CHAPTE 1

Analysis of Financial Statements

Course Instructor:
AJ Mahesar, Lecturer
Institute of Commerce, University of Sindh, Jamshoro
 Contents
2

 Introduction
 Meaning of Financial Statements
 Significance of Financial Statements
 Purposes or Objectives of Analysis of Financial
Statements
 Types of Financial Statement Analysis
 Introduction
3

 Financial reporting is the process of producing

statements that disclose an organization's financial status
to management, investors and the government.
 The objective of financial reporting is “to provide
information about the financial position, performance and
changes in financial position of an enterprise that is
useful to a wide range of users in making economic
decisions.”
 Introduction
4

 The guidelines used to prepare and maintain financial

records and reports are known as generally accepted
accounting principles (GAAP).
 GAAP is authorized by the Financial Accounting
Standards Board (FASB).
 The Sarbanes-Oxley Act of 2002, passed to eliminate the
many disclosure and conflict of interest problems of
corporations, established the Public Company Accounting
Oversight Board (PCAOB), which is a not-for-profit
corporation that overseas auditors.
 The PCAOB is charged with protecting the interests of
 Components of Financial Statements
5

 Balance Sheet - statement of financial position at a given

point in time.
 Balance sheet provides a snapshot of the following on a
specific date (for example, as of December 31, 2020)
• Assets (value of what the firm owns),
• Liabilities (value of firm’s debts), and
• Shareholder’s equity (the money invested by the
company owners).
 Components of Financial Statements
6

 Income Statement - incomes minus expenses for a given

time period ending at a specified date.
 An income statement provides the following information
for a specific period of time (for example, a year or 6
months or 3 months):
• Revenue,
• Expenses, and
• Profit
 Components of Financial Statements
7

 Statement of changes in Equity - also known as

Statement of Retained Earnings or Equity Statement.
 Cash Flows Statement - summarizes inflows and outflows
of cash and cash equivalents for a given time period
ending at a specified date.
 Notes - includes accounting policies, disclosures and
other explanatory information.
 Meaning of Financial Statements
8

 The process of critical evaluation of the financial

information contained in the financial statements in order
to understand and make decisions regarding the
operations of the firm is called “Financial Statement
Analysis (FSA)”.
 It is basically a study of relationship among various
financial facts and figures as given in a set of financial
statements, and the interpretation thereof to gain an
insight into the profitability and operational efficiency of
the firm to assess its financial health and future
prospects.

 Significance of Financial Statements
9

 Analysis of financial statements has become very

significant due to widespread interest of various parties in
the financial results of a business unit.
 The various parties interested in the analysis of financial
statements are:
 Investors  Suppliers and  Employees

 Management trade creditors  Government and

 Tax authorities their agencies
 Trade unions
 Researchers  Stock exchange
 Lenders
 Purposes or Objectives of Analysis of
10
Financial Statements
 Financial analysis is undertaken to serve the following
purposes/objectives.
1. Measuring the profitability

2. Indicating the trend of Achievements

3. Assessing the growth potential of the business

4. Comparative position in relation to other firms

5. Assess overall financial strength

6. Assess solvency of the firm

 Types of Financial Statement Analysis
11

1. On the basis of users

2. On the basis techniques employed for analyzing
financial statements
 1. Based on Users
12

1. External Analysis
2. Internal Analysis
 1. External Analysis
13

 External analysis is done by outsiders who do not have

access to the detailed internal accounting records of the
business firm.
 These outsiders include investors, potential investors,
creditors, potential creditors, government agencies,
credit agencies, and the general public.
 For financial analysis, these external parties to the firm
depend almost entirely on the published financial
statements.
 2. Internal Analysis
14

 Internal analysis conducted by persons who have access

to the internal accounting records of a business firm is
known as internal analysis.
 Such an analysis can, therefore, be performed by
executives and employees of the organization as well as
government agencies which have statutory powers
vested in them.
 2. On the basis techniques employed for analyzing financial
statements
15

 Cross-sectional analysis
 Time series analysis
 Cross-sectional cum time series analysis
 Cross-sectional Analysis – Inter Firm
16
Comparison
 This analysis helps in analyzing financial characteristics of an
enterprise with financial characteristics of another similar
enterprise in that accounting period.
 For example, if company A has earned 15% profit on capital
invested. This does not say whether it is adequate or not.
 If we analyze further and find that a similar company has earned
16% during the same period, then only we can make a conclusion
that company B is better.
 Time Series Analysis – Intra Firm
17
Comparison
 According to this method, the relationship between different items
of financial statement is established, comparisons are made, and
results obtained.
 In time series analysis the comparison of the financial statements
of different years of the same business unit are made.
 Cross-section cum Time Series
18
Analysis
 This analysis is intended to compare the financial characteristics of
two or more enterprises for a defined accounting period.
 It is possible to extend such a comparison over the year.
 This approach is most effective in analyzing of financial statements
 FSA (cont.)
19

 Several methods are used to study the relationship

between financial statements.
 Following are the important tools which are commonly
used for analyzing and interpreting financial statements:
1. Comparative financial statements
2. Common size statements
3. Trend analysis
4. Ratio analysis
5. Cash flow analysis
 Comparative financial statements
20

 These are the statements showing the profitability and

financial position of a firm for different periods of time in
a comparative form to give an idea about the position of
two or more periods.
 It usually applies to the two important financial
statements, namely, balance sheet and statement of
profit and loss prepared in a comparative form.
 Comparative figures indicate the trend and direction of
financial position and operating results.
 This analysis is also known as horizontal analysis.
 Comparative financial statements
21
(Cont.)
Particulars 2018 2019 Absolute Percentage
Increase (+) Increase (+)
or or
Decrease (–) Decrease (–)
Current 2,000 5,000 3,000 150%
Assets
Current 5,000 2,000 (3,000) (40%)
Liabilities
Sales 4,00,000 6,00,000 2,00,000 50%
 Comparative financial statements
22
(Cont.)
 To illustrate horizontal analysis, consider the financial statements
of Quality Department Store Inc. and LOWE’S Inc.
 These changes
suggest that the
company
expanded its
asset base
during 2007
and financed
this expansion
primarily by
retaining
income rather
than assuming
additional long-
term debt.
23
 Overall, gross
profit and net
income were up
substantially.
Gross profit
increased
17.1%, and net
income, 26.5%.
Quality’s profit
trend appears
favorable.

24
 In the horizontal analysis of the balance sheet the, net income
increased $55,300, or 26.5%, whereas dividends on the common
stock increased only $1,200, or 2%, ending retained earnings
increased 38.6%. As indicated earlier, the company retained a
25 significant portion of net income to finance additional plant
facilities.
 Common size statements
26

 Common size statements are income statement and

balance sheets in which dollar figures have been
converted into percentages.
 These are the statements which indicate the relationship
of different items of a financial statement with a common
item by expressing each item as a percentage of that
common item.
 Common size statements (Cont.)
27

 Common size statements are useful, both, in intra-firm

comparisons over different years and in making inter-
firm comparisons for the same year or for several
years.
 This analysis is also known as Vertical analysis.
 Common size statements (Cont.)
28

 Vertical analysis, also called common-size analysis, is a

technique that expresses each financial statement item
as a percent of a base amount.
 On a balance sheet we might say that current assets are
22% of total assets—total assets being the base amount.
 On an income statement we might say that selling
expenses are 16% of net sales—net sales being the base
amount.
 Common size statements (Cont.)
29

 To illustrate vertical analysis, consider the financial statements of

Quality Department Store Inc. and LOWE’S Inc.
 Quality is choosing
to finance its
growth through
retention of
earnings rather
than through
issuing additional
debt.
Helpful Hint
The formula to
calculate these
balance sheet
percentages is:
𝑬𝒂𝒄𝒉 𝑰𝒕𝒆𝒎 𝒐𝒏 𝑩/𝑺
× 𝟏𝟎𝟎
𝑻𝒐𝒕𝒂𝒍 𝑨𝒔𝒔𝒕𝒆𝒔

30
 The Quality
appears to be
profitable
enterprise that is
becoming even
more successful.

Helpful Hint
The formula to
calculate these
income statement
percentages is:

𝑬𝒂𝒄𝒉 𝑰𝒕𝒆𝒎 𝒐𝒏 𝑰 /𝑺
× 𝟏𝟎𝟎
𝑵𝒆𝒕 𝑺𝒂𝒍𝒆𝒔

31
 Common size statements (Cont.)
32

Vertical Analysis enables a

comparison of companies
of different sizes.
 Common size statements (Cont.)
33

 To illustrate vertical analysis, consider the financial statements LOWE’S Inc.

 Trend analysis
34

 It is a technique of studying the operational results and

financial position over a series of years.
 Using the previous years’ data of a business enterprise,
trend analysis can be done to observe the percentage
changes over time in the selected data.
 The trend percentage is the percentage relationship, in
which each item of different years bear to the same
item in the base year.
 Trend analysis (Cont.)
35

 Trend analysis is important because, with its long run

view, it may point to basic changes in the nature of the
business.
 By looking at a trend in a particular ratio, one may find
whether the ratio is falling, rising or remaining
relatively constant.
 From this observation, a problem is detected or the
sign of good or poor management is detected.
 Trend analysis (Cont.)
36

Illustration 1
Calculate the trend percentages from the following figures of sales, stock and profit
of Al-Noor Sugar Mills Ltd., taking 2010 as the base year and interpret them.
Year Sales Stock Profit before tax

2010 1,881 709 321

2011 2,340 781 435
2012 2,655 816 458
2013 3,021 944 527
2014 3,768 1,154 627

Helpful Hint 𝑷𝒓𝒆𝒔𝒆𝒏𝒕 𝒀𝒆𝒂𝒓 𝑽𝒂𝒍𝒖𝒆

× 𝟏𝟎𝟎
The formula to calculate the trend 𝑩𝒂𝒔𝒆 𝒀𝒆𝒂𝒓 𝑽𝒂𝒍𝒖𝒆
percentages is:
 Trend analysis (Cont.)
37

Illustration 1: Solution
Sales Stock Profit before tax
Year Amount Trend % Amount Trend % Amount Trend %
2010 1881 100 709 100 321 100
2011 2340 124 781 110 435 136
2012 2655 141 816 115 458 143
2013 3021 161 944 133 527 164
2014 3768 200 1154 163 627 195

• The sales have continuously increased in all the years up to 2014.

• The figures of stock have also increased over a period of five
years. The increase in stock is more in 2013 and 2014 as
compared to earlier years.
 Trend analysis (Cont.)
38

Illustration 2
Coca-Cola Company had the following net sales and operating
income for each of the past five years (in millions). Assuming 2006 is
the base year, calculate the trend percentages.
Particulars 2010 2009 2008 2007 2006
Net sales $35,119 $30,990 $31,944 $28,857 $24,088
Operating
$ 8,449 $ 8,231 $ 8,446 $ 7,252 $ 6,308
income
 Trend analysis (Cont.)
39

Illustration 2: Solution
Net Sales Operating Income
Year Amount Trend % Amount Trend %
2006 $24,088 100 $ 6,308 100
2007 $28,857 120 $ 7,252 115
2008 $31,944 133 $ 8,446 134
2009 $30,990 129 $ 8,231 130
2010 $35,119 146 $ 8,231 134

• It has been noticed that the increase in operating income of 34

percent from 2006 to 2010 was less than the increase in net sales
of 46 percent for the same period.
• This signals that the increase in Coca-Cola’s operating expenses
overtaken the increase in net sales during this period.
 Trend analysis (Cont.)
40
 Ratio analysis
41

 It is possible to assess the profitability, solvency and

efficiency of an enterprise through the technique of
ratio analysis.
 It describes the significant relationship which exists
between various items of a balance sheet and a
statement of profit and loss of a firm.
 Cash flow analysis
42

 It refers to the analysis of actual movement of cash into

and out of an organization.
 The flow of cash into the business is called as cash inflow
or positive cash flow and the flow of cash out of the firm
is called as cash outflow or a negative cash flow.
 The difference between the inflow and outflow of cash is
the net cash flow.
 Cash flow analysis
43

 Cash flow statement is prepared to project the manner in

which the cash has been received and has been utilized
during an accounting year as it shows the sources of cash
receipts and also the purposes for which payments are
made.
 Thus, it summarizes the causes for the changes in cash
position of a business enterprise between dates of two
balance sheets.
44