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Analysis of Financial Statement - Introduction

Updated on November 2, 2011

Financial statements are eagerly awaited by investors, bankers and some other concerns. For them, it is the only source of information on a compay they are interested in. By studying these statements, they can find out how good or bad the company has performanced in the past year. Besides, these statements help them uncover the problems faced by the company and identify actions to be taken to safeguard their own interest.

But it is very difficult to understand the picture painted by the accounts just by looking at them. Some companies publish annual reports running into 100 or more pages. The accounts are, therefore, summarized and analyzed. Trends are spotted and future forecasted. How it is done is the subject matter of this hub. 

Meaning of analysis

In simple words, analysis means "breakup.", just like dismantling. An analyst would deconstruct the statements, or carry out reverse-engineering process, in order to make deeper sense of business performance.

For example, in one year the sales were Rs.150 million. In order to analyse, we can break the sales to month-wise sales or territory-wise sales or variety-wise or a combination thereof. It would now be easy to spot the highest and lowest level in each segmentation.  Adding one or more years with the same breakdown, one can get a clue of the peak month, most lucrative territory or a top-selling variety. 

The FOUR FINANCIAL STATEMENTS

BALANCE SHEET

It shows assets, liabilities and ownership of a company at a given time or date. It is also known as Statement of Financial Position or Statement of Financial Conditions. This statement is primarily of interest to the Commercial Banks who are security oriented. A good financial position safeguards their existing and/or under consideration loans and advances.

Under the accounting equation, assets are always equal to (and thus in balance with) liabilities and owner's equity; hence, the term 'balance sheet.'

INCOME STATEMENT

This covers income, costs, expenses and the residual profit. Also referred to P&L or Profit & Loss Account, this is mainly studied by shareholders who expect dividends out of profit or possibility of Stock Dividend.

As against Balance Sheet which is at a specified time or date, Income Statement is prepared for a particular period usually one year

STATEMENT OF RETAINED EARNINGS

It explains the changes in equity resulting from earnings or losses and dividend declared. This is often combined with the income statement or shown as part of Equity. Its main purpose is to reconcile the beginning and ending retained earnings for the period, using information such as net income from the other financial statements. It also known as Equity Statement or a statement of owner's equity, or statement of shareholders' equity.

STATEMENT OF CASH FLOWS

Shows cash flow activities, particularly operating, investing and financing activities of the company. It complements balance sheet and income statement and is a mandatory part of a company’s financial report. It enables the users to find out how operating are running, where the money is coming from and how it is being spent.

These statements are supported by detailed notes and statements which are considered as their integral part.

 

FINANCIAL STATEMENTS

Analysis of Financial Statements

Analysis of financial statement is a technique used to examine past performance of a company. It is carried out by professionals who study the accounts, calculate relevant ratios, make comments and present them to the management for decision making.

At its most basic, financial analysis involves looking at annual reports and accounts to determine if a company is healthy. But the analysis should be conducted keeping in view the industry and time frame. The information must be supported from other sources like Industrial standards, stock exchange quotations and government policies.

Financial analysis reduces reliance on pure hunches, guesses, and intuition, and this narrows the inevitable areas of uncertainty that attend all decision-making processes. It does not lessen the need for judgment but rather establishes a sound and systematic basis for its rational application.

Main purposes of the Finanial Analysis are :

  • screening proposed investment or mergers,
  • examining managerial, operating or other problem areas,
  • evaluating management capability,
  • predicting future through forecasting methods,
  • ability to meet obligations when due,
  • the appropriateness of capital structure, and
  • cash generating potentials for growth.

But before analysing the financial statements, one must look for:

  • How old are the accounts?
  • What changes have been reported in auditors, bankers, directors, valuation methods and key personnel.
  • Contingent liabilities

LIMITATION OF ACCOUNTING DATA

Limitation of accounting data

It may also be noted that the accounting data has its own limitation such as:

  • It covers only those aspects which can be quantified in term of money,
  • it does not take into account character, health or age of human resources, and quality of R&D,
  • accounts are of interim nature requiring a wide use of individual judgments for provisioning, valuation and other estimation, and
  • the accounts are mostly based on historical cost.

DEVELOPMENT OF GENERALLY ACCEPTED ACCOUNTING PRINCIPLES ( GAAP )

GAAP are accounting principles having substantial authoritative support. Securities and Exchange Commission of Pakistan (SECP) has authority to determine GAAP and to regulate accounting profession. The Institute of Chartered Accountants of Pakistan (ICAP) reviews all International Accounting Standards (IAS) and intimates to the SECP to issue notification. The IAS becomes part of company law and becomes applicable to all listed companies only. Other companies are encouraged to apply them.

Audited Financial Statements

Further topics on Analysis of Financial Statements

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    • Rufi Shahzada profile image

      Rufi Shahzada 7 years ago from Karachi

      Dear Sir,

      You have explained Basic AFS so precisely and simply...

      Thanks for brushing up my concepts.

      RUFI SHAHZADA

    • hafeezrm profile image
      Author

      hafeezrm 7 years ago from Pakistan

      Thank you Rufi, you are most of the time first to comment.

    • Rufi Shahzada profile image

      Rufi Shahzada 7 years ago from Karachi

      You welcome Sir, actually I am enthusiastic for Information and reading...

      Thanks!

      RUFI SHAHZADA

    • profile image

      Shaikha Al Suwaidi 7 years ago

      Dear , Hafeez

      Thanks for these information its really helpful :)

      Regards,

      Shaikha

    • hafeezrm profile image
      Author

      hafeezrm 7 years ago from Pakistan

      Thanks Shaikha for your comments.

    • profile image

      Chucks 7 years ago

      More good informations thanks for helping me out. Always a pleasure to see information that is useful, thanks again

      http://www.kpmgaccountingfirm.info

    • profile image

      RENUKA PHADNIS 5 years ago

      This info is really useful to understand the concept.. Thanx!

    • hafeezrm profile image
      Author

      hafeezrm 5 years ago from Pakistan

      Thanks Chucks for your comments.

    • hafeezrm profile image
      Author

      hafeezrm 5 years ago from Pakistan

      Thanks Renuka Phadis for your nice comments.

    • umeraziz profile image

      umeraziz 4 years ago

      great intoduction to financial ratios.. you made it easier to understand..

      ratios analysis is performed by external auditors as well at the planning stage to assess the risks and discover the fluctuation among financial data.. its really an essential tool for professional accountants...

    • profile image

      ANIL KUMAR 2 years ago

      thanks, for basic concepts and definations

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