Pillai Institute of Management Studies and

Research (PIMSR),
New Panvel

Master of Management Studies (MMS)

MMS Semester-2
Subject : Financial Management
Lesson-2 :
Financial Statements Analysis and
Interpretation
(Session : 2,

date : 12.1.2015 and 13.1.2015)

by
Prof. K.G.S. MANI

Session 2,
date : 12.1.2015 and 13.1.2015
Lesson - 2 : Financial Statements analysis and
interpretation
1) Financial Statement Analysis :
a) Definition :
Analysis of financial statements means a systematic and
specialised treatment of information found in financial
statements so as to derive useful conclusions on the
profitability and solvency of the business entity concerned.
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 study of the trends of these factors as
shown in a series of statements.

b) Meaning and importance of Financial Analysis :

Financial analysis refers to the process of examining
financial
strength and weakness of the company by establishing
relationship between the items of Balance Sheet and P &
L account and other data. Financial statements are used
to find the financial health of a company. Analysis of
financial statements involves evaluating three features of
the company, namely, its liquidity, profitability and
solvency. Analysis consists of breaking down a complex
set of facts or figures into simple elements as below :
) Analysis of financial position of the company as on a
particular date it involves detailed position as disclosed
by one of set of financial statements (P&L, B/S) is sought
to be examined.
) Analysis of financial statements over a number of years
in such a case trend is important.
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c) Purpose of Financial Analysis :

i) Management can identify the problems facing the firm and
take corrective action in time, so that full potential of the
firm can be achieved.
ii) Investors also want to identify the problems of the
firm/company. The decision to keep or sell the investment
in shares of the company, depends on early detection of
problems. An investor can sell away his investment, if he
feels that the future of the company is not bright.
iii) In the changing environment of business, management
must also identify strengths of the company they are
managing. Management can secure growth and confer
wealth on shareholders, only by focusing on the strength
of the company.
iv) Investors also would like to identify firms/companies with
strength so that investments in such companies can give
them more profits (short term) / appreciation in
investments (long term).
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2) Objectives of Financial Statement Analysis :

Analysis involves the following financial areas and it
provides crucial financial information to various target
audiences (as mentioned below) for various purposes :
a) Profitability analysis : Past and present profitability
of business is analysed by prospective investors to take
a decision to invest in shares of the company.
b) Liquidity analysis : This analysis is done by the
suppliers of goods, banks and financial institutions to
find out ability of the company to meet its repayment
obligations (short term loans). This analysis is generally
short term in nature.
c) Solvency analysis : It refers to analysis of long-term
financial position of the Company to repay its debts
(long term loans, debentures) and interest thereon over
a period of time.
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3) Types of Financial Analysis :

a) Intra-firm analysis : This involves analysis of
performance of the company over number of years. It
helps management to take various policy decisions. It is
also referred as Time Series Analysis or Trend Analysis.
b) Inter-firm analysis : It is a comparison of two or more
companies in terms of various financial variables. It
helps the management to decide strengths and
weaknesses of the company. Sometimes analysis of two
or more companies performance may be analysed over
a number of years. Such an analysis is called cross
sectional trend analysis.
c) Standard analysis : In this case only one set of
financial statements of the company is analysed on the
basis of standard set for the industry. For example,
profitability of a Pharmaceutical company be compared
with the standard set at industry level.
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d) Horizontal analysis : It is a comparison of figures

reported in the financial statements of two or more
consecutive account periods i.e. analysis across years.
Comparative financial statement is a tool of horizontal
analysis. (Comparative financial statements are
statements of the financial position of a business so
designed as to facilitate comparison of different
accounting variables for drawing useful inferences).
e) Vertical analysis : Comparing figures in the financial
statements of a single period is known as vertical
analysis, i.e. all figures in a statement are converted to
a common unit by expressing them as a percentage of a
key figure in the statement, such as total sales in the
P&L statement or total assets in B/S. Such statements
are called common size statements.

Another type of financial statements analysis :

Further, on the basis of material used, financial
statements analysis can be classified under two types :
a) External analysis : This analysis is done by those
who are actually outsiders that include investors,
potential investors, government agencies, creditors,
potential creditors and the general public. These
parties may fully depend on the published financial
statements (audited annual reports published in the
paper).
b) Internal analysis : This type of analysis is conducted
by the company internally by the finance officials for
the purpose of management decision making.
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4) Tools of Financial Analysis :

The following are the important tools of financial analysis
i) Comparative financial statements
ii) Common size financial statements (vertical analysis)
iii) Trend analysis (horizontal analysis) / Trend Percentages /
Dynamic Analysis
iv) Ratio Analysis
v) Funds flow analysis
vi) Cash flow analysis

i)

Comparative Financial Statements : These are

statements of financial position of a business so designed
as to facilitate comparison of different accounting
variables for drawing useful inferences. Financial
statements (P&L and B/S) of two or more business
enterprises/companies may be compared over a period
of years. This is known as inter-firm comparison.
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Advantages of Comparative Financial

Statements :
a) These are very useful to financial analysts because
they indicate the direction of movement of financial
position and performance of the company over a period
of years.
b) They facilitate comparison with the financial position of
other companies in the same industry. This enables to
identify the area of weakness in the company for taking
corrective measures.
c) These statements present a review of the past
activities and their cumulative effect on the financial
position of the company/business.
d) Comparative statements enhance the usefulness of
reports and bring out more clearly the nature and
trends of currency changes affecting the enterprise.
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Disadvantages of comparative statements

analysis :
a) Comparison lose their purpose and significance and
tend to mislead, if the application of accounting
principles over a period of time is not consistent.
b) Consistent changes in price levels render accounting
statements useless for comparison.
c) Inter-firm comparison cannot be made, unless all the
firms are of same age, size and follow the same
principles, classifications and groupings of items,
etc.
d) Comparison between two successive accounting
periods, a normal period following an abnormal
period or vice-versa, will also prove to a pointless
analysis.
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ii) Common Size Financial Statements : These

statements are prepared to bring out the ratio of each
asset and liability to the total of the balance sheet, and the
ratio of each item of expense and revenue to net sales.
The analysis which employs this statement as a tool is
called vertical analysis or static analysis because it is
study of relationship between accounts as existing on a
particular date. This also facilitates comparison of two or
more business entities with a common base. In the case of
B/S, total assets or liabilities or capital can be taken as the
common base, and in the case of P & L account, net sales
can be taken as the base for comparison.
Advantages :
a) Common-size analysis reveals how the total funds are
distributed in assets of the business in terms of percentage.
b) This statement over a number of years will clearly indicate
the changing proportions of the various components of
assets, liabilities, costs, net sales and profits.
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c) Comparisons of common-size statements of two or

more companies in the same industry or a company
in the industry as a whole, will facilitate corporate
evaluation and ranking.
Disadvantages :
d) If financial statements of a particular
business/company are not prepared year after year
on a consistent basis, comparative study of commonsize statements will be misleading.
e) In the absence of established standards for
proportion of asset to the total assets or of an item of
expense to the net sales, this analysis may not be
helpful to draw any meaningful inferences.

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iii) Trend Analysis or Trend Percentages or

Dynamic Analysis :
Trend percentages as a tool of analysis are employed
when it is required to analyse the trend of data shown
in a series of financial statements of several successive
years. The trend obtained by such an analysis is
expressed as percentage. This method involves
calculation of percentage relationship that each
statement bears to the same item in the base year.
The base year may be any one of the periods involved
in the analysis but the earliest period is mainly taken as
the base year. This indicates increase or decrease in
an accounted item along with magnitude of change in
percentage which is more effective than absolute data.
This method of analysis facilitates an efficient
comparative study of the financial performance of a
business over a period of time.
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5) Target Audience for Financial Statement Analysis

:
Target audience for financial statement analysis and
the purpose for which information is required by them
are presented below :
i) Shareholders and potential investors : They are
interested in financial strength of the business. They
like to know the earning capacity of business and its
prospects of future growth.
ii) Management : Management of the company is
interested in financial position and performance of the
company. It helps them in preparing budgets and
assessing performance of various departmental heads.
iii) Lenders : Banks, debenture-holders, Leasing
companies are interested to know short term and as
well long term solvency position of the company.
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iv) Suppliers and Trade Creditors : They are interested to know

about the solvency of the business i.e. ability of the company
to meet the debts as and when they fall due.
v) Customers : Customers have a vested interest in monitoring
financial viability of company with which they have long term
relationship, namely, guarantees, warranties, deferred
benefits.
vi) Employees : They want to know about the growth of profit
as a result of which they can demand higher remuneration
and congenial working environment.
vii) Trade Unions : They look for better financial position of the
company for negotiating the higher wages, salaries and bonus
payments.
viii) Tax authorities : Tax authorities are interested in the
financials for determining the tax liability payable by the
company.
ix) Govt. and Regulatory Authorities : They need financial
information to regulate the activities of company. It will help
them to formulate policies and regulation for the industry.
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x) Market Analysts and Researchers : They need

financial statements for the purpose of carrying out
analytical job and research work relating to business
and industry.
xi) Stock Exchanges : They require financial statement
for the purpose of analysis because they provide
useful information about the companies.
6. Practical Problems : (to be solved for the
following)
(a) Comparative statement analysis
(b) Common-size statement analysis
(c) Trend analysis or Trend Percentages or Dynamic
Anaysis
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