ANALYSIS AND INTERPRETATION OF FINANCIAL STATEMENTS NOTES

The term financial statements generally refers to two basic statements : (i) The Income Statement, and (ii) The Balance Sheet. Of course, a business may also prepare a Statement of Retained Earnings, and a Statement of Changes in financial Position in addition to the above two statements.

Financial statements are prepared primarily for decision-making. They

play a dominant role in setting the framework of managerial decisions. But the information provided in the financial statements is not an end in itself as no meaningful conclusions can be drawn from these statements alone. However, the information provided in the financial statements is of immense use in making decisions through analysis and interpretation of financial statements. Financial analysis is the process of identifying the financial strengths and weaknesses of the firm by properly establishing relationship between the items of the balance sheet and the profit and loss account. There are various methods or techniques used in analysing financial statements, such as comparative statements, common-size statements, trend analysis,  schedule of changes in working capital, funds flow, cash flow analysis and ratio analysis.

  • MEANING OF ANALYSIS AND INTERPRETATION OF FINANCIAL STATEMENTS

An analysis of financial statements is the process of critically

examining in detail accounting information given in the financial statements. For the purpose of analysis, individual items are studied, their interrelationships with other related figures are established, the data is sometimes rearranged to have better understanding of the information with the help of different techniques or tools for the purpose. Analysing financial statements is a process of evaluating relationship between component  parts of financial statements to obtain a better understanding of firm’s position and performance. The analysis of financial statements thus refers to the treatment of the information contained in the financial statements in a way so as to afford a full diagnosis of the profitability and financial position of the firm concerned. For this purpose financial statements are classified methodically, analysed and compared with the figures of previous years or other similar firms.

The term ‘Analysis’ and ‘interpretation’ though are closely related,

but distinction can be made between the two. Analysis means evaluating relationship between components of financial statements to understand firm’s performance in a better way. Various account balances appear in the financial statements. These account balances do not represent homogeneous data so it is difficult to interpret them and draw some conclusions. This requires an analysis of the data in the financial statements so as to bring some homogeneity to the figures shown in the financial statements. Interpretation is thus drawing of inference and stating what the figures in the financial statements really mean. Interpretation is dependent on interpreter himself. Interpreter must have experience, understanding and intelligence to draw correct conclusions from the analysed data.

12.3     OBJECTIVES OF FINANCIAL ANALYSIS

Analysis of financial statements is made to assess the financial

position and profitability of a concern. Analysis can be made through accounting ratios, fitting trend line, common size statements, etc. Accounting ratios calculated for a number of years show the trend of the change of position, i.e., whether the trend is upward or downward or static. The ascertainment of trend helps us in making estimates for the future. Keeping in view the importance of accounting ratios the accountant should calculate the ratios in appropriate form, as early as possible, for presentation to management for managerial control. The main objectives of analysis of financial statements are :

  • to assess the profitability of the concern;
  • to examine the operational efficiency of the concern as a whole and of its various parts or departments;
  • to measure the short-term and long-term solvency of the concern for the benefit of the debenture holders and trade creditors;
  • to undertake a comparative study in regard to one firm with another firm or one department with another department; and
  • to assess the financial stability of a business concern.

12.4     TOOLS OF FINANCIAL ANALYSIS

Financial Analyst can use a variety of tools for the purposes of analysis

and interpretation of financial statements particularly with a view to suit the requirements of the specific enterprise. The principal tools are as under :

  1. Comparative Financial Statements
  2. Common-size Statements
  3. Trend Analysis
  4. Cash Flow Statement
  5. Ratio Analysis
  6. Funds Flow statements
  7. Comparative Financial Statements : Comparative financial statements are those statements which have been designed in a way so as to provide time perspective to the consideration of various elements of financial position embodied in such statements. In these statements figures for two or more periods are placed side by side to facilitate comparison.

Both the Income Statement and Balance Sheet can be prepared in the form of Comparative Financial Statements.

  1. a) Comparative Income Statement

The comparative Income Statement is the study of the trend of the

same items/group of items in two or more Income Statements of the firm for different periods. The changes in the Income Statement items over the period would help in forming opinion about the performance of the enterprise in its business operations. The Interpretation of Comparative Income Statement would be as follows:

(i)       The changes in sales should be compared with the changes in cost of goods sold. If increase in sales is more than the increase in the cost of goods sold, then the profitability will improve.

  1. An increase in operating expenses or decrease in sales would imply decrease in operating profit and a decrease in operating expenses or increase in sales would imply increase in operating profit.
  • The increase or decrease in net profit will give an idea about the overall profitability of the concern.

) Comparative Balance Sheet

The comparative Balance Sheet analysis would highlight the trend of

various items and groups of items appearing in two or more Balance Sheets of a firm on different dates. The changes in periodic balance sheet items would reflect the changes in the financial position at two or more periods. The Interpretation of Comparative Balance Sheets are as follows :

  1. i) The increase in working capital would imply increase in the liquidity position of the firm over the period and the decrease in working capital would imply deterioration in the liquidity position of the firm.

(ii) An assessment about the long-term financial position can be made by studying the changes in fixed assets, capital and long-term liabilities. If the increase in capital and long-term liabilities is more than the increase in fixed assets, it implies that a part of capital and long-term liabilities has been used for financing a part of working capital as well. This will be a reflection of the good financial policy. The reverse situation will be a signal towards increasing degree of risk to which the long-term solvency of the concern would be exposed to.

iii) The changes in retained earnings, reserves and surpluses will give an indication about the trend in profitability of the concern. An increase in reserve and surplus and the Profit and Loss Account is an indication of improvement in profitability of the concern. The decrease in these accounts may imply payment of dividends, issue of bonus shares or deterioration in profitability of the concern.

Common-size Financial Statements : Common-size Financial Statements are those in which figures reported are converted into percentages to some common base. In the Income Statement the sale figure is assumed to be 100 and all figures are expressed as a percentage of sales. Similarly in the Balance sheet the total of assets or liabilities is taken as 100 and all the figures are expressed as a percentage of this total.

  1. a) Common Size Income Statement

In the case of Income Statement, the sales figure is assumed to be

equal to 100 and all other figures are expressed as percentage of sales. The relationship between items of Income Statement and volume of sales is quite significant since it would be helpful in evaluating  operational activities of the concern. The selling expenses will certainly go up with increase in sales. The administrative and financial expenses may go up or may remain at the same level. In case of decline in sale, selling expenses should definitely decrease.

Common Size Balance Sheet

For the purpose of common size Balance Sheet, the total of assets or

liabilities is taken as 100 and all the figures are expressed as percentage of the total. In other words, each asset is expressed as percentage to total assets/liabilities and each liability is expressed as percentage to total assets/liabilities. This statement will throw light on the solvency position of the concern by providing an analysis of pattern of financing both long-term and working capital needs of the concern.

Trend Analysis

The third tool of financial analysis is trend analysis. This  is immensely

helpful in making a comparative study of the financial statements of several years. Under this method trend percentages are calculated for each item of the financial statement taking the figure of base year as 100. The starting year is usually taken as the base year. The trend percentages show the relationship of each item with its preceding year’s percentages. These percentages can also be presented in the form of index numbers showing relative change in the financial data of certain period. This will exhibit the direction, (i.e., upward or downward trend) to which the concern is proceeding. These trend ratios may be compared with industry ratios in order to know the strong or weak points of a concern. These are calculated only for major items instead of calculating for all items in the financial statements.

While calculating trend percentages, the following precautions may

be taken :

  • The accounting principles and practices must be followed constantly over the period for which the analysis is made. This is necessary to maintain consistency and comparability.
  • The base year selected should be normal and representative year. (c) Trend percentages should be calculated only for those items which have logical relationship with one another.
  • Trend percentages should also be carefully studied after considering the absolute figures on which these are based. Otherwise, they may give misleading conclusions.
  • To make the comparison meaningful, trend percentages of the current year should be adjusted in the light of price level changes as compared to base year.

Cash Flow Statement

A cash flow statement shows an entity’s cash receipts classified by

major sources and its cash payments classified by major uses during a period. It provides useful information about an entity’s activities in generating cash from operations to repay debt, distribute dividends or reinvest to maintain or expand its operating capacity; about its financing activities, both debt and equity; and about its investment in fixed assets or current assets other than cash. In other words, a cash flow statement lists down various items and their respective magnitude which bring about changes in the cash balance between two balance sheet dates. All the items whether current or non-current which increase or decrease the balance of cash are included in the cash flow statement. Therefore, the effect of changes in the current assets and current liabilities during an accounting period on cash position, which is not shown in a fund flow statement is depicted in a cash flow statement. The depiction of all possible sources and application of cash in the cash flow statement helps the financial manager in short term financial planning in a significant manner because the short term business obligations such as trade creditors, bank loans, interest on debentures and dividend to shareholders can be met out of cash only.

The preparation of cash flow statement is also consistent with the

basic objective of financial reporting which is to provide information to investors, creditors and others which would be useful in making rational decisions. The basic objective is to enable the users of information to make prediction about cash flows in an organisation since the ultimate success or failure of the business depends upon the amount of cash generated. This objective is sought to be met by preparing a cash flow statement.

DISTINCTION BETWEEN FUND FLOW STATEMENT AND CASH FLOW

STATEMENT

Some of the main difference between a fund flow statement and a

cash flow statement are described below :

  1. Concept of funds : A fund flow statement is prepared on the basis of a wider concept of funds i.e., net working capital (excess of current assets over current liabilities) whereas cash flow statement is based upon narrower concept of funds i.e., cash only.
  2. Basis of accounting : A fund flow statement can also be distinguished from a cash flow statement from the point of view of the basis of accounting used for preparing these statements. A fund flow statement is prepared on the basis of accrual basis of accounting, whereas a cash flow statement is based upon cash basis of accounting. Due to this reason, adjustments for incomes received in advance, incomes outstanding, prepaid expenses and outstanding expenses are made to compute cash earned from operations of the business (refer to computation of cash from operations). No such adjustments are made while computing funds from operations in the funds flow statement.
  3. Mode of preparation : A fund flow statement depicts the sources and application of funds. If the total of sources is more than that of applications then it represents increase in net working capital. On the other hand if the total of applications of funds is more than that of sources then the difference represents decrease in net working capital. A cash flow statement depicts opening and closing balance of cash, and inflows and outflows of cash. In a cash flow statement, to the opening balance of cash all the inflows of cash are added and from the resultant total all the outflows of cash are The resultant balance is the closing balance of cash. A cash flow statement is just like a cash account which starts with opening balance of cash on the debit side to which receipts of cash are added and from the resultant total, the total of all the payments of cash (shown on the credit side) is deducted to find out the closing balance of cash.
  4. Treatment of current assets and current liabilities : While preparing a funds flow statement the changes in current assets and current liabilities are not disclosed in the funds flow statement rather these changes are shown in a separate statement known as schedule of changes in working capital. In a cash flow statement no distinction is made between current assets and fixed assets, and current liabilities and long-term liabilities. All changes are summarised in the cash flow statements.
  5. Usefulness in planning : A cash flow statement aims at helping the management in the process of short term financial planning. A cash flow statement is useful to the management in assessing its ability to meet its short term obligations such as trade creditors, bank loans, interest on debentures, dividend to shareholders and so on. A fund flow statement on the other hand is very helpful in intermediate and long-term planning, because though it is difficult to plan cash resources for two, three or more years ahead yet one can plan adequate working capital for future periods.

Uses and Importance of Cash Flow Statements

Cash flow statements are of great importance to a financial manager. The information contained in cash flow statement can help the management in the field of short-run financial planning and cash control. Some of the important advantages of cash flow statements are discussed below :

1) The projected cash flow statements if prepared in a business disclose surplus or shortage of cash well in advance. This helps in arranging utilisation of surplus cash as bank deposits or investment in marketable securities for short periods. Should there be shortage of cash, arrangement can be mode for raising the bank loan or sell marketable securities.

  1. Cash flow statements are of extreme help in planning liquidation of debt, replacement of plant and fixed assets and similar other decisions requiring outflow of cash from the business as they provide information about the cash generating ability of the business.
  2. The cash flow statement pertaining to a particular year compared with the budget for that year reveals the extent to which the actual sources and applications of cash were in consonance with the budget. This exercise helps in refining the planning process in future.
  3. The inter-firm and temporal comparison of cash flow statements reveals the trend in the liquidity position of a firm in comparison to other firms in the industry. It can serve as a pointer to the need for taking corrective action if it is observed that the management of cash in the firm is not effective.
  4. Cash flows statements are more useful in short term financial analysis as compared to fund flow statements since in the short run it is cash which is more important for executing plans rather than working capital.

Limitations of Cash flow Statements

  1. The possibility of window dressing in cash position is more than in the case of working capital position of a business. The cash balance can easily be maneuvered by deferring purchases and other payments, and speeding up collections from debtors before the balance sheet date. The possibility of such maneuvering is lesser in respect of working capital position. Therefore a fund flow statement which shows reasons responsible for the changes in the working capital presents a more realistic picture than cash flow statement.
  2. The liquidity position of a business does not depend upon cash position only. In addition to cash it is also dependent upon those assets also, which can be converted into cash. Exclusion of these assets while assessing the liquidity of a business obscures the true reporting of the ability of the business in meeting it liabilities on becoming due for payment.
  3. Equating of cash generated from the operations of the business with the net operating income of the business is not fair because while computing cash generated from business operations, depreciation on fixed assets is excluded. This treatment leads to mismatch between the expenses and revenue while determining the business results as no charge is made in the profit and Loss account for the use of fixed assets.
  4. Relatively larger amount of cash generated from business operations vis-avis net profit earned may prompt the management to pay higher rate of dividend, which in turn may affect the financial health of the firm adversely.

PROCEDURE FOR PREPARING A CASH FLOW STATEMENT

Cash flow statement shows the impact of various transactions on cash

position of a firm. It is prepared with the  help of financial statements, i.e., balance sheet and profit and loss account and some additional information. A cash flow statement starts with the opening balance of cash and balance at bank, all the inflows of cash are added  to the opening balance and the outflows of cash are deducted from the total. The balance, i.e, opening balance of  cash and bank balance plus inflows of cash minus outflows of cash is reconciled with the closing balance of cash. The preparation of cash flow statement involves the determining of :

  • Inflows of cash.
  • Outflows of cash.

(a)         Sources of Cash Inflows :

The main sources of cash inflows are :

  • Cash flow from operations.
  • Increase in existing liabilities or creation of new liabilities.
  • Reduction in or Sale of Assets.
  • Non-trading Receipts.

(b)         Application of Cash

  • Cash lost in operation.
  • Decrease in or discharge of liabilities.
  • Increase in or purchase of assets.
  • Non-trading payments.

Generally, cash flow statement is prepared in two forms :

  • Report form
  • T Form or an Account Form or Self Balancing Type

SPECIMEN OF REPORT FORM OF CASH FLOW STATEMENT

  Cash balance in the beginning Rs.

Add : Cash inflows :

Cash flow from operations

Sale of assets

Issue of shares

Issue of debentures

Raising of loans

Collection from debtors

Non trading receipts such as :

Dividend received

Income tax refund

Less : Applications or Outflows of cash :

Redemption of Preference shares

Redemption of debentures

Repayment of loans

 
   
   
Purchase of assets

Payment of dividend

Payment of taxes

Cash lost in operations

Cash Balance at the end

   
   

SPECIMEN OF T FORM OR AN ACCOUNT OF CASH FLOW STATEMENT

  Rs.   Rs.
Cash balance in the beginning   Outflow of Cash :  
Add : Cash inflows :   Redemption of Preference  
Cash flow from operation   Shares  
Sale of Assets   Redemption of Debentures  
Issue of Shares   Repayment of Loans  
Issue of Debentures   Purchase of Assets  
Raising of Loans   Payment of Dividends  
Collection from Debtors   Payment of Tax  
Dividends Received   Cash lost in Operations  
Refund of tax   Cash Balance at the end  
   

SOURCE OF CASH INFLOWS

  1. Cash from Operations or Cash Operating Profit

Cash from trading operations during the year is a very important source

of cash inflows. The net effect of various transactions in a business during a particular period is either net profit or net loss. Usually, net profit results in

inflow of cash and net loss in outflow of cash. But it does not mean that cash generated from trading operations in a year shall be equal to the net profit

or that cash lost in operations shall be identical with net loss. It may either be more or less. Even, there may be a net loss in a business, but yet there may

be a cash inflow from operations. It is so because of certain non-operating (expenses or incomes) charged to the income statement, i.e., Profit and Loss Account.

How to Calculate Cash from Operations or Cash Operating Profit ?

There are three methods of determining cash from operations :

  • From Cash Sales : Cash from operations can be calculated by deducting cash purchases and cash operating expenses from cash sales, i.e. Cash from Operations=

(Cash Sales) – (Cash Purchases + Cash Operating Expenses).

Cash sales are calculated by deducting credit sales or increase in

receivables from the total sales. From the cash sales, the cash purchases and cash operating expenses are to be deducted. In the absence of any

information, all expenses may be assumed to be cash expenses. In case outstanding and prepaid expenses are known/given, any decrease in

outstanding expenses or increase in prepaid expenses should be deducted from the corresponding figure.

  • From Net Profit/Net Loss

Cash from operations can also be calculated with the help of net profit

or net loss. Under this method, net profit or net loss is adjusted for non-cash and non-operating expenses and incomes as follows :

Calculation of Cash From Trading Operations

Amount

Net Profit (as given)

Add : Non cash and Non-operating items which have already been debited to P & L A/c :

Depreciation

Transfer to Reserves

Transfer to Provisions

Goodwill written off

Preliminary expenses written off

Other intangible assets written off

Loss on sale or disposal of fixed assets

Increase in Accounts Payable

Increase in outstanding expenses

Decrease in prepaid expenses

Less : Non-cash and Non-operating items which have already been credited to P & L A/c :

Increase in Accounts Receivables

Decrease in Outstanding Expenses

Increase in Prepaid Expenses

Cash from Operations

(C)        Cash Operating Profit

Cash operating profit is also calculated with the help of net profit or

net loss. The difference in this method as compared to the above discussed method is that increase or decrease in accounts payable and

accounts receivable is not adjusted while finding cash from operations and it is directly shown in the cash flow statement as an inflow or outflow

of cash as the cash may be. The cash from operations so calculated is generally called operating profit.

 Calculation of Cash Operating Profit Amount
Net Profit (as given) or Closing Balance of Profit and Loss A/c Add : Non-cash and non-operating items which have already been debited to P& L A/c :

Depreciation

Transfers to Reserves and Provisions

Writing off intangible assets

Outstanding Expenses (current year)

Prepaid Expenses (previous year) Loss on Sale of fixed Assets Dividend Paid, etc.

Less : Non-cash and non-operating items which have already been credited to P& L A/c :

Profit on Sale or disposal of fixed assets

Non-trading receipts such as dividend received, rent received, etc.

Re-transfers from provisions excess provisions charged back)

Outstanding income (current year)

Pre-received income (in previous year)

Opening balance of P&L A/c

Cash Operating Profit

 

(

Note: Generally the cash operating profit method has to be  followed because of its similarity with calculating funds from operations. However, if this method is followed the following two points need particular care :

  • Outstanding/Accrued Expenses : The outstanding/accrued expenses represent those expenses which are although charged to profit and loss account but no cash in paid during the year. For this reason, outstanding/accrued expenses of the current year are added back while calculating cash operating profit. However if some outstanding expenses of the previous year are also given, these may be assumed to have been paid during the year and hence shown as an outflow of cash in the cash flow statement.
  • Prepaid Expenses : Prepaid expenses are those expenses which are paid in advance and hence result in the outflow of cash but are not charged to profit and loss account because they do not relate to the current period of profit and loss account. For this reason, prepaid expenses of the current year should be taken as an outflow of cash in the cash flow statement. But the expenses, if any, paid in the previous year do not involve outflow of cash in the current year but are charged to profit and loss account. Therefore, prepaid expenses of the previous year (related to the current year) should be added back while calculating cash operating profit. In the similar way, we can deal with outstanding and pre-received incomes.

Increase in Existing Liabilities or Creation of new Liabilities

If there is an increase in existing  liabilities or a new liability is created

during the year, it results in the flow of cash into the business. The liability may be either a fixed long-term liability such as equity share capital, preference share capital, debentures, long-term loans, etc. or a current liability such as sundry creditors, bills payable, etc.

The inflow of cash may be either Actual of Notional

There is an actual inflow of cash when cash is actually received and

generally long-term liabilities result into actual inflow of cash, e.g. For issue of Shares, during the year, the journal entry shall be

Cash A/c                                               Dr.

To Share Capital A/c

So, actual cash flows into the business. In the same manner, issue of

debentures, raising of loans for cash, etc. result into actual inflows of cash. But when the fixed liabilities are created in consideration of purchase of assets, i.e., other than cash, there is no inflow of actual cash. The journal entry for the issue of debentures in lieu of purchase of machinery is :

Plant and Machinery A/c              Dr.

To Debentures A/c

Usually, current liabilities result into inflow of notional cash. For example, increase in sundry creditors implies purchase of goods on credit. In this case although no cash in actually received but we may say that creditors have given us loans which have been utilised in purchasing goods from them. Hence, increase in the current  liabilities may be taken as a source of inflow of cash and decrease in current liabilities as an outflow of cash.

  1. Reduction in or Sale of Assets

Whenever a reduction in or sale of any asset-fixed or current-takes

place (otherwise than depreciation) it results into inflow of actual or notional cash. There is an actual inflow of cash when assets are sold for cash and notional cash flows in when assets are sold or disposed off on credit. Thus, sale of building, machinery or even reduction in current assets like stocks, debtors, etc. result in inflow of actual notional cash.

  1. Non-Trading Receipts

Sometimes, there may be non-trading receipts like dividend received,

rent received, refund of tax, etc. Such receipts or incomes are although non-trading in nature but they result into inflow of cash and hence taken in the cash flow statement.

APPLICATIONS OF CASH OR CASH OUTFLOWS

  1. Cash Lost in Operations : Sometimes the net result of trading in a particular period is a loss and some cash may be lost during that period in trading operations. Such loss of cash in trading in called cash lost in operations and is shown as an outflow of cash in Cash Flow Statement.
  2. Decrease in or Discharge of Liabilities :Decrease in or discharge of any liability, fixed or current results in outflow of cash either actual or notional. For example, when redeemable preference shares are redeemed and loans are repaid, it will amount to an outflow of actual cash. But when a liability is converted into another, such as issue of shares for debentures, there will be a notional flow of cash into the business.
  3. Increase in or Purchase of Assets : Just like decrease in or sale of assets is a source or inflow of cash, increase or purchase of any assets is a outflow or application of cash.
  4. Non Trading Payments : Payment of any non-trading expenses also constitute outflow of cash. For example, payment of dividends, payment of incometax, etc.
  • SUMMARY

An analysis of financial statements is the process of critically examining in detail accounting information given in the financial statements. For the purpose of analysis, individual items are studied, their interrelationships with other related figures are established, the data is sometimes rearranged to have better understanding of the information with the help of different techniques or tools for the purpose. Analysing financial statements is a process of evaluating relationship between component parts of financial statements to obtain a better understanding of firm’s position and performance. The principal tools of financial analysis include comparative financial statements, common size statements, trend analysis, cash flow statements, ratio analysis and fund flow statements.

  • KEYWORDS

Financial statement: Financial statements refers to formal and original statements which are prepared to disclose financial health in the terms of profits, position, and prospects as on a certain data.

Analysis of financial statement: It refers to the art of applying various tools to know the behaviour of the accounting information.

Interpretation of financial statement: This refers to evaluating the performance of the business.

Comparative financial statements: These enable comparison of financial information for two or more years placed side by side.

Trend analysis: Trend analysis can be defined as the index numbers of the movements of the various financial items on the financial statement for a number of periods.

Cash flow statement: It is a statement designed to highlight upon the causes which brings changes in cash position between two balance sheet dates.

12.7     SELF ASSESSMENT QUESTIONS

  1. What do you mean by analysis of financial statements? Discuss the different methods used for the analysis and interpretation of financial statements.
  2. What are comparative statements? What is their usefulness ?
  3. What is meant by common-size statements? What purpose do they serve ?
  4. How common-size statements are different from comparative statements ?
  5. Distinguish between fund flow and cash flow statements. What are the advantages of preparing cash flow statements ?
  6. Explain the different formats for preparing a cash flow statement. How this statement can be used as a tool for planning and control?

 

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