Financial Statement Analysis

Financial performance, as a part of financial management, is the main indicator of the success or failure of the companies. Financial performance analysis can be considered as the heart of the financial decisions. Rational evaluation of the performance of the companies is essential to prepare sound financial policies and to attract potential investors. Shareholders are interested in EPS, dividend, net worth and market value per share. Management is interested in all aspects of financial performance to adopt a good financial management system and for the internal control of the company. The creditors are primarily interested in the liquidity of the company. Government is interested from the regulatory point of view. Besides, other stakeholders such as economists, trade associations, competitors, etc are also interested in the financial performance of the company. Therefore, all the stakeholders are interested in the performance of the companies but their perspective may be different.

Financial analysis helps to highlight the financial performance of the company. It is the process of identifying the financial strength and weakness of a firm by properly establishing the relationship between the items on the Balance Sheet and those on the Profit and Loss Account (Pandey 1992, p109). It is a general term referring to the process of extracting and studying information in financial statements for use in management decision making, for example, financial analysis typically involves the use of ratios, comparison with prior periods and budget, and other such procedures. Financial appraisal is a scientific evaluation of the profitability and strength of any business concerns (Jain 1996, p36). It seeks to spotlight the significant impacts and relationships concerning managerial performance, corporate efficiency, financial strength and weakness and creditworthiness of the company (Srivastava 1985, p59).

The objective of financial analysis is a detailed cause and effect study of the profitability and financial position (Hingorani and Ramnthan 1992).

According to Hampton, “Financial Analysis is the process of determining the significant operating and financial characteristics of a firm from accounting data and financial statement. The goal of such analysis is to determine the efficiency and performance of the firm’s management, as reflected in the financial records and reports”(Hampton 1986, p85). Financial statements are such records and reports, which contain the data required for performance management. It is therefore important to analyze the financial statements to identify the strengths and weaknesses of the company.

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The financial statements of a business enterprise are intended to provide much of the basic data used for decision making, and in general, evaluation of performance by various groups such as current owners, potential investors, creditors, government agencies, and in some instance, competitors (Benjamin et al 1975, p412). Financial statements are the reports in which the accountant summarizes and communicates the basic financial data. The financial statements provide the summary of a accounts of the company- the Balance Sheet reflecting the assets, liabilities and capital as of a certain date and the Profit and Loss Account showing the results of operation during a period. The financial statements are a collection of data organized according to logical and consistent accounting procedures (Hampton 1986, p85). The function of financial statement is to convey an understanding of some financial aspects of the company.

Financial statement analysis involves appraising the financial statement and related footnotes of an entity. This may be done by accountants, investment analysts, credit analysts, management and other interested parties. Financial statements indicate an appraisal of a company’s previous financial performance and its future potential (Shim and Siegel 1989, p197). The analysis of a financial statement is done to obtain a better insight into a firm’s position and performance (Munakarmi 2000). Analyzing a financial statement is a process of evaluating the relationship between component parts of financial statement to obtain a better understanding of the firm’s position and performance (Metcalf and Titard 1976, p157). The financial analysis is thus the analysis of the financial statements, which is done to evaluate the performance of the company. Ratio Analysis, Trend Analysis, Comparative Financial Statement Analysis and Common Size Statement Analysis are the major tools of the financial analysis.

Financial statement analysis involves the computation of ratios to evaluate a company’s financial position and results of operation (Shim and Siegel 1989, p196). Ratio is an important tool of financial statement analysis. The relationship between two accounting figures, expressed mathematically is known as financial ratio (Pandey 1992, p110). “Ratio used as an index of yardstick for evaluating the financial position and performance of the firm. It helps analysts to make a quantitative judgement about the financial position and performance of the firm. It uses financial reports and data and summarizes the key relationship in order to appraise financial performance (Munakarmi 2000). Ratio analysis is such a powerful tools of financial analysis that through it, the economic and financial position of a business unit can be fully x-rayed. Ratios are just a convenient way to summarize large quantities of financial data and to compare the performance of the firms (Brealey and Myeres 2003). Ratios are exceptionally useful tools with which one can judge the financial performance of the firm over a period of time (Srivastava 1985, p63). Performance ratio can provide an insight into a bank’s profitability, return on investment, capital adequacy and liquidity (Clark 1999, p257).

The above theories suggest that financial analysis helps to measure the performance of the companies. Different analysts desire different types of ratios, depending largely on whom the analysts are and why the firm is being evaluated. Short-term creditors are concerned with the firm’s ability to pay its bills promptly. In the short run, the amount of liquid assets determines the ability to pay off current liabilities. They are interested in liquidity. Long-terms creditors hold bonds or debentures; mortgages against the firm are interested in current payment of interest and the eventual repayment of the principal. The company must be sufficiently liquid in the short-term and have adequate profits for the long-term. They examine liquidity and the profitability. Stockholders, in addition to liquidity and profitability, are concerned about the policies of the firm’s stock. Without liquidity, the firm could not pay the cash dividends. Without profits, the firm could not be able to declare dividends. With poor policies, the common stock would trade at a lower price in the market (Hampton 1986, p124).

Analysis of the financial statement of a company for one year or for a shorter period would not truly reflect the nature of its operations. For this, it is essential that the analysis reasonably cover a longer period. The analysis made over a longer period is termed as Trend Analysis. Trend Analysis of the ratio indicates the direction of change (Pandey 1992, p51). This method involves the calculation of percentage relationship that each item bears to the same item in the base year. Trend percentage discloses the changes in the financial and operating data between specific periods and makes it possible to form an opinion as to whether favourable and unfavourable tendencies are reflected by the data. Comparative Statement Analysis is another method of measuring the performance of the company. It is used to compare the performance and position of the firm with the average performance of the industry or with other firms, such a comparison will identify areas of weakness which can then be addressed to rectify the situation.

From the above discussion, it is clear that performance is the result of various financials variables. Analysis of performance is not limited to analyzing one or two variable(s). it could be analyzed with the help of various financial indicators. Most of the studies, however, devoted to measure the performance in terms of profitability, stock returns, and turnover, risk adjusted returns on investment, dividends, growth of sales, market capitalization. Analyzing stock return constitutes market price per share and dividend per share. The trend of such variables over the period and comparison of the results with the results of the same variables of another firm or another industry indicates the relative performance of the firm or industry.