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Analysis of Financial Statements

Last updated date: 27th May 2024
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What are Financial Statements?

Financial statements are used by investors and business analysts to evaluate the earning potential and growth of a company. This consists of three major components of a business. They are the Profit and Loss A/c, Income and Expenditure A/c, and Balance Sheet. These three reports together are analyzed to find out the overall financial health of a business. 

The basic analysis of financial statements depends on the information extracted from the financial statements to calculate other ratios. 

Financial Ratios Analysis 

The fundamental financial ratios required for the analysis of financial statements are listed below:

1. Working Capital Ratio – This is an important measure of financial health that reveals the company’s capacity to pay its liabilities with its current assets. The calculation of this ratio is made by dividing current assets by current liabilities.

2. Quick Ratio – This shows how far current liabilities could be covered by cash and by materials with cash value.

3. Earnings per Share (EPS) – This measures the net income earned from every share of the company’s common stock. 

4. Price-Earnings (P/E) Ratio – This shows the investors’ assessments of future earnings. This is obtained by dividing the share price of the company’s stock by EPS.

5. Debt-Equity Ratio - This has to be analyzed with respect to industry norms and company-specific requirements

6. Return on Equity (ROE) – This has to be calculated by subtracting preferred dividends from the company’s net earnings and divide by common equity dollars in the company.

When these ratios are properly applied, using any one of them can help improve the company’s investing performance. The financial ratios analysis helps to pick stocks for investment portfolios.

The Objective of Financial Statement Analysis

The main objective is to give a clear picture of the financial position, performance, and further changes that are useful in making economic decisions. The statements should be clear, relevant, reliable, good and comparable

Financial Ratio Analysis and Interpretation

Analysing and interpreting financial ratios is rather logical while we don’t need to look at the numbers. This analysis is performed by comparing items in the financial statements. And then the interpretation is done with the result of the analyses rather than depending on the items separately.

Financial ratios of business are classified into ratios that measure the profitability, liquidity, management efficiency, leverage, and valuation & growth.

Analysis and interpretation of financial statements can also be defined as an experiment to reveal the significance of the financial statement so that the prospects for earnings, ability to pay liabilities, and profitability of the business in the future.

Financial Reporting and Analysis of Financial Statements

Financial Analysis and reporting is a major part of financial analysis carried out by various business enterprises in India and across the world. It reveals the financial health of any business and helps them to strengthen their financial resources and management of generated funds effectively.

There are so many techniques that are commonly used for financial statement analysis namely Vertical, Horizontal, Leverage, Growth, Profitability, Liquidity, Efficiency, Cash Flow, Rates of Return, Valuation, Variance, and Scenario & Sensitivity

But the three major techniques used are horizontal analysis, vertical analysis, and ratio analysis.

Horizontal Balance Sheet

A horizontal balance sheet shows assets on the right column, and the liabilities are shown on the left. The assets of a company include both tangible and intangible or either of them. The assets that are physically seen are referred to as tangible assets. The horizontal analysis of financial statements is represented in the following figure:

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Methods of Financial Statement Analysis

The various techniques of financial statement analysis are listed below:

  1. Comparative Statement or Comparative Financial and Operating Statements.

  2. Common Size Statements.

  3. Trend Ratios or Trend Analysis.

  4. Average Analysis.

  5. Statement of Changes in Working Capital.

  6. Fund Flow Analysis.

  7. Cash Flow Analysis.

  8. Ratio Analysis.

  9. Cost Volume Profit Analysis

Financial Statement Analysis Project

Project on financial statement analysis ratios is prepared by students to improve their technical, analytical, and communication skills to forecast the economic decisions and discuss the company’s ability to perform and be successful.

FAQs on Analysis of Financial Statements

1. What is a Common Size Financial Statement?

A common size financial statement shows the items as a percentage of a common figure, total sales revenue, etc. This type of statement permits easy analysis and interpretation between companies, or even between periods, for the same company. Common size statements are generally prepared for the income and expenditure account and balance sheet. To calculate common-size percentages the steps will be dividing the Amount by the base Amount and the result is then multiplied by 100 to get a percentage. The entries are displayed as a percentage of a common base figure that is numerical figures. On the balance sheet, the base will be total assets and on the income statement, the base will be net sales in a common-size statement.

2. Tell about Comparative Statement Analysis

A Comparative Financial Statement analysis gives data to assess the direction of change in the business. A financial statement generally shows the financial health of a business for a particular accounting period, whereas the top-level management needs to know the condition and the direction of the business whether it is favourable or not. For this, comparing the figures for the current year and the previous years has to be analyzed. For better forecasting, the comparative statement is prepared and analyzed. It is also referred to as Horizontal analysis. This enables the identification of major developments and weaknesses. There are several types of comparative statement analysis but the distinguished four types are individualizing, universalizing, variation-finding, and encompassing.