INTRODUCTION
A joint-stock company
with its own legal entity performs business activities for the purpose of
earning profits. There are a number of stakeholders of the company such as the
shareholders, management, creditors, employees and workers, consumers, and
government who are keen to know about the results of its financial activities
performed during a certain period of time.
MEANING OF FINANCIAL
STATEMENTS
Financial statements
are written reports of the financial affairs of a company. The report and
communicate the results of its business operations for a particular period of time
and its financial position at the end of that period. Financial statements are
the end product or output of an accounting system designed and used in an
organization. Income statement, statement of retained earnings, balance sheet,
and cash flow statements are the major parts of a financial statement. Just as
the presence of our body reflects our health, financial statements reflect the
health of a business firm. Generally, financial statements are prepared
periodically to show the profitability, solvency, and cash flow situation.
Profitability is the ability of a company to generate income, it is reflected
in the company’s income statement. Solvency is the ability of a company to pay a
debt as they become due, it is reflected in the company’s balance sheet.
CONTENTS OF FINANCIAL
STATEMENTS
“Nepal accounting
standard, July 2002” emphasizes the preparation of financial statements by the
company and offers a framework for the preparation and presentation of these
statements. Accordingly, the financial statements of the company contain the
following:
Income statement: It tells us
about the operating result of a particular accounting period, say a month or a
year. The income statement contains two broad categories of items: revenues and
expenses. Revenues represent the actual or expected inflow of assets, the
settlement of liabilities, or both. While expenses represent the utilization or
consumption of assets or incurring of liabilities or both to produce the
revenue inflow.
Statements of retained
earning:
It is also known as profit and loss appropriation account. It shows how the net
incomes of the period appropriated or distributed. It also shows the change in
retained earnings between the beginning and the end of the period.
Balance sheet: It is also known as the
position statement. The objectives of a balance sheet are to provide the
information concerning assets owned by the company and equity interests (of
both the creditor and owner) in those assets.
Cash flow statement: The statement of
cash flow tells us from what kinds of activities were the cash and cash
equivalents received and where those were applied. It shows the inflow and
outflow over a period of time.
Objectives of
financial statement:
Financial statements
are the end results of the accounting process and they provide the
profitability and solvency position of the company. The following are the main
objectives of financial statements;
1. To provide the
operating result of the company.
2. To provide the
financial position of the company, for the specified period of time.
3. To provide financial
information to the external as well as internal users.
4. To reveal the history
of the firm.
5. To facilitate the
performance evaluation intra and inter company.
6. To evaluate the efficiency
of the management.
7. To provide the
required information to the management for future planning and decision making.
IMPORTANCE OF
FINANCIAL STATEMENTS
Financial statements
provide valuable financial information to various users for a different
purpose. The importance of financial statements can be pointed out as follows:
1. It provides
information relating profit in terms of sales and investment, earning per
share, dividend per share.
2. It shows the Pat
performance of an organization and past performance is a good indicator of the future.
3. It makes the
comparative analysis of profitability, solvency, and activities of the
organization.
4. It provides
information about the solvency position of the business.
5. It provides detailed
information about revenue expenses, income, and profit.
6. It provides
information about profitability, solvency, the activity of the management,
stability, and future prospect.
LIMITATIONS OF FINANCIAL
STATEMENTS
The following are the
main limitations of financial statements:
1. It provides
information relating to the only monetary fact.
2. It records the
financial information relating to historical in nature.
3. It is an only interim
report.
4. It is influenced by the
accounting concept.
5. It fails to disclose
adequate information.
6. It ignores the effect
of price level changes.
7. It is prepared
primarily for shareholders.
FINANCIAL STATEMENT
ANALYSIS
The process of
interpreting financial statements with specific tools and purpose is known as
financial statement analysis. In other words, it can be defined as the process
of knowing the strength and weaknesses of an organization through the
meaningful search of figures contained in the financial statement. Therefore,
the analysis of the financial statements is concerned with collecting, classifying,
and grouping of figures, contained in the financial statement with specific
tools and purposes so that a user can get the required information such as
survival, productivity, stability, profitability, and growth prospect of the
company. Without systematic analysis and interpretation, the figures contained
in the financial statement will be static, and the value of the figures will be
meaningless and these figures cannot be utilized by the users effectively.
Objectives of
financial statement analysis
The following are the
important objectives of financial statements analysis:
To know about
profitability: The financial statement analysis provides information about
the profitability of the company in terms of sales and investment. The profitability
scenario helps shareholders to decide whether to continue holding its shares and
other potential investors to decide whether to invest in its shares or not.
To judge solvency: An analysis of
financial statements helps judge the short-term and long-term solvency of the
company. The banks with such information will be in a position to decide
whether it should extend a loan or not.
To measure strengths
and weaknesses: The analysis of financial statements helps to measure the
financial strengths and weaknesses of the company, which is essential for
deciding the future course of action.
To assess managerial
performance: The financial statement analysis is essential for
measuring the company’s managerial performance, which is important to decide
about rewarding the management or taking action against it.
To make future
planning:
The financial statement analysis provides relevant information about the
present position of the company. The present position of the company provides
guidelines for making plans of the company by deciding what course of action
should it take to achieve its objectives.
METHODS/TECHNIQUES OF
FINANCIAL STATEMENT ANALYSIS
Financial statement
analysis can be performed by employing a number of methods or techniques. The
following are the important methods or techniques of financial statement
analysis:
Ratio analysis: It is the analysis
of the interrelationship between two financial figures.
Cash flow analysis: It is the analysis
of the change in the cash position during a period.
Comparative financial
statements:
It is the analysis of financial statements of the company for two years or of
the two companies of similar type.
Trend analysis: It is the analysis
of the trend of the financial ration of the company over the years.
Importance of
financial statement analysis
The financial
statement analysis is important for different reasons:
i) For the decision of
holding share: Financial statement provides information about profitability
in terms of share and investment. It also provides the information about
earning per share, dividend per share, etc. based on which, an investor decides
whether to continue to hold or sell out the share.
ii) For future
decision and planning: Financial statement shows the past performance of an organization
and past performance is a good indicator of the future. Therefore, management
makes planning and decides for the future based on past performance.
iii) For investment
decision:
Financial statement makes the comparative analysis of profitability, solvency,
and activities of the organization. Based on these comparative analyses an
investor may decide whether to invest or not.
iv) For assessing
corporate tax: Financial statement analysis provides detailed information
about revenue expenses, incomes, and profit. Therefore, it will be the basis
for the government to determine the corporate tax liability.
v) For credit
extending decision: Financial statement provides information about the solvency
position of the business. Solvency position means the ability to pay the debt.
If the company possesses a sufficient amount of current assets, the creditor
extends the credit period of the loan. If not, the creditor does not extend the
credit period.
vi) For forecasting
the trend of stock market price: Financial statement analysis provides
information about profitability, solvency, the activity of the management, stability,
and future prospect. On the basis of this information, stock analysis forecasts
the future market price of the company’s share.
Limitations of
financial statement analysis
Financial statement
analysis is very much important to the various parties as mentioned above.
However, it has some limitations, which are as follows:
Ignore the qualitative
aspects: Financial
statement is prepared by the company on the basis of financial transactions
only. It does not include non-financial transactions, which is also known as
qualitative aspects like entry and exit of competitors, management employee
relation, customer feedback, etc. But the qualitative expects are very
important for the formulation of strategies and policies of the company.
Not free from bias: Financial
statement analysis is made as per the personal judgment of the analyst.
Therefore, the analysis is not free from the business of the analyst.
No possibility to
adjust the effect of the price level change: Financial statement analysis is done on the
basis of historical data contained by the financial statement. Therefore, there
will not be any adjustment of inflation and deflation and it cannot represent
the current value of the business.
No solution but
identification of problems only: Financial statement analysis shows the
strength and weakness of the organization or it identifies the problem only but
it does not provide any guidelines for the solution of the identified problems.
Chance of wrong
analysis: The
accuracy of financial statement analysis mostly depends upon the accuracy of
the figures contained in the financial statement. If these figures are
manipulated, the analysis also will be wrong. The decision made on the basis of
such wrong analysis may mislead the users in making their decision.
PARTIES INTERESTED IN
FINANCIAL STATEMENT ANALYSIS
Financial statement
analysis is the process of knowing the strength and weaknesses of an
organization through the meaningful search of figures contained in the financial
statement. It is useful for various parties to obtain the required information
about the organization. The following are the parties interested in financial
statement analysis.
Management: Management is
interested in financial analysis for the performance evaluation of employees,
implementation of planning, policies, and decisions. Management analyzes
financial statements to know the solvency positions, profitability, liquidity
position, and return on investment from the business.
Shareholders: Shareholders are
interested in the financial statement to know the profitability position in
terms of sales and investment. The profitability position shows the safety of
investment made by the shareholder and the prospective growth of an
organization.
Creditors: Creditors are
interested in financial statement analysis to know the solvency position of the
organization. Solvency position indicates whether the firm is financially sound
or solvency as far as its current obligation is concerned. On the basis of
financial information, creditors know the firm’s ability to pay current
obligations and they take the decision about the supply of raw materials.
Investors or lenders: They analyze the
financial statement to know the solvency position of the organization. On the
basis of financial information, they will know whether the organization can pay
interest and principal amount of the loan on the due date or not. In addition
to this, they also know about the safety of their investment.
Employees: the financial
information provided by the financial statement, employees might decide whether
they demand higher wages and salaries or other benefits from the management.
Government: Government is
interested in the financial statement analysis for determining the amount of
tax liability.
Reviewed by Bijay Munikar
on
March 15, 2021
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