E-LESSON-6 , 7

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M.B.A FINANCIAL REPORTING AND ANALYSIS Course Code: MBA604 Semester: 1 SLM UNITS : 6&7 E-lesson Unit: 4 www.cuidol.in Unit-6 & 7 (MBA 604) All right are reserved with CU-IDOL

UNDERSTANDING FINANCIAL 3 STATEMENT OBJECTIVES INTRODUCTION Student will be able to : Describe and draft a report on inter-firm and intra- Financial statement is an analysis which firm comparison highlights important relationships in the financial statements Perform financial statement analysis for Financial system analysis is an important management control purposes means of assessing past performance and in forecasting and planning future performance Prepare and interpret common size statements of This is an information processing system, income and financial position designed to provide data for decision making models such as portfolio selection model and bank lending decision model www.cuidol.in Unit-6 & 7 (MBA 604) INASllTITriUgThEt aOrFeDreISsTeArNveCdE AwNitDh OCNUL-IIDNOE LLEARNING

TOPICS TO BE COVERED > Objectives of Financial System Analysis > Techniques of Financial System Analysis > Common Size statements www.cuidol.in Unit-6 & 7 (MBA 604) All right are reserved with CU-IDOL

Financial Statement Analysis  Meaning of Financial Statement Analysis:  Financial Statement Analysis is an analysis which highlights important relationships in the financial statements. Financial Statement analysis embraces the methods used in assessing and interpreting the results of past performance and current financial position as they relate to particular factors of interest in investment decisions. It is an important means of assessing past performance and in forecasting and planning future performance.  “Financial Statement Analysis is an information processing system designed to provide data for decision-making models, such as the portfolio selection model, bank lending decision models, and corporate financial management models.” www.cuidol.in Unit-6 & 7 (MBA 604) All right are reserved with CU-IDOL

Financial Statement Analysis  The process of reviewing and analyzing a company’s financial statements to make better economic decisions is called analysis of financial statements. In other words, the process of determining financial strengths and weaknesses of the entity by establishing the strategic relationship between the items of the balance sheet, profit and loss account, and other financial statements.  The term ‘analysis’ means the simplification of financial data by methodical classification of the data given in the financial statements, ‘interpretation’ means, ‘explaining the meaning and significance of the data so simplified.’ However, both’ analysis and interpretation’ are interlinked and complementary to each other. www.cuidol.in Unit-6 & 7 (MBA 604) All right are reserved with CU-IDOL

Parties Interested in Financial Analysis  The following parties are interested in the analysis of financial statements: (1) Investors or potential investors. (2) Management. (3) Creditors or suppliers. (4) Bankers and financial institutions. (5) Employees. (6) Government. (7) Trade associations. (8) Stock exchanges. (9) Economists and researchers. (10) Taxation authorities www.cuidol.in Unit-6 & 7 (MBA 604) All right are reserved with CU-IDOL

Objectives of Financial Statement Analysis  The major objectives of financial statement analysis are to provide decision makers information about a business enterprise for use in decision-making. Users of financial statement information are the decision- makers concerned with evaluating the economic situation of the firm and predicting its future course.  Financial statement analysis can be used by the different users and decision makers to achieve the following objectives: 1. Assessment of Past Performance and Current Position 2. Prediction of Net Income and Growth Prospects 3. Prediction of Bankruptcy and Failure 4. Loan Decision by Financial Institutions and Banks www.cuidol.in Unit-6 & 7 (MBA 604) All right are reserved with CU-IDOL

Objectives of Financial Statement Analysis 1. Reviewing the performance of a company over the past periods: To predict the future prospects of the company, past performance is analyzed. Past performance is analyzed by reviewing the trend of past sales, profitability, cash flows, return on investment, debt-equity structure and operating expenses 2. Assessing the current position & operational efficiency: Examining the current profitability & operational efficiency of the enterprise so that the financial health of the company can be determined. For long-term decision making, assets & liabilities of the company are reviewed. Analysis helps in finding out the earning capacity & operating performance of the company. 3. Predicting growth & profitability prospects: The top management is concerned with future prospects of the company. Financial analysis helps them in reviewing the investment alternatives for judging the earning potential of the enterprise. With the help of financial statement analysis, assessment and prediction of the bankruptcy and probability of business failure can be done. 4. Loan Decision by Financial Institutions and Banks: Financial analysis helps the financial institutions, loan agencies & banks to decide whether a loan can be given to the company or not. It helps them in determining the credit risk, deciding the terms and conditions of a loan if sanctioned, interest rate, maturity date etc. www.cuidol.in Unit-6 & 7 (MBA 604) All right are reserved with CU-IDOL

Significance of Financial Statement Analysis Analysis of financial statements helps the finance manager in:  Assessing the operational efficiency and managerial effectiveness of the company  Analyzing the financial strengths and weaknesses and creditworthiness of the company  Analyzing the current position of financial analysis  Assessing the types of assets owned by a business enterprise and the liabilities which are due to the enterprise  Providing information about the cash position company is holding and how much debt the company has in relation to equity  Studying the reasonability of stock and debtors held by the company www.cuidol.in Unit-6 & 7 (MBA 604) All right are reserved with CU-IDOL

Significance of Financial Statement Analysis Financial analysis helps the top management to: • Assess whether the resources of the firm are used in the most efficient manner • Whether the financial condition of the firm is sound • To determine the success of the company’s operations • Appraising the individual’s performance • Evaluating the system of internal control • To investigate the future prospects of the enterprise. www.cuidol.in Unit-6 & 7 (MBA 604) All right are reserved with CU-IDOL

Significance of Financial Statement Analysis Trade payables analyze financial statements for: • Appraising the ability of the company to meet its short-term obligations • Judging the probability of firm’s continued ability to meet all its financial obligations in the future • Firm’s ability to meet claims of creditors over a very short period of time • Evaluating the financial position and ability to pay off the concerns Suppliers of long-term debt are concerned with the firm’s long-term solvency and survival. They analyze the firm’s financial statements • To ascertain the profitability of the company over a period of time, • For determining a company’s ability to generate cash, to pay interest and repay the principal amount • To assess the relationship between various sources of funds (i.e. capital structure relationships) • To assess financial statements which contain information on past performances and interpret it as a basis for forecasting future rates of return and for assessing risk. • For determining credit risk, deciding the terms and conditions of a loan if sanctioned, interest rate, and maturity date etc. www.cuidol.in Unit-6 & 7 (MBA 604) All right are reserved with CU-IDOL

Significance of Financial Statement Analysis Investors Investors, who have invested their money in the firm’s shares, are interested in the firm’s earnings and future profitability. Financial statement analysis helps them in predicting the bankruptcy and failure probability of business enterprises. After being aware of the probable failure, investors can take preventive measures to avoid/minimize losses. Labour unions analyze the financial statements: • To assess whether an enterprise can increase their pay. • To check whether an enterprise can increase productivity or raise the prices of products/ services to absorb a wage increase. www.cuidol.in Unit-6 & 7 (MBA 604) All right are reserved with CU-IDOL

Techniques of Financial Statement Analysis  There is a myriad of techniques that can be used to analyze the performance of a commercial enterprise, but the most common methods use the following strategies: (1) Horizontal Analysis, (2) Vertical Analysis, (3) Trend Analysis, and (4) Ratio Analysis. www.cuidol.in Unit-6 & 7 (MBA 604) All right are reserved with CU-IDOL

Techniques of Financial Statement Analysis 1. Horizontal Analysis: This method uses past performance as a baseline metric for the success of the company. There are variations in this method that may use some number of years as a standard; for example, if the company has been in existence for some time, the two years prior may be used as a comparison. If the company is relatively new, it is common to use the initial year as a baseline and plot performance in relation to it. 2. Vertical Analysis: Also known as component percentages, this type of analysis compares the profits to assets, liabilities, and equities. This method is generally helpful when comparing a large number of similar companies. The limitation of this method is that it often does not weight factors that impact future viability appropriately, like long-term partnerships, and one-time losses or investments. www.cuidol.in Unit-6 & 7 (MBA 604) All right are reserved with CU-IDOL

Techniques of Financial Statement Analysis 3. Ratio Analysis: This method analyzes various aspects of the company’s financial health. For example, a current ratio is the comparison of assets to liabilities. This type of analysis is extremely popular due to the analyst’s ability to choose two key features of businesses to analyze. Many analysts utilize this type of analysis to support their evaluations of organizations even if conventional analytical methodologies may not be as positive. The weakness in this type of analysis is that if the two characteristics are poorly chosen, an unreliable estimation of financial viability may be produced. 4. Stock Price Movement: This technique relies on analyzing the performance of the company’s stock rather than their financial health. In essence, this method uses the financial markets as an analytical tool. Various methods may be used to evaluate the stock’s performance including enlarging or narrowing the window of evaluation, comparison to similar companies and trend analysis. There are some serious drawbacks to this technique. If the markets are relying on inaccurate data or analytical methodologies, it may be pricing stocks higher than their actual value. Stock analyses often ignore the company’s intrinsic sustainability in order to profit from stock price fluctuations and are unreliable foundations for establishing long-term investment relationships. www.cuidol.in Unit-6 & 7 (MBA 604) All right are reserved with CU-IDOL

Limitations of Financial Statement Analysis  Financial analysis is a powerful mechanism of determining financial strengths and weaknesses of a firm. But, the analysis is based on the information available in the financial statements. The financial analyst has also to be careful about the impact of price level changes, window-dressing of financial statements, changes in accounting policies of a firm, accounting concepts and conventions, and personal judgment , etc. Some of the important limitations of financial analysis are: (i) It is only a study of interim reports (ii) Financial analysis is based upon only monetary information and non-monetary factors are ignored. (iii) It does not consider changes in price levels. (iv) As the financial statements are prepared on the basis of a going concern, it does not give exact position. Thus accounting concepts and conventions cause a serious limitation to financial analysis. (v) Changes in accounting procedure by a firm may often make financial analysis misleading. (vi) Analysis is only a means and not an end in itself. The analyst has to make interpretation and draw his own conclusions. Different people may interpret the same analysis in different ways. www.cuidol.in Unit-6 & 7 (MBA 604) All right are reserved with CU-IDOL

Common Size Statements  Common size statements involve expressing comparisons in percentages. Common size statements may be prepared in order to compare percentages of a current period with past periods, to compare individual business, or to compare one business with industry percentages published by trade associations and financial information services.  Common size financial statements contain the percentages of a key figure alone, without the corresponding amount figures. The use of percentages is usually preferable to the use of absolute figures. An illustration will make this clear. If company A earns Rs. 10,000 and Company B earns Rs. 1,000, which is more profitable? The answer is likely to be company A.  However, the total shareholder’s equity of company A is Rs. 10,00,000 and company B is Rs. 10,000 the return on equity will be as follows:  Comparing the return on equity, it can be clearly said that company B is more profitable than company A. www.cuidol.in Unit-6 & 7 (MBA 604) All right are reserved with CU-IDOL

Comparative Statement Analysis Meaning of Comparative Statements : The comparative financial statements are statements of the financial position at different periods of time. The elements of financial position are shown in a comparative form so as to give an idea of financial position at two or more periods. Any statement prepared in a comparative form will be covered in comparative statements. From practical point of view, generally, two financial statements (balance sheet and income statement) are prepared in comparative form for financial analysis purposes. Not only the comparison of the figures of two periods but also be relationship between balance sheet and income statement enables an in depth study of financial position and operative results. The comparative statement may show: (i) Absolute figures (rupee amounts). (ii) Changes in absolute figures i.e., increase or decrease in absolute figures. (iii) Absolute data in terms of percentages. (iv) Increase or decrease in terms of percentages. www.cuidol.in Unit-6 & 7 (MBA 604) All right are reserved with CU-IDOL

Types of Comparative Statements  The two comparative statements are: (i) Balance sheet, and (ii) Income statement. (i) Comparative Balance Sheet:  The comparative balance sheet analysis is the study of the trend of the same items, group of items and computed items in two or more balance sheets of the same business enterprise on different dates.’ The changes in periodic balance sheet items reflect the conduct of a business.  The changes can be observed by comparison of the balance sheet at the beginning and at the end of a period and these changes can help in forming an opinion about the progress of an enterprise. The comparative balance sheet has two columns for the data of original balance sheets. A third column is used to show increases in figures. The fourth column may be added for giving percentages of increases or decreases. www.cuidol.in Unit-6 & 7 (MBA 604) All right are reserved with CU-IDOL

Interpretation of Comparative Balance Sheet  While interpreting Comparative Balance Sheet the interpreter is expected to study the following aspects: (1) Current financial position and liquidity position (2) Long -term financial position. (3) Profitability of the concern. www.cuidol.in Unit-6 & 7 (MBA 604) All right are reserved with CU-IDOL

Interpretation of Comparative Balance Sheet  For studying current financial position or short -term financial position of a concern, one should see the working capital in both the years. The excess of current assets over current liabilities will give the figures of working capital. The increase in working capital will mean improvement in the current financial position of the business.  An increase in current assets is accompanied by the increase in current liabilities of the same amount will not show any improvement in the short-term financial position. A student should study the increase or decrease in current assets and current liabilities and this will enable him to analyze the current financial position.  The second aspect which should be studied in current financial position is the liquidity position of the concern. If liquid assets like cash in hand, cash at bank, bills receivables, debtors, etc. show an increase in the second year over the first year, this will improve the liquidity position of the concern.  The increase in inventory can be on account of accumulation of stocks for want of customers, decrease in demand or inadequate sales promotion efforts. An increase in inventory may increase working capital of the business but it will not be good for the business. www.cuidol.in Unit-6 & 7 (MBA 604) All right are reserved with CU-IDOL

SUMMARY  Meaning of Financial Statement : “Financial Statement Analysis is an information processing system designed to provide data for decision-making models, such as the portfolio selection model, bank lending decision models, and corporate financial management models.”  Objectives of Financial Statement Analysis  Parties interested in Financial Statement Analysis: (1) Investors or potential investors. (2) Management. (3) Creditors or suppliers. (4) Bankers and financial institutions. (5) Employees. (6) Government.  Significance of Financial Statement Analysis: Assessing the operational efficiency and managerial effectiveness of the company Analyzing the financial strengths and weaknesses a creditworthiness of the company Limitations of Financial Statement Analysis Common Size Statements Comparative Statement Analysis : The comparative balance sheet analysis is the study of the trend of the same items, group of items and computed items in two or more balance sheets of the same business enterprise on different dates.’ The changes in periodic balance sheet items reflect the conduct of a business. www.cuidol.in Unit-6 & 7 (MBA 604) All right are reserved with CU-IDOL

MULTIPLE CHOICE QUESTIONS Q1. Dividend is paid on ............ b) Issued Capital a) Assured Capital d) Reserve Capital legally enforceable c) A subscribed capital that wa paid up Q2. Debentures are shown in the balance sheet under the head of a) Long term borrowings b) Current Liabilties c) Long term provisions d) Shareholders Fund Q3. Which among the followign is a tool for Financial Statement analysis? a) Comparative Statement b) Ratio Analysis c) Common size statement d) All the above Q4. Comparative Statements are prepared to show a) Absolute amount b) Percentage of totals c) Increase / decreastd d) All of the above Ans: 1 (b) 2 (a) 3 (d) 4 (d) www.cuidol.in Unit-6 & 7 (MBA 604) All right are reserved with CU-IDOL

FREQUENTLY ASKED QUESTIONS Q1. What is one of the main objectives of financial analysis? (in brief) Ans. Analysis of financial statements provides information about the financial position & performance of the company. It helps the management in planning & deciding the future policies of the company. Analysis helps in finding out the earning capacity & operating performance of the company. For More Detail Refer to SLM Q2. What are the tools of Financial Analysis? Ans. The principal tools are: Comparative Financial Statements; Common-size Statements; Trend Analysis; Cash Flow Statement; Ratio Analysis; Funds Flow statements For More Detail Refer to SLM Q3. Which parties are interested in the analysis of financial statements Ans. The following parties are interested in the analysis of financial statements: (1) Investors or potential investors (2) Management (3) Creditors or suppliers (4) Bankers and financial institutions (5) Employees (6) Government (7) Trade associations (8) Stock exchanges (9) Economists and researchers (10) Taxation authorities For More Detail Refer to SLM www.cuidol.in Unit-6 & 7 (MBA 604) All right are reserved with CU-IDOL

REFERENCES  Accounting Principles Board, Statement No 4, Basic Concepts and Accounting Principles Underlying Financial Statements of Business Enterprises, NewYork: AICPA, 1970, p.50  Financial Accounting Standards Board, Concept No 6, Elements of Financial Statements, Stamford: FASB, December 1985, p 35  The Institute of Chartered Accountants of India, Guidance note on Terms Used in Financial Statements, New Delhi, ICAI September 1983, p. 19  Ahmed Belkaoi, Accounting Theory, Thomson Learning, 2000, p. 168  Eldon S Hendriksen, Accounting Theory, Irwin, 1984, p. 459  American Institute of Certified Public Accountants, Accounting Research Bulletin, No 43, AICPA, 1968. www.cuidol.in Unit-6 & 7 (MBA 604) All right are reserved with CU-IDOL

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