FINANCIAL STATEMENT:

Financial statements are written reports created by a company’s management to

summarize the business’s financial condition over a certain period (quarter, six-
monthly, or yearly). These statements, which comprise the balance sheet, income
statement, cash flow statement, and statement of shareholders’ equity, must be
prepared by specified and standardized accounting standards to ensure that reporting
is consistent.
BASICS OF FINANCIAL STATEMENT
Now, let’s look at the basics of financial statements and a practical example.
1 – Balance Sheet
The balance sheet is a financial statement that provides a snapshot of the assets,
liabilities, and shareholder’s equity. Many companies use the shareholders’ equity
as a separate financial statement. But usually, it comes with the balance sheet.
The equation that you need to remember when you prepare a balance sheet is this –
Assets = Liabilities + Shareholders Equity
 Under the current assets, you can consider cash, accounts receivable, rent
prepaid, etc. Under the non-current assets we can put equipment, plant, building,
etc.
 The idea is to follow a sequence from more liquid to less liquid.
 At the same time, on the other hand, you can consider account payable including
creditors, outstanding salaries, etc. As a long-term/non-current liability, you can
consider long-term debt.
The balance sheet sometimes gets quite complex. The accountants need to make sure
that every record is properly reported so that the total assets always equal total
liabilities plus shareholders’ equity.
2- Income Statement
The Income Statement is the next financial statement everyone should look at. It
looks quite different from the balance sheet. In the income statement, it’s about the
revenue and the expenses.
 Well, it starts with the Gross Sales or revenue. Then we deduct any sales return
or sales discount from the gross sales to get the net sales. This net sale is what we
use for Ratio Analysis.
 We deduct the costs of goods sold from net sales, and we get the Gross Profit.
 We deduct the operating expenses from gross profit, like the expenses required
for daily Administrative Exp. We get the EBIT, meaning the Earnings before Interest
and Taxes, by deducting the operating expenses.
 From EBIT, we deduct the interest charges paid or add interest received (if any),
and we get EBT, meaning Earnings before Taxes.
 From EBT, we deduct the income taxes for the period, and we get the Net Income
means Profit after Tax.
3- Cash Flow Statement
The Cash Flow Statement is the third most important statement every investor should
look at.These statements are cash flow from the operating activities, cash flow from
investing activities, and cash flow from finance activities.
 Cash flow from Operation is the cash generated from the business’s core
operations.
 Cash flow from Investing Activities relates to the cash inflows and outflows
related to investments in the company like buying property, plants, and equipment
or other investments.
 Cash flow from Financing Activities relates to the cash inflows or outflows
related to the debt or equity of the company. It includes raising debt or equity, loan
repayments, buyback of shares, etc.
4 - Statement of Changes in Shareholders Equity
Statement of Changes in Shareholders Equity is a financial statement that
summarizes changes in the shareholder’s equity in a given period.
 Common Stock is the first and most important component of Shareholders Equity.
Common stockholders are the owners of the company.
 Additional Paid in Capital means when the company receives a premium on the
shares.
 Retained Earnings or losses are accumulated from the previous period. In simple
terms, retained earnings are the amount the company keeps after paying the dividend
from net income.
 Treasury shares are the total of all the common shares that have been purchased
back by the company.
 Accumulated other comprehensive income contains unrealized gain/losses that do
not flow through the income statement.

USES OF FINANCIAL STATEMENT

Following are some of the uses of financial statements:
1. Determine the financial position of the business: The most important use
of the financial statements is to provide information about the financial
position of the business on a given date. This piece of information is used by
various stakeholders in order to take important decisions regarding the
business.
2. To obtain credit: Financial statements present the picture of the business to
the potential lenders and this information can be used by them to provide
 additional credit for business expansion or restrict the credit so as to start
recovery.
3. Helps investors in decision making: Financial statements contain all the
essential information required by the potential investors for determining how
much they want to invest in the business. It is also helpful in decision making
regarding the price per share that the investors want to invest. A sound
financial statement is the key to obtaining investments.
4. Helps in policy making: The financial statements help the government in
deciding the taxation and regulations policies based on the way the company
is running its operations. The government bodies can tax a business based on
the level of their income and assets.
5. Useful for stock traders: Financials statements help stock traders with the
knowledge of the situation the company is in and therefore adjusting their
quotes accordingly.
IMPORTANCE OF FINANCIAL STATEMENT
The significance of financial statements prevails in their service to persuade the
diverse interests of distinct classes of parties such as creditors, public, management,
etc.,
1. Importance to Management: Increase in size and intricacies of aspects
influencing the business functions requires scientific and strategic access in
the management of contemporary trading concerns. The management team
needs up to date, precise and methodical financial data for the intentions.
Financial statements assist the management in comprehending the progress,
prospects, and position of the business counterpart in the industry.
2. Importance to the Shareholders: Management is detached from control in
the case of companies. Shareholders cannot take part in the day-to-day
business pursuits. However, the outcome of these pursuits should be disclosed
 to shareholders during the annual general body meeting in the form of
financial statements.
MEANING OF FINANCIAL STATEMENT ANALYSIS:
Financial statement analysis is the process of analyzing a company's financial
statements for decision-making purposes. External stakeholders use it to understand
the overall health of an organization as well as to evaluate financial performance
and business value. Internal constituents use it as a monitoring tool for managing
the finances.
HOW TO ANALYSE FINANCIAL STATEMENT
The financial statements of a company record important financial data on every
aspect of a business’s activities. As such, they can be evaluated on the basis of past,
current, and projected performance.
In general, financial statements are centered on Generally Accepted Accounting
Principles (GAAP) in the U.S. These principles require a company to create and
maintain three main financial statements: the balance sheet, the income statement,
and the cash flow statement. Public companies have stricter standards for financial
statement reporting. Public companies must follow GAAP, which requires accrual
accounting.1 Private companies have greater flexibility in their financial statement
preparation and also have the option to use either accrual or cash accounting.
Several techniques are commonly used as part of financial statement analysis. Three
of the most important techniques include horizontal analysis, vertical analysis and
ratio analysis. Horizontal analysis compares data horizontally, by analyzing values
of line items across two or more years. Vertical analysis looks at the vertical effects
line items have on other parts of the business and also the business’s proportions.
Ratio analysis uses important ratio metrics to calculate statistical relationships.
TECHNIQUES OF FINANCIAL STATEMENT ANALYSIS:
While there are several techniques of financial statement analysis, the three most
widely used techniques are briefly discussed below:

1. HORIZONTAL ANALYSIS
Horizontal Analysis involves evaluation of financial statements on a historical basis.
Under this technique, financial data is compared across time periods. For example,
the progression of sales is evaluated over the years to evaluate the sales growth rate
of the entity.
Horizontal analysis uses a base period and one or more comparison periods. The
result of this analysis is generally expressed as a percentage with reference to the
specified base period. The formula used to calculate percentages in a horizontal
analysis is given below:

Advantages:
This technique of financial statement analysis offers the following advantages:
 Horizontal analysis helps identify and analyze trends and patterns in entity’s
financial performance.
 By analyzing the progression of various financial parameters over the years,
it helps in identifying areas of the strengths and weaknesses in the entity’s
financial operations. For example, management can analyze the growth in
 entity’s profitability in relation to the growth in sales revenue over the years
which may reveal actions needed to be taken towards cost control.
 This analysis provides a basis for estimating the entity’s future performance
as well as assists in setting benchmarks or standards for forthcoming years.
Limitations:
Horizontal analysis technique also suffers from certain drawbacks; such as:
 It only compares relative financial performance without considering
performance in absolute terms.
 Under this type of analysis, a change in classification of reported accounts
can lead to misleading results.
 It can be manipulated to indicate desired but misleading results; for example,
a comparison of line items amongst different quarters of the same year can
lead to significantly different results when compared to the same quarter of
different years.
2. VERTICAL ANALYSIS
As the name suggests, vertical analysis involves the assessment of various line items
of a financial statement as a percentage of a specific base line item. For example,
various expenses on an income statement are expressed as a percentage of sales and
the share of each type of asset is expressed as a percentage of total assets. The
percentages under a vertical analysis are derived by the following formula:

Advantages:
 It is an easy representation of relationship between various line items of the
financial statement.
  It helps understand the relative share of each line item. For example, if direct
material is a significant percentage of sales in relation to say, direct labour,
the management can understand its impact on profitability and can thus focus
a greater attention towards any possibility of reducing or controlling it.
 Since a vertical analysis converts absolute numbers to percentage terms, it can
be employed for inter-firm comparison with other entities within the industry
by equating companies of different scales.
 It helps in identifying trends to aid comparison over time periods.
Limitations:
 It requires a standard benchmark percentage defined for the analysis to be
meaningful and to actually assist in decision making. For example, a
company may know that its marketing expenses are 10% of its sales; however
without a defined standard percentage, it may not be able to decide on the
reasonableness of this derived percentage.
 Need for consistency in base – for an appropriate comparison from year to
year or company to company, the base used for comparison must be the same.
3. RATIO ANALYSIS:
Ratio analysis involves evaluating relationship between various line items of
financial statements like income statement and balance sheet. This is done by
calculating various financial ratios and comparing them with some set standards. On
the basis of this comparison, management can take corrective steps and other
stakeholders can make informed decisions according to their specific situations.
The ratios that are derived to perform a financial statement analysis are typically
categorized as follows:
 Liquidity ratios: measure an entity’s ability to service its near-term debts as
well as to meet its near-term fund requirements. A typical set of liquidity
ratios includes current ration, liquid ratio etc.
  Solvency ratios: measure the long-term stability of a business entity by
evaluating its ability to meet its fund requirements over a long period of time.
These typically include debt-equity ratio, fixed assets to equity ratio,
and capital gearing ratio etc.
 Profitability ratios: measure the ability of a commercial entity to generate
profits for its stockholders or owners. These ratios can include gross and net
profit ratio, P/E ratio, EPS, and return on capital employed etc.
 Activity ratios: measure the efficiency of a business entity to utilize or
convert its assets into sales revenue or liquid funds. These ratios can
include inventory turnover ratio, receivable turnover ratio and fixed assets
turnover ratio etc.
Advantages of Ratio Analysis:
 Ratios analysis indicates an entity’s financial health as well as its operational
efficiency through various parameters (e.g., liquidity and solvency) which
other analysis techniques may not address.
 This analysis indicates the entity’s current position and any necessary
remedial actions that it needs to take. It, thus, helps management in financial
activity planning of the entity.
 Ratios analysis provides a standard for inter-firm comparison.
Drawbacks of ratios analysis technique:
 Ratios analysis can give erroneous results if there is a difference in accounting
presentation of different entities compared or different periods considered in
the analysis.
 Its results are often limited to quantitative analysis only, and not qualitative
analysis. For example, balance sheet may exhibit a healthy current ratio but
will not reveal the level of obsolescence present in the inventory considered
in the calculation.
PURPOSE OF FINANCIAL STATEMENT ANALYSIS:
Financial statement analysis has considerable utility for all stakeholders of an entity.
Some of its salient purposes are mentioned below:
 The primary purpose: The primary purpose of performing a financial
statement analysis is to dig into financial health as well as operational
efficiency of the entity through its various analysis techniques.
 Aids industry comparison: It helps stakeholders gauge where the entity’s
financial performance stands as compared to its peers in the industry. This is
possible even when other entities operate at materially different scales.
 Aids historical comparison: It helps identify trends in financial performance
as well as understand the financial progression of the entity over the years.
 Forecasting and budgeting: The interpretation of financial statement
analysis can help management take budgeting decisions. Stakeholders can
also estimate and project future performance based on results of financial
analysis.
 Basis for decision making: The ultimate goal of the analysis is to provide
stakeholders with a means to evaluate financial performance giving them a
basis for comprehensive decision making.
LIMITATIONS OF FINANCIAL STATEMENT ANALYSIS:
While financial statement analysis is an important and useful exercise, it does suffer
from certain limitations. These can include:
 High dependency on accuracy of financial statements: A financial
statement analysis can be inaccurate and in fact can even be manipulated if
the base financial statements are inaccurate.
 Change in accounting policies: Any change in accounting methodology or
presentation can result in erroneous results, hampering the efficacy of inter-
period or inter-firm comparison.
  Focus on quantitative analysis: While exercising a financial statement
analysis, the primary focus is on quantitative data. The non-monetary and
qualitative aspects that impact financial performance are often side-lined
under.
 Only a tool not a solution: The analysis of financial statements is only a
means to an end. The actual success of the analysis requires expert analysts
to meaningfully interpret, analyze and then take appropriate and timely
decisions about the matters involved.
CLASSIFICATION OF FINANCIAL STATEMENT ANALYSIS:
 1. Comparative Financial Statement Analysis (Horizontal Analysis): As
the name suggests, comparative analysis provides a year-on-year review of
the various financial statements. For example, in the Income Statement, the
Sales figure may be compared over a period of consecutive years to
understand how the sales figures have grown (or declined) over the year. It
should be noted that horizontal analysis compares the internal performance of
the company.
Below is an example of a Comparative Income Statement.
Comparative Income Statement (All figures are in INR ‘000)
 2. Common-size Financial Statement Analysis (Vertical Analysis):
Vertical analysis is applicable for internal performance review as well as for
comparison to peers and bench-marking. In vertical analysis all the items in a
particular statement are represented as a percentage of a particular item. For
example, Operating Expenses, Depreciation, Amortization, Profit before tax,
Tax, Profit after tax, etc. may be represented as a percentage of Sales in the
Income Statement. Common standard base can easily reveal the internal
make-up of financial statements and any proportionate increase and decrease
of the same.
Vertical analysis is also put to use for comparison across companies as
financial statements are converted to common-size format, which can then be
used to compare with competitor or industry averages, highlighting key
differences which can then be analyzed.
Below is an example of a Common Size Income Statement. Values are
expressed as % age of Revenue.
Common size statements are also known as ‘Vertical analysis’. Financial
statements, when read with absolute figures, can be misleading. Therefore, a
vertical analysis of financial information is done by considering the percentage
form. The balance sheet items are compared:
 to the total assets in terms of percentage by taking the total assets as 100.
 to the total liabilities in terms of percentage by taking the total liabilities as
100.
Therefore the whole Balance Sheet is converted into percentage form. And such
converted Balance Sheet is known as Common-Size Balance Sheet. Similarly profit
& loss items are compared:
 to the total incomes in terms of percentage by taking the total incomes as 100.
 to the total expenses in terms of percentage by taking the total expenses as 100.
Therefore the whole Profit & loss account is converted into percentage form. And
such converted profit & loss account is known as Common-Size Profit & Loss
account. As the numbers are brought to a common base, the percentage can be
easily compared with the results of corresponding percentages of the previous year
or of some other firms.
Trend analysis is used to reveal the trend of items with the passage of time and is
generally used as a statistical tool. Trend analysis is used in conjunction with
ratio analysis, horizontal and vertical analysis to spot a particular trend, explore
the causes of the same and if required prepare future projections.
The ratios of different items for various periods are find out and then compared
under this analysis. The analysis of the ratios over a period of years gives an idea
of whether the business concern is trending upward or downward. This analysis
is otherwise called as Pyramid Method. Trend Statements are prepared to analyze
long term movement in financial figures. In trend statements initial year is taken
as base (100) and percentage is calculated for the following years. It enables an
analysis of performance of the same company for many years. While comparative
statements show the size of change, trends show the direction (up or down) of the
changes. It is more accurate because it is based on percentages and not absolute
figures. Trend analysis will give a distorted figure if the accounting policies, with
respect to depreciation, valuation of closing stock, etc. have changed during the
period under study. The trend may change if a different year is chosen as the base
Trend percentage = Current year ÷ Base year
From the following data relating to the Equity and liabilities of balance sheet of
X Ltd., for the period March 31, 2010 to 2013, calculate the trend percentages
taking 2010-11 as the base year.
Interpretation –
i) Shareholders’ funds have increased over the period because of retention of
profits in the business in the form of reserves, and the share capital has also
increased, may be due to issue of fresh shares or bonus shares.
ii) The increase in current liabilities is more than that of long-term debt. This may
be due to expansion of business and/or availability of greater credit activities.