Class 7: IGNOU MBA – MMPC 004: Accounting for Managers
Unit 7: Analysis of Financial Statements
Overview of Unit 7:
Unit 7 covers the Analysis of Financial Statements, a critical tool for understanding a company's financial performance and health. This unit delves into different methods of financial analysis, such as ratio analysis, common size statements, and trend analysis. It provides insight into how managers, investors, and other stakeholders can evaluate the financial position and performance of an organization effectively.
Topics Covered in Unit 7:
7.1 Introduction to Financial Statement Analysis
Financial statement analysis involves reviewing and analyzing a company's financial reports to make informed economic decisions. The goal is to assess the company’s financial stability, profitability, and operational efficiency.
- Objectives of Financial Analysis:
- Understand the financial health of the company.
- Evaluate operational performance.
- Make comparisons across time periods or with competitors.
- Assist in forecasting future performance.
7.2 Tools and Techniques of Financial Statement Analysis
Financial statement analysis uses various tools and techniques to interpret data from financial reports. The main techniques discussed in this unit are:
7.2.1 Ratio Analysis
Ratio analysis is a powerful tool for understanding financial relationships within a company's financial statements. Ratios are typically categorized into four types:
-
Liquidity Ratios: These ratios assess the ability of a company to meet its short-term obligations.
- Current Ratio = Current Assets / Current Liabilities
- Quick Ratio = (Current Assets - Inventory) / Current Liabilities
-
Profitability Ratios: These ratios evaluate how efficiently a company generates profits from its operations.
- Gross Profit Margin = (Gross Profit / Net Sales) x 100
- Net Profit Margin = (Net Profit / Net Sales) x 100
- Return on Equity (ROE) = (Net Income / Shareholder’s Equity) x 100
-
Solvency Ratios: These ratios measure a company's ability to meet its long-term obligations.
- Debt-to-Equity Ratio = Total Debt / Shareholders’ Equity
- Interest Coverage Ratio = EBIT / Interest Expenses
-
Activity Ratios: These ratios assess the efficiency with which a company uses its assets to generate sales.
- Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory
- Asset Turnover Ratio = Net Sales / Total Assets
Example of Ratio Calculation:
-
Assume Company A has the following financials:
- Current Assets: ₹5,00,000
- Current Liabilities: ₹2,50,000
- Inventory: ₹1,00,000
-
Current Ratio = 5,00,000 / 2,50,000 = 2.0
-
Quick Ratio = (5,00,000 - 1,00,000) / 2,50,000 = 1.6
7.3 Comparative Financial Statements
In comparative financial statements, data from two or more periods is presented side by side for easy comparison. This technique highlights trends and changes in financial performance over time.
- Key Aspects of Comparative Analysis:
- It helps in identifying growth or decline in key metrics such as sales, profits, and expenses.
- Useful in detecting areas of operational improvement or potential financial risks.
7.4 Common Size Financial Statements
In a Common Size Financial Statement, each line item is expressed as a percentage of a base figure. For example:
- In a Common Size Balance Sheet, each item is presented as a percentage of total assets.
- In a Common Size Income Statement, each item is presented as a percentage of net sales.
Benefits of Common Size Statements:
- Easy comparison of financial statements across companies of different sizes.
- Simplifies analysis by removing the scale of figures and focusing on proportionate changes.
Example of a Common Size Balance Sheet (in ₹ Lakhs):
7.5 Trend Analysis
Trend Analysis examines changes in financial statement items over several periods to detect patterns or trends. It helps in identifying long-term performance and potential future financial outcomes.
- Key Areas to Analyze:
- Sales Trends: Examine growth in sales over time.
- Expense Trends: Track the proportion of different expenses (e.g., operating costs, interest payments).
- Profit Trends: Evaluate how profit margins have evolved over the years.
Example: If sales figures for a company are as follows:
- 2020: ₹10,00,000
- 2021: ₹12,00,000
- 2022: ₹15,00,000
The Sales Growth Trend = ((15,00,000 - 10,00,000) / 10,00,000) × 100 = 50%
7.6 Limitations of Financial Statement Analysis
While financial statement analysis provides valuable insights, there are limitations:
- Historical Data: Financial statements are based on historical data and may not reflect current conditions.
- Window Dressing: Companies may manipulate financial data to present a better picture than reality.
- Non-Financial Factors: Financial statements do not capture non-financial elements like market competition, customer satisfaction, or management efficiency.
Experiments and Real-Life Examples
- Experiment: Perform a comparative analysis for a company over three years, focusing on sales growth, expense control, and profitability.
- Real-Life Example: Analyze the financial ratios of companies in the same industry (e.g., Tata Motors and Mahindra & Mahindra). Compare their liquidity, solvency, and profitability using publicly available financial reports.
Assignment Questions
- What are liquidity and profitability ratios? Calculate and explain two ratios for a hypothetical company.
- Explain the purpose of common size statements. How can they help compare companies of different sizes?
- Perform trend analysis on sales and operating profits for a company over the past five years.
Self-Study Questions
- Why is ratio analysis an important tool for evaluating financial statements?
- What is the difference between comparative and common size financial statements?
- How can trend analysis help in predicting a company's future financial performance?
Exam Questions
- Discuss the various types of financial ratios used in financial statement analysis. Provide examples of each.
- Explain how trend analysis can be used to track a company's performance over time. Provide an example.
- What are the limitations of financial statement analysis? How can investors overcome these limitations?
Conclusion
In this class, we explored the techniques used in the analysis of financial statements, including ratio analysis, comparative analysis, common size statements, and trend analysis. These tools enable managers, investors, and analysts to assess the financial health and operational efficiency of a company, providing insights into areas for improvement and guiding future financial decisions.
