Analysis and Interpretation of Financial Statements

The goal of Analysis and Interpretation of Financial Statements is to ascertain the significance and meaning of the financial statement data in order to forecast future earnings, the capacity to make interest payments, the maturities of current and long-term debt, and the viability of a sound dividend policy.

The primary goal of Analysis and Interpretation of Financial Statements is to identify a business undertaking’s strengths and weaknesses by combining and analysing the data found in financial statements, by contrasting different elements, and by reading their text. The final of the four main processes of accounting is the study and interpretation of financial statements.

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Financial Statement Analysis and Interpretation 

The process of critical evaluation of the financial information contained in the financial statements in order to understand and make decisions regarding the operations of the firm is called ‘Financial Statement Analysis’. It is basically a study of relationship among various financial facts and figures as given in a set of financial statements, and the interpretation thereof to gain an insight into the profitability and operational efficiency of the firm to
assess its financial health and future prospects.

The term ‘financial analysis’ includes both ‘analysis and interpretation’. The term analysis means simplification of financial data by methodical classification given in the financial statements. Interpretation means explaining the meaning and significance of the data. These two are
complimentary to each other.

• Financial statement analysis is used by internal and external stakeholders to evaluate business performance and value.
• Financial accounting calls for all companies to create a balance sheet, income statement, and cash flow statement, which form the basis for financial statement analysis.
• Horizontal, vertical, and ratio analysis are three techniques that analysts use when analyzing financial statements.

Types of Financial Analysis

The various forms of analysis may be involved. It is typically divided into four categories based on the information used and the modus operandi.

• External analysis.
• Internal analysis.
• Horizontal analysis.
• Vertical analysis.

External analysis

• External analysis is an analysis based on information easily available to outsiders (externals) for the business.
• Outsiders include creditors, suppliers, investors, and government agencies regulating the business in a normal way.
• These parties do not have access to the internal records (information) of the concern and generally obtain data for analysis from the published financial statements. Thus an analysis done by outsiders is known as external analysis.

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Internal analysis

• Internal analysis is an analysis done on the basis of information obtained from the internal and unpublished records and books. While conducting this analysis, the analyst is a part of the enterprise he is analysing.
• Analysis for managerial purposes is the internal type of analysis and is conducted by executives and employees of the enterprise as well as governmental and court agencies which may have major regulatory and other jurisdiction over the business.

Horizontal analysis

• Horizontal analysis is also known as ‘dynamic analysis’ or ‘trend analysis’.
• This analysis is done by analysing the statements over a period of time. Under this analysis, we try to examine as to what has been the periodical trend of various items shown in the statement.
• The horizontal analysis consists of a study of the behaviour of each of the entities in the statement.

Vertical analysis 

• Vertical analysis is also known as ‘static analysis’ or ‘structural analysis’.
• It is made by analysing a single set of financial statement prepared at a particular date. Under such a type of analysis, quantitative relationship is established between the different items shown in a particular statement.
• Common size statements are the form of vertical analysis. Thus vertical analysis is the study of quantitative relationship existing among the items of a particular data.

Objectives of Financial Statements

• To provide adequate information about the source 
• of finance and obligations  of the finance firm.
• To provide reliable information about the financial performance and financial soundness of the concern.
• To provide sufficient information about results  of operations of business over a period  of time.
• To provide useful information about the financial conditions of the business and movement  of resources in and out of business.
• To provide necessary information to enable the users to evaluate the earning performance of resources or managerial performance in forecasting the earning potentials of business.

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Types of Financial Statements

Companies manage the operations of their business and give transparency to their stakeholders by using the balance sheet, income statement, and cash flow statement. The three assertions are connected to one another and produce various interpretations of a company’s operations and performance.

Balance Sheet

• The balance sheet is a report of a company’s financial worth in terms of book value. It is broken into three parts to include a company’s assets, liabilities, and shareholder equity.
• Short-term assets such as cash and accounts receivable can tell a lot about a company’s operational efficiency; liabilities include the company’s expense arrangements and the debt capital it is paying off; and shareholder equity includes details on equity capital investments and retained earnings from periodic net income.
• The balance sheet must balance assets and liabilities to equal shareholder equity.

Income Statement

• The income statement breaks down the revenue that a company earns against the expenses involved in its business to provide a bottom line, meaning the net profit or loss.
• The income statement is broken into three parts that help to analyze business efficiency at three different points. It begins with revenue and the direct costs associated with revenue to identify gross profit.
• It then moves to operating profit, which subtracts indirect expenses like marketing costs, general costs, and depreciation. Finally, after deducting interest and taxes, the net income is reached.

Cash Flow Statement

• The cash flow statement provides an overview of the company’s cash flows from operating activities, investing activities, and financing activities.
• Net income is carried over to the cash flow statement, where it is included as the top line item for operating activities.
• The financing activities section includes cash flow from both debt and equity financing.

Techniques of Analysis and Interpretation:

The most important techniques of analysis and interpretation are:

1. Ratio Analysis

2. Fund Flow Analysis

3. Cash Flow Analysis.

1. Ratio Analysis:

Two distinct items on the statements can be compared to one another, and the comparison results in an expression of the relationship as a ratio. For items on the same financial statement or on multiple statements, ratios are calculated. To make these ratios more significant, they are compared to those from previous years and to those from other companies.

An easy mathematical expression is a ratio. Various methods can be used to express ratios. It is a number that has been converted into another number. It is a metric for measuring the relationship between two figures in statistics.

2. Fund Flow Analysis:

The most notable aspect of the development of accounting theory and practise has been funds flow analysis. Only a limited amount of information about a business’s financial activity is provided by its financial statement. The balance sheet displays changes in assets and liabilities, while the income statement only addresses operations.

In fact, this study of static financial statement components is largely what these statements are. The fund movements in the business concern must be studied and analysed in this perspective. The “Statement of Sources and Uses of Funds,” also known as the “Fund Statement” or “Fund Flow Analysis,” is another financial analysis instrument that may be used to conduct such a study or analysis.

3. Cash Flow Analysis:

The Fund Flow Statement is unable to accurately reflect the amount of cash coming in and going out. When we talk about cash, we’re talking about the company’s bank balances at the end of the accounting period as shown on the balance sheet of the company. Similar to inventory and accounts receivable, cash is a current asset. Cash displays its current liquidity situation.

The term cash can be viewed in two senses. In a narrow sense, it includes actual cash in the form of notes and coins and bank drafts held by a firm and the deposits withdrawable on demand the company has held in commercial banks. But in a broader sense, it also includes what are called ‘marketable securities’ which are those securities which can be immediately sold or converted into cash if required.

Cash flow statement is a statement of cash flow and cash flow signifies the movements of cash in and out of a business concern. Inflow of cash is known as sources of cash and outflow of cash is called uses of cash. This statement also depicts factors for such inflow and outflow of cash.

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Advantages of Financial Statements Analysis

The various advantages of financial statement analysis are:

• The government authorities use financial statement analysis to determine the amount of taxes owed by the company.
• Any business can examine its own performance over any time period by looking at its financial accounts.
• The information provided to investors is sufficient for them to decide whether to place their money in a certain company.
• The most significant advantage of financial statement analysis is that it gives investors guidance on whether to invest their money in a particular business.
• Another advantage of financial statement analysis is that regulatory authorities like IASB (International Accounting Standards Board) can ensure the company following the required accounting standards.
• Financial statement analysis is helpful to the government agencies in analyzing the taxation owed to the firm.
• Above all, the company is able to analyze its own performance over a specific time period.

Limitations of Financial Statements Analysis

• Financial analysis does not consider price level changes.
• Financial analysis may be misleading without the knowledge of the changes in accounting procedure followed by a firm.
• Financial analysis is just a study of reports of the company.
• Monetary information alone is considered in financial analysis while non-monetary aspects are ignored.
• The financial statements are prepared on the basis of accounting concept, as such, it does not reflect the current position.

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Conclusion

Analysis of financial statements is extremely important for every business to grow and increase their revenue. It should not be compromised since it increases the efficiency of business operations. Better processes and expert analysts can help in the detailed analysis process.

FAQs

Q1. Which are the basic tools used in financial statement analysis?

Ans. Financial ratios, vertical and horizontal analysis are the three tools used in the analysis of financial statements.

Q2. What techniques are used in the analysis of financial statements?

Ans. Common-Size Statements, Comparative Statements, Trend Analysis, fund flow analysis, cash flow statements and ratio analysis are the techniques used for analysis.

Q3. How do analysts analyze balance sheets?

Ans. Analysts analyze balance sheets by referring to different accounts and their values under assets and liabilities.