In this article we will discuss about the analysis and interpretation of financial statements of a company.
Financial statements are prepared primarily for decision making. The statements are not an end in themselves, but are useful in decision making. Financial analysis is the process of determining the significant operating and financial characteristics of a firm from accounting data.
The profit and Loss Account and Balance Sheet are indicators of two significant factors- Profitability and Financial Soundness. Analysis of statement means such a treatment of the information contained in the two statements as to afford a full diagnosis of the profitability and financial position of the firm concerned.
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 a study of the trends of these factors as shown in a series of statements.
The main function of financial analysis is the pinpointing of the strength and weakness of a business undertaking by regrouping and analysis of figures contained in the financial statements, by making comparisons of various components and by examining their content.
The financial statements are the best media of documenting the results of managerial efforts to the owners of the business, its employees, its customers and the public at large, and thus become excellent tools of the public relations.
(a) Breaking financial statements into simpler ones,
(c) Rearranging the figures given in financial statements and
(d) Finding out ratios and percentages.
Thus all processes which help in drawing certain results from the financial statements are included in analysis. The data provided in the financial statements should be methodically classified and compared with figures of previous period or other similar firms.
Thereafter, the significance of the figures is established. The work of an accountant in making analysis of financial statements is the same as that of a pathologist, who takes a drop of blood and analyses it to point out its various components and gives a report on the basis of his analysis.
Similarly, an accountant makes analysis of each item appearing in financial statements and then gives a report on the basis of his analysis. Analysis only establishes a relationship between various amounts mentioned in Balance Sheet and Profit and Loss Account. After making analysis of the financial statements, the next step is to use mind for forming an opinion about the enterprise. This is the interpretation stage.
The technique is called “Analysis and Interpretation” of financial statements. Analysis consists in breaking down a complex set of facts or figures into simple elements. Interpretation, on the other hand, consists in explaining the real significance of these simplified statements. Interpretation includes both analysis and criticism.
To interpret means to put the meaning of statement into simple terms for the benefit of a person. Interpretation is to explain in such a simple language the financial position and earning capacity of the company which may be understood even by a layman, who does not know accounting.
The analysis and interpretation of financial statements requires a comprehensive and intelligent understanding of their nature and limitations as well as the determination of the monetary valuation of the items. The analyst must grasp what represent sound and unsound relationship reflected by the financial statements. Interpretation is impossible without analysis. “Interpretation is not possible without analysis and without interpretation analysis has no value”.
Analysis and interpretation act as a bridge between the art of recording and reporting financial information and the act of using this information. Analysis refers to the process of fact finding and breaking down complex set of figures into simple components while interpretation stands for explaining the real significance of these simplified components. Interpretation is a mental process based on analysis and criticism.
George O May points out the following uses of financial statements:
1. As a report of stewardship;
2. As a basis for fiscal policy;
3. To determine the legality of dividends;
4. As a guide to advise dividend action;
5. As a basis for granting of credit;
6. As informative for prospective investors in an enterprise;
7. As a guide to the value of investment already made;
8. As an aid to Government supervision;
9. As a basis for price or rate regulation;
10. As a basis for taxation.
A financial analyst can adopt the following tools for analysis of the financial statements:-
1. Comparative Financial Statements
2. Common Size Statements
3. Trend Ratios or Trend Analysis.
4. Statement of Changes in Working Capital
5. Fund Flow and Cash Flow Analysis
6. Ratio Analysis
Procedure for Interpretation:
1. Ascertain the purpose and the extent of analysis and interpretation.
2. Study the available data contained in financial statements.
3. Get additional information, if needed.
4. Arrange the data in useful manner.
5. Prepare comparative statements, ratios etc.
6. Interpret the facts revealed by the analysis.
Objectives of Analysis and Interpretation:
The following are the main objectives of analysis and interpretation of financial statements:
1. To estimate the earning capacity of the firm.
2. To assess the financial position of the firm.
3. To decide about the future prospects of the firm.
4. To know the progress of the firm.
5. To judge the solvency of the firm.
6. To measure the efficiency of operations.
7. To determine debt capacity of the firm.
8. To assess the financial performance of the firm.
9. To have comparative study.
10. To help in making future plans.
Analysis of financial statements should always be tuned to the objective. People use financial statements for satisfying their particular curiosity. Financial accounts are interpreted by different persons in different ways according to their objects. For instance same financial statement may be very good for one; ordinarily good for the other and worst for the third.
This is because their views and objects of interpretation differ.
(1) A prospective shareholder would like to know whether the business is profitable and is progressing on sound lines.
(2) A supplier who would like to transact business with the firms may be interested in the company’s ability to honour its short-term commitments.
(3) A financier would like to be satisfied with safety and reliability of return on his investment. Thus, the object of the analysis determine the extent, depth and nature of analysis.