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FINANCIAL STATEMENT ANALYSIS

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30 views34 pages

FINANCIAL STATEMENT ANALYSIS

Uploaded by

yulakbey101
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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FUNDAMENTAL OF FINANCIAL

ACCOUNTING
PROGRAMME: ODBMC II

MODULE CODE: BMT 06101

Facilitator: Mr. D. Massawe

NTA Level: SIX (6)

Semester: One

Academic year: 2024/2025


Financial Statement Analysis
Financial statement analysis is as a process of understanding
the risk and profitability of a business by analyzing the
financial information reported in the statement of profit or
loss and the statement of financial position.
Ratios help analysts interpret financial statements by
focusing on specific relationships. It is possible to compute
an unlimited number of ratios from the financial statements.
However, this would be of no use.
FSA
Cont…………………………………………
……………
The user of financial statements has to compute only those ratios
which are suited to his needs and which represent meaningful figures.
These ratios are then compared with similar ratios of a different
reporting period of the entity another similar entity for the same
reporting period industry average ratio.
The user then needs to analyze them and interpret the results. Analysis
of ratios is not an exact science; there can be no hard and fast rules.
The analysis and interpretation will depend upon the circumstances of
each entity.
Factors on which analysis and interpretation of financial ratios
depend include:

i) The size of the business .


ii)The state of the economy.
iii)The policies of management.
iv)The company philosophy.
v)The industry norms.
vi)Government rules and regulations.
Objectives of financial statement analysis.

The objective of a financial statement analysis broadly includes the following:


1. Assessment of past and current performance
Financial statement analysis of past financial statements helps in predicting future
trends. Also, financial statement analysis of past data can be used to set a
benchmark in the assessment of current performance.
2. Aid in decision making.
Financial statements on their own may not reveal important financial information
required for decision making. Financial statement analysis uses various ratios to
perform analysis and get the desired information for business decision making. For
example, a company may analyze the various investor performance ratios and take
decision as to whether dividend needs to be declared during the year.
Objectives of financial statement analysis.
3. Prediction of profitability and growth prospects.
Financial statement analysis helps to predict the growth
prospects and profitability of a company by doing a trend
analysis and also through industry comparison.
4. Prediction of bankruptcy and failure.
Financial statement analysis helps in assessing and predicting
bankruptcy and probability of business failure.
Objectives of financial statement analysis.

5. Assessment of the operational efficiency.


Financial statement analysis helps in judging the company's
efficiency in terms of its operations and management. They
help judge how well the company has been able to utilize its
assets and earn profits.
TOOLS OF FINANCIAL STATEMENTS ANALYSIS.

There are several techniques of financial statement analysis.

1. Ratio analysis.
2. Vertical analysis.
3. Horizontal analysis.
4. Industry comparison.
5. Trend analysis.
1. RATIO ANALYSIS.

Ratio analysis is one of the most important tools for evaluation of financial
statements. It is important to note that an analyst would be interested in gauging the
overall performance and position of the company and not necessarily only the
profitability.

Hence following categories of ratios may be considered:

•Profitability Ratio Profitability ratio helps to measure the profitability position of


the business concern.
PROFITABILITY.
PROFITABILITY RATIOS.
Liquidity Ratio

•It is also called as short-term ratio.

•This ratio helps to understand the liquidity in a business which


is the potential ability to meet current obligations. This ratio
expresses the relationship between current assets and current
liabilities of the business concern during a particular period.
LIQUIDITY RATIOS
Activity/Efficiency Ratio

It is also called as turnover ratio. This ratio measures the


efficiency of the current assets and liabilities in the business
concern during a particular period. This ratio is helpful to
understand the performance of the business concern.
Activity/Efficiency Ratio
Solvency Ratio/ Financial structure.

It is also called as leverage ratio, which measures the long-


term obligation of the business concern. This ratio helps to
understand, how the long-term funds are used in the business
concern.
Solvency Ratio/ Financial structure.
Example. UD Company
Comparative Balance Sheets, December, 2015 and
2014.
UD Company
Comparative Balance Sheets, December, 2015 and
2014 (cont…)
UD Company
Comparative Balance Sheets, December, 2015 and
2014 (cont…)
Required;Calculate the following
ratios and interpret
i) Net profit margin.
ii) Gross profit margin.
iii) Returns on capital employed(ROCE)
iv) Return on assets
v) Operating profit margin
vi) Return on equity
vii) Current ratio
viii) Quick ratio
ix) Debtors collection period
x) Creditors payment period days.
xi) Assets turnover
xii) Inventory turnover
xiii) Gearing ratio
xiv) Debt ratio.
xv) Interest cover.
2. VERTICAL ANALYSIS.
Vertical analysis of a financial statement identifies the relationship of each item to
its base amount (base amount is assumed to be 100%). Every other item on the
financial statement is computed as a percentage of that base.
3. HORIZONTAL ANALYSIS.

• Horizontal analysis spotlights trends and establishes relationships between items that appear on the
same row of a comparative statement. Horizontal analysis discloses changes on items in financial
statements over time.

•Each item (such as sales) on a row for one fiscal period is compared with the same item in a
different period. Horizontal analysis can be carried out in terms of changes in dollar amounts, in
percentages of change, or in a ration format.

•This indicates comparison of financial statements of a company for the current period with the
previous periods as well as with other companies in the same industry.
Example.
4. INDUSTRY COMPARISON

This involves comparison of ratios of a firm with similar firms or


with industry averages. The intention behind these comparisons is to
determine whether the firm is performing well as compared to its
competitors. Industry averages can be obtained from firms involved
in similar research, professional articles, membership of trade
associations, etc.
5. TREND ANALYSIS.

•Trend analysis involves comparison of a firm’s present ratio with its past and
expected future ratios to determine whether the company’s financial position is
improving or deteriorating over time. Horizontal analysis is an example of trend
analysis.
•A horizontal analysis involves comparing financial ratios or line items in a
financial statement over a period of time. The time analyzed is generally chosen
based on the purpose of analysis. This technique is also referred to as comparative
analysis.
For example, management takes decision based on whether sales are
increasing. But considered alone, this fact may not be very helpful.
•The information that may be pertinent is
•i) Whether the sales have increased compared to the last year?
•ii) If so, by how much percentage has it increased?
LIMITATIONS OF RATIOS ANALYSIS.

A lot of problems are encountered while using the tool of ratio analysis
for assessing the performance of an entity. Some of these problems are
as follows:
1. Ratio analysis is not a very useful tool to determine the future prospects of an
entity.
This is because ratio analysis is generally performed on historical data. Also, the
future prospects of the company depend on various assumptions made by an entity,
relating to sales forecast, investments to be made, etc. Furthermore, there is a time
lag between the period of the financial statements and the time when the financial
statements are published and available for analysis. This would make the ratio
analysis outdated.
2. The ratios can be distorted due to inflation, use of different bases for
valuing assets, or specific price changes. These shortcomings are
basically on account of the limitations of historical cost accounting.
3. Changes in the accounting policies and practices of a company and
differences in accounting policies and practices between two entities
may lead to an incorrect comparison of ratios. If there is a change in
method of depreciation from straight line to reducing balance, the ratios
which are calculated using these figures would also be affected. Another
example is the difference in the basis of valuation of inventory (LIFO,
FIFO or weighted average).
4. Companies may have different accounting periods, due to
which ratio analysis in which the performance of these
companies are compared may not be realistic.
5. There are differences of opinion regarding the various variables used
to compute ratios. For example, the capital gearing ratio can be
calculated as a relation between the long-term debts and: the total long-
term funds (equity + long-term debts) of a company, or the
shareholders’ funds of a company.
6. Entities sometimes apply creative accounting in order to show a good
financial performance or position which can be misleading to the users
of financial accounting. At such times, ratio analysis may not show the
correct position.
7. Ratio analysis in which the performance of an entity is compared with
the industry average may not be possible if the information relating to
industry average not available.

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