assets. For example, if cash equals $5,000 and
total assets equals $25,000, then cash would be reported as 20% of total assets.
Significance of Financial Analysis to Different parties
1. Shareholders
Shareholders are interested in financial statement analysis to know the profitability of the organization.
Profitability shows the growth potentiality of an organization and safety of investment of shareholders.
2. Investors And Lenders
Investors and lenders are interested to know the solvency position of an organization. They analyze the
financial statement position to know about the safety of their investment and ability to pay interest and
repayment of principle amount on due date.
3. Creditors
Creditors are interested in analyzing the financial statements in order to know the short term liquidity
position of an organization. Creditors analyse the financial statement to know either the organization is
enable to pay the amount of short term liabilities on due date.
4. Management
Management is interested to analyze the financial statement for measuring the effectivenessof its policies
and decisions.It analyze the financial statements to know short term and long term solvency
position,profitability,liquidity position and return on investment from the business.
5.Government
Government is interested to analyze the financial position in determining the amount of tax liability. It
also helps for formulating effective plans and policies for economic growth.