CHAPTER I

INTRODUCTION

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FINANCIAL ANALYSIS

Introduction

Financial analysis (also known as financial statement analysis, accounting

analysis, or analysis of finance) refers to an assessment of the viability, stability, and
profitability of a business, sub-business or project. Financial analysis is the process of
evaluating businesses, projects, budgets, and other finance-related transactions to
determine their performance and suitability. Typically, financial analysis is used to
analysis whether an entity is stable, solvent, liquid, or profitable enough to warrant a
monetary investment.

It is performed by professionals who prepare reports using ratios and other

techniques, 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. Financial analysis may determine if a business will:

 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 shares or negotiate for a bank loan to increase its working capital;
 Make decisions regarding investing or lending capital;
 Make other decisions that allow management to make an informed
selection on various alternatives in the conduct of its business.

Financial statement analysis is the process of analysing a company's financial

statements for decision-making purposes. External stakeholders use it to understand the
overall health of an organization as well as to evaluate financial performance and
business value. Internal constituents use it as a monitoring tool for managing the
finances.

The financial statements of a company record important financial data on every

aspect of a business’s activities. As such they can be evaluated on the basis of past,
current, and projected performance.
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Meaning of Financial Statement Analysis:

The term ‘financial analysis’, also known as analysis and interpretation of

financial statements’, refers to the process of determining financial strengths and
weaknesses of the firm by establishing strategic relationship between the items of the
balance sheet, profit and loss account and other operative data.

“Analysing financial statements,” according to Metcalf and Titard, “is a process

of evaluating the relationship between component parts of a financial statement to
obtain a better understanding of a firm’s position and performance.”

In the words of Myers, “Financial statement analysis is largely a study of

relationship among the various financial factors in a business as disclosed by a single
set-of statements and a study of the trend of these factors as shown in a series of
statements.”

The purpose of financial analysis is to diagnose the information contained in

financial statements so as to judge the profitability and financial soundness of the firm.
Just like a doctor examines his patient by recording his body temperature, blood
pressure, etc. before making his conclusion regarding the illness and before giving his
treatment, a financial analyst analysis the financial statements with various tools of
analysis before commenting upon the financial health or weaknesses of an enterprise.

The analysis and interpretation of financial statements is essential to bring out

the mystery behind the figures in financial statements. Financial statements analysis is
an attempt to determine the significance and meaning of the financial statement data so
that forecast may be made of the future earnings, ability to pay interest and debt
maturities (both current and long-term) and profitability of a sound dividend policy.

The term ‘financial statement analysis’ includes both ‘analysis’, and

‘interpretation’. A distinction should, therefore, be made between the two terms. While
the term ‘analysis’ is used to mean the simplification of financial data by methodical
classification of the data given in the financial statements, ‘interpretation’ means,
‘explaining the meaning and significance of the data so simplified. ’However, both’
analysis and interpretation’ are interlinked and complimentary to each other Analysis is

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useless without interpretation and interpretation without analysis is difficult or even
impossible.

Most of the authors have used the term ‘analysis’ only to cover the meanings of
both analysis and interpretation as the objective of analysis is to study the relationship
between various items of financial statements by interpretation. We have also used the
term ‘Financial statement Analysis or simply ‘Financial Analysis’ to cover the meaning
of both analysis and interpretation.

Uses of Financial Statements

Following are some of the uses of financial statements:

 Determine the financial position of the business: The most important use of
the financial statements is to provide information about the financial position of
the business on a given date. This piece of information is used by various
stakeholders in order to take important decisions regarding the business.
 To obtain credit: Financial statements present the picture of the business to the
potential lenders and this information can be used by them to provide additional
credit for business expansion or restrict the credit so as to start recovery.
 Helps investors in decision making: Financial statements contain all the
essential information required by the potential investors for determining how
much they want to invest in the business. It is also helpful in decision making
regarding the price per share that the investors want to invest. A sound financial
statement is the key to obtaining investments.
 Helps in policy making: The financial statements help the government in
deciding the taxation and regulations policies based on the way the company is
running its operations. The government bodies can tax a business based on the
level of their income and assets.
 Useful for stock traders: Financials statements help stock traders with the
knowledge of the situation the company is in and therefore adjusting their
quotes accordingly.

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Importance of Financial Statement

The significance of financial statements prevails in their service to persuade the

diverse interests of distinct classes of parties such as creditors, public, management,
etc.,

Importance to Management: Increase in size and intricacies of aspects influencing

the business functions requires scientific and strategic access in the management of
contemporary trading concerns. The management team needs up to date, precise and
methodical financial data for the intentions. Financial statements assist the management
in comprehending the progress, prospects, and position of the business counterpart in
the industry.

Importance to the Shareholders: Management is detached from control in the case of

companies. Shareholders cannot take part in the day-to-day business pursuits. However,
the outcome of these pursuits should be disclosed to shareholders during the annual
general body meeting in the form of financial statements.

Fundamental Analysis

Fundamental analysis uses ratios gathered from data within the financial
statements, such as a company's earnings per share (EPS), in order to determine the
business's value. Using ratio analysis in addition to a thorough review of economic and
financial situations surrounding the company, the analyst is able to arrive at an intrinsic
value for the security. The end goal is to arrive at a number that an investor can compare
with a security's current price in order to see whether the security is undervalued or
overvalued.

Technical Analysis

Technical analysis uses statistical trends gathered from trading activity, such as
moving averages (MA). Essentially, technical analysis assumes that a security’s price
already reflects all publicly available information and instead focuses on the statistical
analysis of price movements. Technical analysis attempts to understand the market

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sentiment behind price trends by looking for patterns and trends rather than analyzing
a security’s fundamental attributes.

Horizontal vs. Vertical Analysis

When reviewing a company's financial statements, two common types of

financial analysis are horizontal analysis and vertical analysis. Both use the same set of
data, though each analytical approach is different.

Horizontal analysis entails selecting several years of comparable financial data.

One year is selected as the baseline, often the oldest. Then, each account for each
subsequent year is compared to this baseline, creating a percentage that easily identifies
which accounts are growing (hopefully revenue) and which accounts are shrinking
(hopefully expenses).

Vertical analysis entails choosing a specific line item benchmark, then seeing
how every other component on a financial statement compares to that benchmark. Most
often, net sales is used as the benchmark. A company would then compare cost of goods
sold, gross profit, operating profit, or net income as a percentage to this benchmark.
Companies can then track how the percent changes over time.

Types of Financial Statement

 Balance Sheet
 Income Statement
 Cash flow Statement
 Statement of Owner's Equity
 Free Cash Flow and Other Valuation Statements

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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
shareholders' equity. Short-term assets such as cash and accounts receivable can tell a
lot about a company’s operational efficiency. Liabilities include its expense
arrangements and the debt capital it is paying off. Shareholder’s equity includes details
on equity capital investments and retained earnings from periodic net income. The
balance sheet must balance with assets minus liabilities equalling shareholder’s equity.
The resulting shareholder’s equity is considered a company’s book value. This value is
an important performance metric that increases or decreases with the financial activities
of a company.

Income Statement

The income statement breaks down the revenue a company earns against the
expenses involved in its business to provide a bottom line, net income profit or loss.
The income statement is broken into three parts which help to analysis 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 such as marketing costs, general costs, and depreciation. Finally it
ends with net profit which deducts interest and taxes. Basic analysis of the income
statement usually involves the calculation of gross profit margin, operating profit
margin, and net profit margin which each divide profit by revenue. Profit margin helps
to show where company costs are low or high at different points of the operations.

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. Like its title, investing activities include cash flows involved with firm-wide
investments. The financing activities section includes cash flow from both debt and
equity financing. The bottom line shows how much cash a company has available.

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Free Cash Flow and Other Valuation Statements

Companies and analysts also use free cash flow statements and other valuation
statements to analysis the value of a company. Free cash flow statements arrive at a net
present value by discounting the free cash flow a company is estimated to generate over
time. Private companies may keep a valuation statement as they progress toward
potentially going public.

Statement of Owner's Equity

The fourth financial statement that a business needs is a statement of owner's

equity, also known as a statement of changes in equity, or a statement of shareholders'
equity. It shows the business's retained earnings—the profit kept, or retained, within a
business rather than distributed to owners or shareholders—both at the beginning and
at the end of a specific reporting period. Retained earnings are often used to either
reinvest in the company, or to pay off the business's debt obligations. It provides users
with information regarding the financial health of a business, as it shows whether the
business is capable of meeting ongoing financial and operating obligations without
requiring its owners to contribute more capital. By preparing each of these financial
statements, not only will you be able to provide a prospective investor or creditor with
important information that they need to assess your business, but also you will be able
to identify trends in your business's performance that will help you to position your
business for continued success.

Advantages & Disadvantages of Financial Statement Analysis

Financial statements are financial data documents a company publishes on an

annual, biannual, quarterly or monthly basis. These documents include the company’s
net worth based on assets and liabilities, as well as the company’s expenses, earnings
and operational budget. Financial planners, senior executives and accountants may use
financial statements to make decisions regarding future planning, expansions and
product launches, but there are disadvantages to using this method.

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Advantage: The Ability to Detect Patterns

Financial statements reveal how much a company earns per year in sales. The
sales may fluctuate, but financial planners should be able to identify a pattern over years
of sales figures. For example, the company may have a pattern of increased sales when
a new product is released. The sales may drop after a year or so of being on the market.
This is beneficial, as it shows potential and sales patterns so executives know to expect
a drop in sales.

Advantage: A Chance to Budget Outline

Another advantage of using financial statements for future planning and decision
making is that they show the company’s budgets. The budgets reveal how much wiggle
room the company has to spend on launching products, developing marketing
campaigns or expanding the current office size. Knowing how much money is available
for planning and decision making ensures that the company does not spend more than
expected.

Disadvantage: Based on Market Patterns

One disadvantage of using financial statements for decision making is that the
data and figures are based on the market at that given time. Depending on the market,
it may change quickly, so executives should not assume that the numbers from a
previous financial statement will remain the same or increase. Just because a company
has sold 5 million copies of a product during one year does not guarantee it will sell the
same amount or more. It may sell much less if a competitor releases a similar product.

Disadvantage: At-One-Time Analysis

Another disadvantage is that a single financial statement only shows how a

company is doing at one single time. The financial statement does not show whether
the company is doing better or worse than the year before, for example. If executives
decide to use financial statements for making decisions about the future, they should
use several financial statements from previous months and years to ensure they get an

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overall picture of how much the company is doing. The financial statement becomes a
continuous analysis, which is more useful than using a single statement.

USERS OF FINANCIAL STATEMENT ANALYSIS:

There are different users of financial statement analysis. These can be classified
into internal and external users. Internal users refer to the management of the company
who analysis financial statements in order to make decisions related to the operations
of the company. On the other hand, external users do not necessarily belong to the
company but still hold some sort of financial interest. These include owners, investors,
creditors, government, employees, customers, and the general public. These users are
elaborated on below.

1. Management
The managers of the company use their financial statement analysis to make
intelligent decisions about their performance. For instance, they may gauge cost per
distribution channel, or how much cash they have left, from their accounting reports
and make decisions from these analysis results.
2. Owners
Small business owners need financial information from their operations to
determine whether the business is profitable. It helps in making decisions like
whether to continue operating the business, whether to improve business strategies
or whether to give up on the business altogether.
3. Investors
People who have purchased stock or shares in a company need financial
information to analysis the way the company is performing. They use
financial statement analysis to determine what to do with their investments in the
company. So depending on how the company is doing, they will either hold onto
their stock, sell it or buy more.

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4. Creditors
Creditors are interested in knowing if a company will be able to honour its
payments as they become due. They use cash flow analysis of the company’s
accounting records to measure the company’s liquidity, or its ability to make short-
term payments.
5. Government
Governing and regulating bodies of the state look at financial statement analysis
to determine how the economy is performing in general so they can plan their
financial and industrial policies. Tax authorities also analysis a company’s
statements to calculate the tax burden that the company has to pay.
6. Employees
Employees need to know if their employment is secure and if there is a
possibility of a pay raise. They want to be abreast of their company’s
profitability and stability. Employees may also be interested in knowing the
company’s financial position to see whether there may be plans for
expansion and hence, career prospects for them.
7. Customers
Customers need to know about the ability of the company to service its clients
into the future. The need to know about the company’s stability of operations is
heightened if the customer (i.e. a distributor or procurer of specialized products) is
dependent wholly on the company for its supplies.
8. General Public
Anyone in the general public, like students, analysts and researchers, may be
interested in using a company’s financial statement analysis. They may wish to
evaluate the effects of the firm on the environment, or the economy or even the local
community. For instance, if the company is running corporate social responsibility
programs for improving the community, the public may want to be aware of the
future operations of the company.

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