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					Meaning of Financial Statements: Financial statements are the final product of accounting work done during the accounting period, i.e., quarterly, half-yearly or annually.Financial statements normally includes Balance Sheet and Profit and Loss Account. Profit and Loss Account is also called income statement. Publicly available financial statements do not contain Manufacturing Account and Trading Account. The annual accounts also contain fund-flow and cash flow statements. The financial statements are historical documents and relate to the past period. Financial statements are the end products of the accounting process. The last but not the least leg of the accounting process is summarizing the accounting data in the form of balance sheet, income statement and statement of changes in the financial position hich help in analysis and interpretation of the accounting data. Balance Sheet is a sheet of balances of assets, liabilities and capital indicating the financial position of the enterprise at a point in time. Profit and Loss Account is a report of business activities for a given period, say a quarter or a year, and is prepared to ascertain profit (or loss), earned (or sustained) by the enterprise for that period. It contains items of sales and other incomes, expenses and losses pertaining to the accounting period. The statement of changes in financial position explains the inflow and outflow of working capital and cash flow statement portrays the movement of cash. Financial statements are prepared in monetary terms. In real life, some organizations refer to them as „Annual Accounts‟ also, when they are prepared on a yearly basis. However, interim financial statements are prepared for a shorter period, usually a quarter, and hence called „Quarterly Financial Statements‟. The financial statements are prepared by the board of directors for reporting to shareholders in discharge of their stewardship function and hence corporate law enjoins upon them the responsibility of laying down them before annual general meeting of the


shareholders so as to give a „true and fair view‟ of the affairs of the company. The profit and loss account shall be annexed to the balance sheet and auditor‟s report (including the auditor‟s separate, special or supplementary report, if any) shall be attached thereto. Contents of Financial Statements: Following are the contents of financial statements: (a) Board‟s Report (b) Director‟s Responsibility Statement (c) Management Discussion and Analysis (d) Auditor‟s Report (e) Report on Corporate Governance (f) Accounting Policies (g) Balance Sheet (h) Profit and Loss Account (i) Cash Flow Statement (j) Segment Report The above stated statement, account; reports are statutory requirements to be complied with by the management. In some cases non-statutory disclosures are also made which are voluntary in nature, such as, Human Resource Accounting, Accounting for Changing Prices, Value Added Statement, Social Accounting Report etc. Hereunder what follows is the discussion essentially on statutory disclosures. Concept of Financial Analysis The analysis includes establishing relationship, comparisons and ascertaining trends. Financial analysis deals with the use of financial data in the evaluation of current and past performance of an enterprise and to assess its sustainability in future. This implies that


the person attempting to make financial analysis should not only be in command of the appropriate financial analysis tools and Techniques, but must be a master craftsman to make creative and imaginative use of such tools and techniques. Besides, he should also be endowed with the sound statistical knowledge to relate the current performance with the future of the business, keeping in view the changes that are shaping in the business environment of the firm. To sum up, it requires two-fold exercise — (a) analysis of past performance, and (b) prospective analysis to predict the likely future. Uses of Financial Analysis Financial Analysis can be used for a variety of decision contexts such as security analysis, analysis of credit worthiness, credit analysis, debt analysis, dividend decision, mergers, take- overs, acquisitions and general business analysis. These are explained below: Security Analysis An investor would like to know whether the firm is fulfilling his expectations with regard to payment of dividend, capital appreciation and security of money. He would like to know whether his investment in a particular firm is enhancing his wealth or not. If not, what are the reasons thereof? If Yes, how well is he being served in comparison to other firms in the same industry. Should he continue to hold his investment or sell the same? In accounting terms, the security analyst is interested in cash-generating ability, dividend payout policy and the behavior of share prices. Credit Analysis The manager of the firm may have to offer credit to a prospective dealer and therefore he would like to know whether to extend credit


to him or not. the risk associated in extending credit to the new customer/dealer. The same type of questions can be raised by a banker when we approach for a loan. Debt Analysis The manager of the firm may be interested in knowing the borrowing capacity of the firm which in turn requires analysis of the relationship of debt and equity, capacity to repay and the capacity to borrow further. Dividend Decisions The management have to reward the shareholders of the company by paying dividends (returns on equity) periodically. For this, management needs to assure the sustainability of the rate of dividends in the future years as also the past performance of the company and the practice of the industry. Dividend income provides cash inflows to the shareholders to meet their consumption needs as also it indicates the profitability of the firm and hence to some extent affects the behavior of share prices. Mergers & Acquisitions If the company is doing well in relation to its competitors and is generating surplus cash flows, the management may be tempted to expand the business by acquiring other companies or brands to expand the market and make the profitable investment. This would require analysis of the competing/supporting brands and products for horizontally or vertically linking the operations. For example, Reliance Industries has acquired strategic stake in Indian Petrochemicals Corporation Ltd. for horizontal expansion of the petrochemical business. In the same way Hindustan Lever Ltd. has acquired products of Lakme India Ltd.


General Business Analysis The general business analysis aims at identifying the key profit drivers and business risks in order to assess the profit potential of the firm. This analysis is required to create sustainable competitive advantage. This analysis also helps in developing future growth scenarios for the firm. Regulatory Compliance The regulators include the Registrar of Companies, Department of Company Affairs, Stock Exchanges, SEBI use these reports for analyzing the contents toensure compliance with different rules and regulations enforced from time to time. Limitations of Analysis of Financial Statements Analysis of financial statements is a powerful mechanism to ascertain strengths and weaknesses in the operations and financial position of an enterprise. However, it suffers from certain limitations, which should be kept in mind while making the analysis. Some of the major limitations are listed below : 1. The quality of information disclosed in the published financial statements is constrained by the accounting quality and rules. The application of accounting rules, conventions and principles may change from time to time, from firm to firm and from industry to industry rendering the accounting numbers incomparable. This is further complicated by the selective application of the accounting rules by the management in order to smoothen the financial position and income statement. There is a variety of reasons for tainted accounting reports such as, tax considerations, managerial compensation, capital market considerations, competition etc. In order to safeguard from accounting creativity, the analyst need to ask the following questions:


(a) Does company provide adequate disclosures to assess the economic performance? (b) Does the firm adequately explain its current performance? (c) Does management highlight the risk factors associated with the business? (d) What is the quality of performance of the firm in different segments? (e) How forthcoming is the management with respect to the bad news? (f) How good is firms investor relations programme? 2. The disclosure of accounting information is also constrained by the quality of enforcement of regulation. If the regulations are not strictly enforced and penalties are not sufficiently high, the management may be motivated to manipulate the accounting numbers, which will further complicate the financial analysis. 3. The level of development of accounting standards and the required level of disclosure will also affect the quality of financial analysis. For example, in India, after the enactment of the SEBI Act, the accounting disclosures and standardization thereof has come of age but is not as good as in Europe. 4. The Capital Market regulations also impact the quality and quantity of disclosures.In the Listing Agreement, companies were not disclosing about cash flow and corporate governance matters. 5. The development in corporate law and enforcement thereof also impacts the quality of financial disclosures. For example, following the recommendation of Naresh Chandra Committee on “CompanyAuditor Relationship”, the Chief Finance Officer (CFO) is required to certify the correctness of the accounting numbers disclosed in the periodic financial statements. 6. Poor quality of auditing standards and professional ethics of the chartered accountants also affects the quality of accounting reports. The increase in accounting scandals across the globe has compelled


the Governments to tighten the Code of Conduct and quality standards for audit both for Government and Private enterprises. The setting up of the Public Oversight Board (POB) in the USA and proposed Review Board in India in the Institutes of Chartered Accountants, Cost and Works Accountants and Company Secretaries is a step towards improving the compliance and quality. 7. The level of maturity of profession of financial analysis also impacts the quality of disclosures. The profession of financial analysts is in a nascent stage in India as there are few professional houses to carry out independent financial analysis and so are the regulations governing the conduct of the financial analysts. We need to go a long way to make financial analysts accountable for their professional services. What are the functions of financial statements? •Provide information to owners and creditors about the firm‟s current status and past financial performance •Provide a convenient way for owners and creditors to set performance targets and impose restrictions on managers •Provide a convenient way for a firm‟s financial planning Do financial analysts disagree with balance sheet

information? •Main issue: Book values vs. market values •Balance sheets omit some economically significant assets called intangible assets, such as R&D •Intangible assets, such as goodwill, are not reported at market values •Some economically significant liabilities are also omitted, e.g. pending lawsuits


REALITY In assessing the significance of various financial data, experts engage in financial analysis, the process of determining and evaluating financial ratios. A ratio is a relationship that indicates something about a company's activities, such as the ratio between the company's current assets and current liabilities or between its accounts receivable and its annual sales. The basic source for these ratios is the company's financial statements that contain figures on assets, liabilities, profits, and losses. Ratios are only meaningful when compared with other financial information. Since they are most often compared with industry data, ratios help an individual understand a company's performance relative to that of competitors and are often used to trace performance over time. Financial analysis can reveal much about a company and its operations. However, there are several points to keep in mind about ratios. First, a ratio is a "flag" indicating areas of strength or weakness. One or even several ratios might be misleading, but when combined with other knowledge of a company's management and economic circumstances, financial analysis can tell much about a corporation. Second, there is no single correct value for a ratio. The observation that the value of a particular ratio is too high, too low, or just right depends on the perspective of the analyst and on the company's competitive strategy. Third, financial ratios are meaningful only when compared with some standard, such as an industry trend, ratio trend, a trend for the specific company being analyzed, or a stated management objective. In trend analysis, financial ratios are compared over time, typically years. Year-to-year comparisons can highlight trends and point up the need for action. Trend analysis works best with five years of ratios. The second type of ratio analysis, cross-sectional analysis, compares the ratios of two or more companies in similar lines of


business. Highly recommended by VentureLine is one of the most popular forms of cross-sectional analysis: comparing a company's financial ratios to the industry in which the company competes. The report is broken down into the various categories: • • • • Predictor Ratios indicate the potential for growth or failure. Profitability Ratios which use margin analysis and show the Asset Management Ratios which use turnover measures to Liquidity Ratios which give a picture of a company's short

return on sales and capital employed. show how efficient a company is in its operations and use of assets. cash-flow situation or solvency. • Debt Management Ratios which show the extent that debt is

used in a company's capital structure. Steps to a Basic Company Financial Analysis you cannot analyze the numbers in a vacuum. The numbers only provide indicators to trigger further questions in your mind. In order to do a thorough job, you must understand something about the company‟s business and strategies, and its industry. Financial indicators vary from industry to industry; the ratios can only be interpreted when compared and contrasted with other companies in that industry. For example, financial indicators are (and should be) different among financial institutions, manufacturing companies, companies that provide services, and technology and computer information and services companies. Financial analysis is something of an art. managers, investors and analysts develop a Experienced bank of


information over time, and after doing many such analyses, that they bring to bear every time they review a company.


Step 1. 5 years. · · · ·

Acquire the company‟s financial statements for several

years. As a minimum, get the following statements, for at least 3 to

Balance sheets Income statements Shareholders equity statements Cash flow statements Quickly scan all of the statements to look for large For

Step 2.

movements in specific items from one year to the next.

example, did revenues have a big jump, or a big fall, from one particular year to the next? Did total or fixed assets grow or fall? If you find anything that looks very suspicious, research the For information you have about the company to find out why. of its operations, that year? Step 3. Review the notes accompanying the financial statements for additional information that may be significant to your analysis. Step 4. Examine the balance sheet. Look for large changes in the overall components of the company's assets, liabilities or equity. For example, have fixed assets grown rapidly in one or two years, due to acquisitions or new facilities? Has the proportion of debt If you find grown rapidly, to reflect a new financing strategy? have about the company to find out why. Step 5. Examine the income statement. Look for trends over time. Calculate and graph the growth of the following entries over the past several years.

example, did the company purchase a new division, or sell off part

anything that looks very suspicious, research the information you

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· ·

Revenues (sales) Net income (profit, earnings)

Are the revenues and profits growing over time? Are they moving in a smooth and consistent fashion, or erratically up and down? Investors value predictability, and prefer more consistent movements to large swings. For each of the key expense components on the income statement, calculate it as a percentage of sales for each year. For example, calculate the percent of cost of goods sold over sales, general and administrative expenses over sales, and research and development over sales. Look for favorable or unfavorable trends. For example, rising G&A expenses as a percent of sales could mean lavish spending. Also, determine whether the spending trends support the company‟s strategies. For example, increased emphasis on new products and innovation will probably be reflected by an increased proportion of spending on research and development. Look for non-recurring or non-operating items. These are "unusual" expenses not directly related to ongoing operations. do these reflect on the earnings quality? If you find anything that looks very suspicious, research the information you have about the company to find out why. Step 6. Examine the shareholder's equity statement. Has the Has the Why? Are However, some companies have such items on almost an annual basis. How

company issued new shares, or bought some back? retained earnings account been growing or shrinking? there signals about the company's long-term strategy here?

If you find anything that looks very suspicious, research the information you have about the company to find out why. Step 7. Examine the cash flow statement, which gives information

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about the cash inflows and outflows from operations, financing, and investing.While the income statement provides information about both cash and non-cash items, the cash flow statement attempts to reconstruct that information to make it clear how cash is obtained and used by the business, since that is what investors and creditors really care about.If you find anything that looks very suspicious, research the information you have about the company to find out why. Step 8. Calculate financial ratios in each of the following categories, for each year. You may use the formulas found in your textbook, or other materials you have from your finance and accounting courses. A summary of some useful ratios appears at the end of this document. · · · · · Liquidity ratios Leverage (or debt) ratios Profitability ratios Efficiency ratios Value ratios

Graph the ratios over time, to find the trends in the ratios from year to year. Are they going up or down? Is that favorable or unfavorable? This should trigger further questions in your mind,

and help you to look for the underlying reasons. Step 9. Obtain data for the company‟s key competitors, and data about the industry. For competitor companies, you can get the data and calculate the ratios in the same way you did for the company being studied. You can also get company and industry ratios from the Evaluator, Schwab Stock Evaluator, or other locations on my LINKS website.

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Compare the ratios for the competitors and the industry to the company being studied. Is the company favorable in comparison? Do you have enough information to determine why or why not? If you don‟t, you may need to do further research. Step 10. Review the market data you have about the company‟s stock price, and the price to earnings (P/E) ratio. Try to research and understand the movements in the stock price and P/E over time. Determine in your own mind whether the stock market is reacting favorably to the company‟s results and its strategies for doing business in the future. Review the evaluations of stock market analysts. website. Step 11. Review the dividend payout. Graph the payout over These may be found at any brokerage site, or from various locations on my LINKS

several years. Determine whether the company‟s dividend policies are supporting their strategies. earnings dividends? convinced rather that than the For example, if the company is them to investors through for attempting to grow, are they retaining and reinvesting their distributing company has Based on your research into the industry, are you sufficient opportunities

profitable reinvestment and growth, or should they be distributing more to the owners in the form of dividends? Viewed another way, can you learn anything about their long-term strategies from the way they pay dividends? Step 12. Review all of the data that you have generated. You will probably find that there is a mix of positive and negative results. Answer the following question: “Based on everything I know about this company and its strategies, the industry and the competitors, and the external factors that will

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influence the company in the future, do I think this company is worth investing in for the long term?” Interest Groups in Financial Analysis Financial Statement Analysis seeks to measure the enterprise liquidity, profitability, solvency and other indicators to assess the efficiency and performance of the business enterprise. Analysis of financial statements is linked with the objective and interest of the individual/agency involved. Some of the agencies interested in the enterprise include investors, bankers, lenders, suppliers, customers, employees, management and regulatory authorities like, tax authorities, stock exchanges, Company Law Board. Many of these agencies have diverse and conflicting interests. An Investor is interested in the profitability and safety of his investment and would like to know whether the business is profitable, has growth potential and is progressing on sound lines. Bankers and lenders are interested in servicing of their loans by the enterprise, i.e., regular payment of interest and repayment of principal amount on scheduled dates. Banker and lenders would, also like to know the safety of their investment and stability of returns. Suppliers dealing with the enterprise are interested in receiving their payments as and when become due and would like to know its ability to honor its short-term commitments. An Employees are interested in better emoluments, bonus and continuance of business, would like to know its financial performance and profitability and operating sustainability.

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Management is interested in the financial performance and financial condition of the enterprise. It would like to know about its viability as a going concern, management of cash, debtors, inventory and fixed assets, and adequacy of capital structure. Management would also be interested in the overall financial position and profitability of the enterprise as a whole and its various departments or divisions. Regulatory authorities (such as, Company Law Board, SEBI, Stock Exchanges, Tax Authorities etc.) would like that the financial statements prepared are in conformity with the specified laws and rules, and are to safeguard the interest of various concerned agencies. For example, taxation authorities would be interested in ensuring proper assessment of tax liability of the enterprise as per the laws in force from time to time. Different agencies, thus look at the enterprise from their respective viewpoint, and are interested in knowing its profitability and financial condition. In short, a detailed cause and effect study of profitability and financial condition is the overall objective of financial statement analysis.

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