Chapter - 4

1. Introduction
Definition: Financial statement analysis involves examining a company's financial statements to evaluate its performance and financial health.

• Purpose:

  • Assess profitability and operational efficiency.

  • Evaluate liquidity and solvency.

  • Assist in investment and credit decisions.

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2. Types of Financial Analysis

• Horizontal Analysis: Compares financial data over multiple periods to identify trends and growth patterns.

• Vertical Analysis: Involves comparing each item in a financial statement to a base item within the same statement, expressed as a percentage.

• Ratio Analysis: Uses financial ratios to evaluate relationships between different financial statement items.

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3. Horizontal Analysis
Definition: Analysis of financial statements over a series of periods.

• Method:

  • Calculate the percentage change from one period to the next.

  • Identify trends in revenue, expenses, and profits.

Formula:
Percentage Change = (Current Period Amount - Previous Period Amount) / Previous Period Amount × 100

4. Vertical Analysis
Definition: Analysis of financial statements by expressing each item as a percentage of a base amount within the same period.

• Method:

  • For the balance sheet: Express each item as a percentage of total assets.

  • For the income statement: Express each item as a percentage of total sales.

Example:
If total sales are ₹100,000 and cost of goods sold is ₹60,000:
Cost of Goods Sold Percentage = (₹60,000 / ₹100,000) × 100 = 60%

 

5. Ratio Analysis

Definition: Analysis using financial ratios to assess various aspects of a company's performance.

• Types of Ratios:

  • Liquidity Ratios: Measure the ability to meet short-term obligations.

  • Current Ratio = Current Assets / Current Liabilities

  • Quick Ratio = (Current Assets - Inventory) / Current Liabilities

  • Solvency Ratios: Measure the ability to meet long-term obligations.

  • Debt to Equity Ratio = Total Debt / Total Equity

  • Interest Coverage Ratio = EBIT / Interest Expense

  • Profitability Ratios: Measure the ability to generate profit.

  • Gross Profit Margin = Gross Profit / Net Sales × 100

  • Net Profit Margin = Net Profit / Net Sales × 100

  • Return on Equity (ROE) = Net Profit / Shareholders' Equity × 100

  • Efficiency Ratios: Measure how effectively assets are utilized.

  • Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory

  • Accounts Receivable Turnover Ratio = Net Credit Sales / Average Accounts Receivable

 

6. Cash Flow Analysis
Definition: Analysis of cash inflows and outflows to assess the liquidity and financial flexibility.

• Components:

  • Operating Activities: Cash flows related to core business operations.

  • Investing Activities: Cash flows from buying or selling assets.

  • Financing Activities: Cash flows from issuing or repaying debt or equity.

 

7. Common Size Statements
Definition: Financial statements that present all items as percentages of a common base.

• Purpose:

  • Facilitate comparison across companies of different sizes.

  • Highlight structural differences and similarities.

• Preparation:

  • Balance Sheet: Express each item as a percentage of total assets.

  • Income Statement: Express each item as a percentage of net sales.

 

8. Trend Analysis
Definition: Analysis of financial statements to identify patterns and trends over multiple periods.

• Purpose:

  • Detect growth patterns.

  • Assess sustainability of performance.

• Method:

  • Calculate the trend percentage for each financial statement item over several periods.

 

9. Comparative Financial Statements
Definition: Financial statements that present figures for multiple periods side by side.

• Purpose:

  • Simplify the process of comparing performance over time.

  • Highlight significant changes and trends.

• Preparation:

  • Include columns for each period’s figures for easy comparison.

10. Limitations of Financial Statement Analysis

• Historical Data: Based on past performance, which may not necessarily predict future performance.

• Window Dressing: Companies may manipulate financial data to present a more favorable picture.

• Inflation: Financial statements do not account for changes in purchasing power.

• Different Accounting Policies: Companies may use different accounting methods, complicating comparisons.

11. Practical Illustrations
Example Problems: Various scenarios demonstrating the calculation and interpretation of financial ratios, trend analysis, and comparative financial statements.
 

Key Terms

• Liquidity: The ability to meet short-term obligations.

• Solvency: The ability to meet long-term obligations.

• Profitability: The ability to generate profit.

• Efficiency: The effectiveness of using resources.

• Common Size Statements: Financial statements showing items as percentages of a common base.

• Trend Analysis: Identifying patterns over multiple periods.

• Comparative Financial Statements: Statements presenting figures for multiple periods side by side.

 

These notes cover the essential aspects of financial statement analysis, focusing on various methods and tools used to evaluate a company's financial performance and position.