Why Financial Statements Are Analysed
Chapter Twelve
Syllabus topic 1, "Meaning, objectives, advantages and limitations of financial statement analysis and interpretation."
Pages 28 to 30 of 162
In one line
Financial statements are analysed to find out whether a business is profitable, whether it can pay its debts, whether it is soundly financed and whether it is being run efficiently.
The meaning, once more and precisely
Financial statement analysis is the process of establishing the relationships between the items in the financial statements, and of interpreting those relationships to reach conclusions about the profitability, liquidity, solvency and efficiency of the business.
Three words in that sentence do work.
| Word | What it means here |
|---|---|
| Relationships | Not the figures themselves; a rupee figure alone says nothing |
| Interpreting | Reaching a conclusion, which is the point of the exercise |
| About the business | Not about the accounts; the accounts are the evidence, not the subject |
The seven objectives
Learn them as seven questions, because that is how they are answered.
| Objective | The question it asks | |
|---|---|---|
| 1 | Profitability | Is the business earning enough on what has been put into it? |
| 2 | Liquidity, or short-term solvency | Can it pay what falls due within a year? |
| 3 | Long-term solvency | Can it pay the interest and repay the principal when it falls due? |
| 4 | Operating efficiency | Is it getting enough sales out of its assets, and turning its stock and debtors fast enough? |
| 5 | Earning capacity and future prospects | Will next year be like this one, or better? |
| 6 | Comparison | How does it stand against last year, against the budget, and against its rivals? |
| 7 | Assisting the decision to be taken | Whether to lend, to invest, to supply on credit, to buy the business |
Objectives one to four are the four Module III measures, and MU's own topic in Module II names three of them: "profitability, liquidity and financial stability".
Whose objective it is
The seventh objective changes shape depending on who is asking, and naming the party is what makes an answer specific.
| Party | The decision they are taking | The objective that serves it |
|---|---|---|
| Existing shareholder | Hold or sell | Profitability, earning capacity |
| Prospective investor | Buy or not | Future prospects, comparison with rivals |
| Bank giving an overdraft | Lend for ninety days | Liquidity |
| Debenture holder | Subscribe | Long-term solvency |
| Supplier on credit | Give thirty days | Liquidity |
| Management | Everything | All seven |
| Employee or union | Press a wage claim | Profitability and its trend |
| Government | Assess tax, regulate | Profitability, and the statements themselves |
| Competitor | Price, expand, enter | Comparison, cost structure |
The material of the analysis
| Source | What it gives |
|---|---|
| The balance sheet | Position at a date |
| The revenue statement | Performance over a period |
| The cash flow statement | The movement of cash, Module IV |
| The notes to accounts | Accounting policies, contingent liabilities, the detail behind every face figure |
| The Board's report and the auditor's report | What the directors say about the year, and any qualification |
| Earlier years' statements | The comparison, without which no ratio means anything |
The rest of this chapter
Module one is free. The rest of this chapter comes with the B.Com. (Accountancy) Semester 3 notes.
You are reading a chapter from a later module. Everything in module one of every subject stays free, and so does the syllabus.
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Free either way: the syllabus, and module one of every subject.
The rest of this subject
These notes are cut from the University's printed syllabus. Open the syllabus itself, or the past papers, for the same subject.