Chapter 4 — Analysis of Financial Statements

Chapter 4 covers Analysis of Financial Statements, including the meaning, significance, and objectives of financial analysis, an overview of the five major tools (comparative statements, common size statements, trend analysis, ratio analysis, and cash flow analysis), detailed preparation of comparative and common size statements, trend percentages, and the limitations of financial analysis.

Financial Statement Analysis is the process of critically evaluating the financial information contained in financial statements to understand and make decisions regarding the operations of a firm. It is a study of relationships among various financial facts and figures to gain insight into the profitability, operational efficiency, and financial health of a firm.

Analysis means simplification of financial data by methodical classification given in the financial statements. Interpretation means explaining the meaning and significance of that data. The two are complementary — analysis without interpretation is useless, and interpretation without analysis is difficult or even impossible.

The five commonly used tools are comparative statements, common size statements, trend analysis, ratio analysis, and cash flow analysis. Chapter 4 covers comparative statements, common size statements, and trend analysis in detail; ratio analysis and cash flow analysis are covered in Chapters 5 and 6 respectively.

Comparative statements show the profitability and financial position of a firm for different periods of time in a comparative form, displaying absolute and percentage changes between periods. They are called horizontal analysis because data is compared across time periods (horizontally) to indicate trends and direction of financial position and operating results.

A common size statement expresses each item of a financial statement as a percentage of a common base — revenue from operations for the statement of profit and loss, and total assets or total liabilities for the balance sheet. This analysis is also called vertical analysis and is useful for both intra-firm comparisons over different years and inter-firm comparisons for the same year.

Trend analysis is a technique of studying operational results and financial position over a series of years by calculating trend percentages — the percentage relationship each item of different years bears to the same item in the base year. It can point to basic changes in the nature of the business and help detect whether a ratio is falling, rising, or remaining relatively constant.

Finance managers use it for rational decisions and financial control; top management uses it to ensure resources are used efficiently; trade payables evaluate short-term liquidity; long-term lenders assess solvency and profitability; investors analyse present and future profitability and capital structure; labour unions assess the firm's ability to afford wage increases; and government agencies use it for price regulation, taxation, and other purposes.

The objectives are to assess current profitability and operational efficiency of the firm and its departments, ascertain the relative importance of different components of financial position, identify reasons for changes in profitability or financial position, and judge the firm's ability to repay debt while assessing its short-term and long-term liquidity position.

Financial analysis does not consider price level changes, may be misleading if the accounting procedures of a firm change, ignores non-monetary aspects of the business, and is limited to the monetary information contained in financial reports. Because financial statements are prepared on accounting concepts, the analysis may not reflect the current position of the firm.

Horizontal analysis (comparative statements) shows changes in financial data across different time periods in absolute and percentage terms, indicating trends over time. Vertical analysis (common size statements) expresses each item as a percentage of a common base within a period, enabling comparison between firms of different sizes or across successive periods.

Cash flow analysis refers to the analysis of the actual movement of cash into and out of an organisation. Cash inflow is the flow of cash into the business and cash outflow is the flow of cash out of the firm. A cash flow statement summarises the sources of cash receipts and the purposes for which payments are made during an accounting year, showing the causes of changes in the cash position between two balance sheet dates.

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