STuDY ON FINANCIAL STATEMENT ANALYSIS AT PM TECHNO PVT.

LTD

Chapter 02
Theoretical background
Financial statement analysis is a critical process used by various stakeholders, such as
investors, creditors, and management, to evaluate the financial health and performance of a
company. It involves the examination and interpretation of a company’s financial statements,
which typically include the balance sheet, income statement, statement of cash flows, and
statement of changes in equity.

Business is mainly concerned with the financial activities. In order to ascertain the financial
status of the business every enterprise prepares certain statements, known as financial
statements. Financial statements are mainly prepared for decision making purposes. But the
information as is provided in the financial statements is not adequately helpful in drawing a
meaningful conclusion. Thus, an effective analysis and interpretation of financial statements
is required. Analysis means establishing a meaningful relationship between various items of
the two financial statements with each other in such a way that a conclusion is drawn. By
financial statements we mean two statements:

(i) Profit and loss Account or Income Statement

(ii) Balance Sheet or Position Statement

These are prepared at the end of a given period of time. They are the indicators of
profitability and financial soundness of the business concern. Financial statement analysis is
an exceptionally powerful tool for a variety of users of financial statements, each having
different objectives in learning about the financial circumstances of the entity.

Overall, a central focus of financial analysis is evaluating the company’s ability to earn a
return on its capital that is at least equal to the cost of that capital, to profitably grow its
operations, and to generate enough cash to meet obligations and pursue opportunities.

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2.1 Meaning of financial statement analysis

Properly comparing a balance sheet with the corresponding profit and loss account to
determine the strengths and weaknesses of a business describes financial statement analysis.
Financial analysis determines a company's health and stability. The data gives you an
intuitive understanding of how the company conducts business. Stockholders can find out
how management employs resources and whether they use them properly. Governments and
regulatory authorities use financial statements to determine the legality of a company's fiscal
decisions and whether the firm is following correct accounting procedures. Finally,
government agencies, such as the Internal Revenue Service, use financial statement analysis
to decide the correct taxation for the company.

2.2 Objectives of financial statement analysis

The term financial analysis is also known as analysis and interpretation of financial
statements. It refers to the establishing meaningful relationship between various items of the
two financial statements i.e. Income statement and position statement. It determines financial
strength and weaknesses of the firm. Analysis of financial statements is an attempt to assess
the efficiency and performance of an enterprise. Thus, the analysis and interpretation of
financial statements is very essential to measure the efficiency, profitability, financial
soundness and future prospects of the business units.

Financial analysis serves the following purposes.

 Measuring the profitability

The main objective of a business is to earn a satisfactory return on the funds invested
in it. Financial analysis helps in ascertaining whether adequate profits are being
earned on the capital invested in the business or not. It also helps in knowing the
capacity to pay the interest and dividend. .

 Indicating the trend of Achievements

Financial statements of the previous years can be compared and the trend regarding
various expenses, purchases, sales, gross profits and net profit etc. can be ascertained.
Value of assets and liabilities can be compared and the future prospects of the
business can be envisaged.

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 Assessing the growth potential of the business

The trend and other analysis of the business provide sufficient information indicating
the growth potential of the business.

 Comparative position in relation to other firms

The purpose of financial statements analysis is to help the management to make a
comparative study of the profitability of various firms engaged in similar businesses.
Such comparison also helps the management to study the position of their firm in
respect of sales, expenses, profitability and utilizing capital, etc.

 Assess overall financial strength

The purpose of financial analysis is to assess the financial strength of the business.
Analysis also helps in taking decisions, whether funds required for the purchase of
new machines and equipment are provided from internal sources of the business or
not if yes, how much? And also to assess how much funds have been received from
external sources.

 Assess solvency of the firm

The different tools of an analysis tell us whether the firm has sufficient funds to meet
its short term and long-term liabilities or not.

2.3 Procedure of financial statement analysis

A common procedure is followed for financial statement analysis. Such procedure is

briefly explained below.

 Objective of Analysis:
The objective of analysis is differing from one interested party to another. In
other words, the user of financial statement analysis fixes or determines the objectives
of analysis.

 Decide the Extent of Analysis:

The extent of analysis is also decided by the interested party. For example:
Shareholder considers long term solvency of the business concern. The debenture
holder considers short term solvency of the business concern.

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 Scope of Analysis:
It means that an analyst should determine the depth of the analysis. This can be
decided depending upon the nature of problem.

 Going through the Financial Statements:

The analyst should go through every item of the financial statements. If not so,
the hidden facts cannot be found out through analysis. v. Pooling of Relevant Data:
The analyst should collect relevant data from the financial statements. If not so,
he/she can get relevant information from the published financial statements.

 Rearrangement of Financial Data:

The contents of the financial statements are rearranged before making actual
analysis and interpretation. Under this step, approximation of figures, consolidation of
items etc. is done. vii. Understanding: The analyst should go through financial
documents and other documents for clearly understand the problem.

 Classification:
After understanding the problem, the collected relevant data are to be classified
according to the needs of the problem to find out a correct solution.

 Analysis:
After making above preparation, actual analysis is done. Any one of the tools or
techniques of financial statement analysis can be used.

 Interpretation and Conclusion:

The interpretation is made and the inferences are drawn only on the basis of
analysis.

 Report Form:
All the inferences and interpretation should be presented in a report form to the
management

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2.4 Type of financial statement analysis

There are two key methods for analysing financial statements. The first method is the use
of horizontal and vertical analysis. Horizontal analysis is the comparison of financial
information over a series of reporting periods, while vertical analysis is the proportional
analysis of a financial statement, where each line item on a financial statement is listed as
a percentage of another item. Typically, this means that every line item on an income
statement is stated as a percentage of gross sales, while every line item on a balance sheet
is stated as a percentage of total assets. Thus, horizontal analysis is the review of the
results of multiple time periods; while vertical analysis is the review of the proportion of
accounts to each other within a single period. The following links will direct you to more
information about horizontal and vertical analysis:

 Horizontal analysis:
Horizontal Analysis (also known as Trend Analysis) is a financial analysis
method that involves comparing financial data over a series of periods. This
analysis looks at the changes in financial statement items, such as revenues,
expenses, assets, or liabilities, over time.
 Vertical analysis:
Vertical analysis is a financial analysis method that involves expressing each
item on a financial statement as a percentage of a key figure within the same
statement.
 Ratio Analysis:
Ratio analysis involves calculating and interpreting financial ratios to assess
various aspects of a company’s performance, including liquidity, profitability,
efficiency, and solvency.
 Cash Flow Analysis:
Cash flow analysis focuses on the cash inflows and outflows reported in the
cash flow statement. It assesses how well a company generates cash to meet its
obligations and fund its operations.

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 Common-Size Analysis:
Common-size analysis is a variation of vertical analysis where financial
statements are standardized by converting all figures into percentages. This
allows for easier comparison across companies and industries.
 Benchmarking:
Benchmarking involves comparing a company's financial metrics to those
of industry standards or leading competitors to assess relative performance.
 Trend Analysis:
Trend analysis looks at financial data over time to identify patterns or
trends. This can involve both horizontal and vertical analyses.

Each type of financial statement analysis provides a unique perspective on a

company's financial health and operational effectiveness. Using these analyses
together offers a comprehensive understanding of a company’s financial position
and performance.

2.5 Types of Ratio Analysis

 Liquidity ratios.
Liquidity ratios assess a company’s ability to meet its short-term
obligations using its most liquid assets. These ratios are crucial for evaluating
whether a company can quickly convert its assets into cash to pay off its current
liabilities. This is the most fundamentally important set of ratios, because they
measure the ability of a company to remain in business.
 Market ratio.
Market ratios relate the company’s financial statements to its stock market
performance, helping investors understand the relationship between the
company’s financial health and its stock price.
 Activity ratios / Efficiency ratio.
Efficiency ratios measure how well a company utilizes its assets and
manages its operations. These ratios are used to assess the effectiveness of a
company’s resource management. These ratios are a strong indicator of the
quality of management, since they reveal how well management is utilizing
company resources.

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 Leverage ratio / Solvency ratio.

Solvency ratios, also known as leverage ratios, assess a company’s ability
to meet its long-term debt obligations. These ratios provide insight into the
company’s capital structure and financial stability. These ratios reveal the extent
to which a company is relying upon debt to fund its operations, and its ability to
pay back the debt.
 Coverage ratio.
Coverage ratios assess a company’s ability to service its debt and cover its
fixed obligations, such as interest payments or dividends.
 Profitability ratios.
Profitability ratios evaluate a company’s ability to generate income
relative to revenue, assets, equity, or other financial metrics. These ratios provide
insight into how well a company is using its resources to generate profit. These
ratios measure how well a company performs in generating a profit.

2.5 Sources of financial information

Published financial statements provide the primary source of data about any
organization’s financial condition and performance. A company’s annual report, quarterly
reports, and financial news releases provide a wealth of information about the firm. A
brief discussion is given below.
 Annual Reports:
 Management Discussion and Analysis (MD&A):
This section of the annual report gives management’s perspective on the
company's financial condition, results of operations, and future outlook. It
provides context beyond the raw numbers, including strategic plans and risks.
 Financial Highlights:
Summarizes key financial metrics such as revenue, profit margins, and
earnings per share. It offers a quick overview of the company's financial
performance over the year.
 Quarterly Reports:

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These reports provide interim financial statements and updates on the

company's performance for each quarter of the fiscal year. They include unaudited
financial statements and management discussion, offering timely insights into recent
developments and trends.
 Financial Statements:
 Income Statement:
This statement details a company’s revenues, expenses, and profits or
losses over a specific period. It helps assess the company’s profitability and
performance by showing how revenue is converted into net income.
 Balance Sheet:
Provides a snapshot of a company’s assets, liabilities, and shareholders'
equity at a particular date. It helps evaluate the company's financial position and
capital structure.
 Cash Flow Statement:
Reports cash inflows and outflows from operating, investing, and financing
activities. It is crucial for understanding the company’s liquidity and cash
management.
 Earnings Releases:
 Press Releases:
Companies issue press releases to announce their earnings results, providing
initial insights into performance and significant developments. These releases
often include key metrics and commentary from management.
 Investor Presentations:
 Slide Decks:
Presentations made to investors that typically include financial results,
business strategy, and outlook. They are used to communicate key information in
a structured and visual format.

 Industry Reports:

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 Market Research Reports:

Provide insights into industry trends, market size, and growth projections.
They help contextualize a company's performance within its industry.
 Analyst Reports:
Produced by financial analysts, these reports offer detailed analyses and
forecasts about companies and industries, providing expert opinions and
recommendations.

 Stock Exchanges:
 Filings and Reports:
Publicly traded companies must file reports with the stock exchanges where
their shares are listed, such as the NYSE or NASDAQ. These filings include
annual and quarterly reports, and they ensure transparency and compliance with
exchange regulations.
Stock exchanges maintain a library of annual reports of companies. They
publish consolidated reports of company’s performance.
 Credit Rating Agencies:
Credit Reports: Issued by agencies like Moody’s, S&P, and Fitch, these reports
assess a company's creditworthiness and risk profile. They provide an independent
evaluation of the company's ability to meet its debt obligations.
 Professional Services Firms:
 Audit Reports:
External auditors provide independent assessments of a company's
financial statements, ensuring accuracy and compliance with accounting
standards. These reports add credibility to the financial statements.
 Financial Databases and Platforms
 Bloomberg, Reuters, Yahoo Finance:
These platforms offer extensive databases of financial information,
including real-time data, historical financials, and analytical tools. They are
valuable for detailed financial analysis and research.

 Business Periodicals:

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Business newspapers such as Business Standard, Economic Times; business

magazines such as Business India, Business World, Dalal Street Journal are also
source of financial information.
2.6 Role of financial statement analysis

Financial Analysts use the company’s financial statements (i.e. income statement,
balance sheet and cash flow statements). One of the most common approaches is to use
financial ratios (e.g. profitability ratios, debt ratios) to compare against those of another
company or against the company’s own historical performance.

The Financial Analyst researches and models macroeconomic and microeconomic

conditions and company fundamentals to make business, sector and industry
recommendations and decisions. The Financial Analyst collects and analysis financial
information such as budgets, operations performance data, economic forecasts, trading
volumes and cash flow to provide advice for their company or their company’s clients.

 Investment Decision-Making:
Investors use financial statement analysis to assess a company's profitability, growth
potential, and risk levels, helping them decide whether to buy, hold, or sell a
company's stock or other securities.
 Credit Evaluation:
Creditors and lenders analysis financial statements to evaluate a company's
creditworthiness and ability to repay loans. This helps in determining the terms and
conditions of credit.
 Performance Assessment:
Management uses financial statement analysis to monitor the company's performance
against goals, industry benchmarks, and competitors. This analysis aids in strategic
planning, budgeting, and operational adjustments.
 Valuation:
Analysts and investors use financial statement analysis to determine a company's
intrinsic value, aiding in mergers, acquisitions, and other corporate finance activities.

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 Regulatory Compliance:

Regulators and auditors use financial statement analysis to ensure companies comply
with financial reporting standards and detect any potential fraud or accounting
irregularities.
 Stakeholder Communication:

Financial statements provide a transparent view of a company's financial status,

helping communicate its health to stakeholders, including shareholders, employees,
and the public.

2.7 Users of financial statement analysis

The various users of financial statement analysis include:

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 Management of the company:

The topmost priority of the board of directors and senior management is in the
financial performance of their organisation. For the board and management, the
finance department of the company does an ongoing analysis of the company’s
financial statements, particularly operational metrics that aren’t seen by external
entities.

 Investors:
The prospective investors scrutinize the health of the organization by performing due
diligence using analysis of the financial statements to understand the company’s
ability to continue as a going concern, issue dividends, generate cash flows and ensure
that the company continues to grow at least at the historical or current rate.

 Creditors:
A creditor or anyone for that matter, who has provided funds to the company will be
interested to know the ability of the company to pay back the debt and obligation, and
their cash management measures.

 Regulatory authorities:
In cases of publicly held or listed companies, the Securities and Exchange Board of
India (SEBI) examines their financial statements to see if the statements conform to
accounting standards as well as the SEBI rules and guidelines. In addition, financial
statements are to be filed with ROC and Tax authorities.

 Shareholders or members:
Audited financial statements are to be placed before shareholders in annual meetings
and have to be adopted or approved by the shareholder members.

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2.8 Limitations of financial statement analysis

Although analysis of financial statement is essential to obtain relevant information for
making several decisions and formulating corporate plans and policies, it should be
carefully performed as it suffers from a number of the following limitations.

 Historical Data:
Financial statements reflect past performance and may not be indicative of future
trends or conditions. Decisions based solely on historical data might not account for
upcoming changes in the market or the business environment.
 Subjectivity in Estimates:
Many elements in financial statements are based on estimates, such as depreciation,
provisions for bad debts, and inventory valuation. These estimates involve judgment
and can vary significantly between companies, affecting comparability and accuracy.
 Different Accounting Methods:
Companies can choose different accounting policies (e.g., depreciation methods,
inventory valuation techniques), which can lead to variations in financial results. This
can make it difficult to compare companies directly, even within the same industry.
 Omission of Non-Financial Information:
Financial statements do not capture non-financial factors like customer satisfaction,
employee engagement, brand value, or innovation capacity, which are crucial for a
company's long-term success.
 Potential for Manipulation:
Companies might engage in "window dressing" or other practices to make their
financial statements appear more favorable. This can include timing revenue
recognition, deferring expenses, or other accounting tricks to meet financial targets.
 Impact of Inflation:
Financial statements are typically not adjusted for inflation, which can distort the true
financial position and performance, especially over longer periods or in high-inflation
environments.

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 Limited Forward-Looking Information:

Financial statements primarily focus on past performance and do not provide forward-
looking information like projections, future plans, or market outlooks, which are
important for making informed decisions.
 Comparability Issues:
Differences in accounting standards (e.g., IFRS vs. GAAP) and practices across
countries and industries can make it difficult to compare the financial statements of
different companies.
 Complexity and Technicality:
Financial statements can be complex and technical, making it difficult for non-experts
to understand and interpret them correctly. This complexity can lead to
misinterpretation of the data.
 Time Lag:
There is often a delay between the end of a financial period and when the financial
statements are released. During this time, the financial condition of the company
could have changed, making the statements less relevant.

Recognizing these limitations helps users of financial statements to approach the analysis
with caution and to supplement it with other forms of information and analysis.

2.9 Problems with financial statement analysis

While financial statement analysis is an excellent tool, there are several issues to be aware of
that can interfere with your interpretation of the analysis results. These issues are:

 Inconsistency in Accounting Practices:

Different companies may use varying accounting methods, such as different inventory
valuation techniques (FIFO, LIFO) or depreciation methods, leading to
inconsistencies that can hinder accurate comparisons.
 Manipulation of Financial Data:
Companies may engage in creative accounting practices to present a more favorable
picture of their financial health. This can include tactics like revenue recognition
manipulation, off-balance-sheet financing, or delaying expenses, which can mislead
users.

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 Lack of Standardization Across Regions:

Differences in accounting standards between countries (e.g., IFRS vs. GAAP) can
lead to significant discrepancies in financial reporting, making it difficult to compare
companies operating in different regions.
 Overemphasis on Short-Term Performance:
Financial statements often focus on short-term results, such as quarterly earnings,
which can obscure a company’s long-term strategic goals and sustainability.
 Ignoring Qualitative Factors:
Financial statements primarily deal with quantitative data, neglecting important
qualitative factors like brand reputation, employee satisfaction, customer loyalty, and
innovation, which are crucial for a company’s success.
 Complexity and Technicality:
Financial statements can be complex and difficult to understand, especially for those
without a financial background. This complexity can lead to misinterpretation of the
data and poor decision-making.
 Historical Nature of Data:
Since financial statements are based on historical data, they may not accurately reflect
the current financial position or future potential of a company, particularly in rapidly
changing industries.
 Potential for Bias in Estimates:
Many elements of financial statements are based on management’s estimates, such as
provisions for bad debts, asset valuations, and depreciation. These estimates can be
subjective and may introduce bias, affecting the accuracy of the analysis.
 Inadequate Disclosure:
Sometimes, financial statements may not provide enough information or may omit
crucial details, making it difficult to fully assess a company’s financial condition or
the risks it faces.
 Time Lag:
There is often a significant delay between the reporting period and the publication of
financial statements, meaning the information might be outdated by the time it is
analysed.

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 Economic and Market Conditions Not Fully Reflected:

Financial statements may not fully capture the impact of external factors such as
economic downturns, market volatility, or changes in regulatory environments, which
can significantly affect a company’s performance.
 Overreliance on Ratios:
Financial ratios are often used in analysis, but they can be misleading if taken out of
context. Ratios alone do not provide a complete picture and should be interpreted with
caution, considering the broader business environment.
 Limited Scope:
Financial statements typically do not cover all aspects of a company’s operations,
such as social responsibility initiatives, environmental impact, or future strategic
plans, which can be critical for comprehensive analysis.
 Difficulty in Detecting Fraud:
While financial statement analysis can identify some red flags, it may not always
detect fraudulent activities or significant financial misstatements, particularly if the
company is intentionally obscuring certain details.

Understanding these problems helps analysts to use financial statement analysis more
effectively by combining it with other analytical tools and considering a broader range of
information.

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owing limitations.

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