Unit -3

Introduction

Financial Statement Analysis refers to the process of reviewing and analyzing a company’s financial
statements. It is primarily done to make better financial decisions and devise plans for the company to earn
more income in the future. Financial Analysis meaning as well as procedure is important both for the
accounting exam point of view as well as for practical purposes.

o Different types of financial statements are the income statement, statement of cash flow, balance
sheet, notes to accounts, statement of changes in equity, and so on.
o A few common types of financial statements analysis are Horizontal Analysis, Vertical Analysis,
Liquidity Analysis, Profitability Analysis, Variance Analysis, Valuation Analysis, and Scenario and
Sensitivity Analysis.
o Comparison, analysis, and rearrangement, and interpretation of data are the major steps involved in
financial statement analysis.
o The activity of analysis of financial statements is primarily done to measure the company’s
profitability and evaluate its operational efficiency.

Financial Statement Analysis:

The term ‘Financial Statement Analysis’ refers to the systematic numerical representation of the
relationship of one financial aspect with the other. The activity of financial statement analysis is undertaken
to analyse the company on the basis of its profitability, solvency, operational efficiency, and growth
prospects.

Financial Analysis chiefly involves bifurcating the financial records on the basis of a definite plan, arranging
them in sections, and presenting them in a user-friendly manner.

Purpose of Financial Statement Analysis

Following is the list of purpose of financial statement analysis:

o To measure the financial standing of the business

o To evaluate the profitability (earning capacity) of the business
o To make comparisons within the firm (intra-firm) and with other firms (inter-firm)
o To find out the business’ capability of paying interest, dividend, etc.
o To judge the performance of the management
o To measure the firm’s short-term and long-term solvency

Pass
Financial statement analysis is a process of examining a company's financial statements in order to gain an
understanding of its financial health and performance. The analysis typically involves comparing the
company's financial results to its historical performance, as well as to the performance of its peers in the
industry.
 There are three main financial statements that are used in financial statement analysis: the balance sheet,
income statement, and cash flow statement. The balance sheet provides a snapshot of a company's assets,
liabilities, and equity at a particular point in time. The income statement shows a company's revenues and
expenses over a period of time, and the cash flow statement shows a company's inflows and outflows of
cash over a period of time.

In financial statement analysis, various ratios and metrics are used to evaluate a company's financial health
and performance. These include liquidity ratios, such as the current ratio and quick ratio, which measure a
company's ability to meet its short-term obligations; profitability ratios, such as the return on assets and
return on equity, which measure a company's ability to generate profits; and leverage ratios, such as the
debt-to-equity ratio and interest coverage ratio, which measure a company's use of debt financing.

It is important to consider the context of a company's financial statements when conducting financial
statement analysis. This includes factors such as the industry in which the company operates, its
competitive position, and the broader economic environment. Additionally, it is important to consider the
quality and reliability of the financial statements themselves, as well as any potential accounting issues or
irregularities.

Overall, financial statement analysis is a critical tool for investors, analysts, and other stakeholders to
evaluate a company's financial health and performance. By examining a company's financial statements and
using various ratios and metrics, it is possible to gain insights into its strengths and weaknesses, as well as
to identify potential opportunities and risks.

Financial statement analysis involves examining a company's financial statements to gain insights into its
financial health and performance. Some of the key components of financial statement analysis include:

1. Income statement analysis: Examining a company's income statement can provide insights into its revenue,
expenses, and profitability. This analysis can include examining revenue growth, cost of goods sold, gross
profit margins, operating expenses, and net income.
2. Balance sheet analysis: Analyzing a company's balance sheet can provide insights into its assets, liabilities,
and equity. This analysis can include examining a company's liquidity, solvency, and capital structure.
3. Cash flow statement analysis: Examining a company's cash flow statement can provide insights into its cash
inflows and outflows, as well as its ability to generate cash from its operations. This analysis can include
examining a company's cash flow from operating activities, investing activities, and financing activities.
4. Ratio analysis: Using financial ratios to analyze a company's financial statements can provide insights into its
financial performance, liquidity, profitability, and efficiency. Some common financial ratios include the
current ratio, quick ratio, debt-to-equity ratio, and return on investment (ROI) ratio.
5. Trend analysis: Examining trends in a company's financial statements over time can provide insights into its
financial performance and potential future growth. This analysis can include examining trends in revenue
growth, profitability, and financial ratios over several years.

Financial statement analysis is the process of analyzing a company's financial statements to gain insights
into its financial health, performance, and prospects. Here are some advantages and disadvantages of
financial statement analysis:

Advantages:
1. Helps in decision making: Financial statement analysis provides valuable information to investors, creditors,
and other stakeholders to make informed decisions about investing in a company, lending money, or
engaging in other transactions.
2. Identifies strengths and weaknesses: Analysis of financial statements helps to identify a company's
strengths and weaknesses. This information can be used to take corrective action to improve the company's
financial health and performance.
3. Helps in forecasting: Financial statement analysis helps in forecasting future performance and trends. This
information can be used to make strategic decisions and plan for the future.
4. Easy to understand: Financial statements are standardized and prepared using accounting principles,
making them easy to understand and analyze.

Disadvantages:

1. Limitations of accounting principles: Financial statements are prepared using accounting principles that may
not always reflect the economic reality of a company. Accounting methods such as depreciation, inventory
valuation, and revenue recognition can distort the financial results.
2. Limited information: Financial statements provide limited information about a company's operations,
customers, suppliers, and other factors that can affect its financial performance.
3. Comparability issues: Comparing financial statements of different companies can be challenging due to
differences in accounting methods, industry standards, and business models.
4. Lack of timeliness: Financial statements are prepared on a quarterly or annual basis, which means that the
information may not be current or timely enough to make decisions in a fast-paced business environment.

Ratio analysis is a tool used to evaluate the financial performance of a company. It involves analyzing the
relationships between various financial statement items such as income statement and balance sheet to
calculate ratios that provide insights into a company's financial health, efficiency, and profitability.
 Commonly used financial ratios include:

1. Liquidity ratios: These ratios measure a company's ability to meet its short-term obligations. Examples
include the current ratio and the quick ratio.
2. Solvency ratios: These ratios measure a company's ability to meet its long-term obligations. Examples
include the debt-to-equity ratio and the interest coverage ratio.
3. Profitability ratios: These ratios measure a company's ability to generate profits. Examples include the gross
profit margin, net profit margin, and return on equity.
4. Efficiency ratios: These ratios measure how efficiently a company uses its resources to generate revenue.
Examples include inventory turnover ratio, accounts receivable turnover ratio, and accounts payable
turnover ratio.
 Ratio analysis provides a quick and easy way to assess a company's financial performance and to compare it
to industry standards or competitors. However, it should not be the only tool used to evaluate a company's
financial health as it has limitations and does not provide a complete picture of a company's financial
situation. It should be used in conjunction with other financial analysis methods and considerations.

Liquidity ratio is a financial ratio that measures a company's ability to pay off its short-term obligations with
its short-term assets. It is an important indicator of a company's financial health, as it shows whether the
company has enough liquid assets to meet its current liabilities.

There are several types of liquidity ratios, including:

Acid Test Ratio = Cash & Cash Equivalent Assets / Liquid Liabilities

1. Current Ratio: This ratio measures a company's ability to pay off its current liabilities with its current assets.
It is calculated by dividing current assets by current liabilities.
2. Quick Ratio: This ratio measures a company's ability to pay off its current liabilities with its most liquid
assets (such as cash and marketable securities) without having to sell its inventory. It is calculated by
dividing quick assets by current liabilities.
3. Cash Ratio: This ratio measures a company's ability to pay off its current liabilities with its cash and cash
equivalents. It is calculated by dividing cash and cash equivalents by current liabilities.

These ratios are important tools for investors and creditors to assess a company's financial health and
ability to meet its short-term obligations. A higher liquidity ratio indicates that a company is more capable
of meeting its short-term obligations, while a lower liquidity ratio indicates the opposite.

#Numerical- calculate Current, Quick Ratio

2. The solvency ratio is a financial metric that measures a company's ability to meet its long-term debt
obligations. It is a ratio of a company's assets to its liabilities, and it indicates the extent to which a
company's assets can cover its outstanding debts.

The solvency ratio is calculated by dividing a company's total assets by its total liabilities. This ratio is
expressed as a percentage, and the higher the percentage, the more solvent the company is considered to
be.
 A solvency ratio of 1 or greater indicates that a company's assets are sufficient to cover its liabilities.

A solvency ratio below 1 means that the company may have difficulty meeting its long-term debt
obligations.

The solvency ratio is an important measure of a company's financial health, as it indicates its ability to
continue operating in the long term. It is commonly used by investors, creditors, and analysts to evaluate a
company's creditworthiness and financial stability.
However, it is important to note that the solvency ratio is just one of many financial ratios that should be
considered when analyzing a company's financial health. Other important ratios include profitability ratios,
liquidity ratios, and efficiency ratios.

Activity ratios, also known as efficiency ratios, are financial metrics that measure how well a company uses
its assets to generate revenue. They are useful in evaluating a company's operational efficiency and can
help investors and analysts assess how well a company is managing its resources.

Some commonly used activity ratios include:

1. Inventory turnover ratio: This measures how quickly a company sells its inventory over a given period of
time. It is calculated by dividing the cost of goods sold by the average inventory value during the same
period.
2. Accounts receivable turnover ratio: This measures how quickly a company collects its accounts receivable. It
is calculated by dividing net credit sales by the average accounts receivable during the same period.
3. Asset turnover ratio: This measures how efficiently a company uses its assets to generate revenue. It is
calculated by dividing revenue by total assets.
4. Fixed asset turnover ratio: This measures how efficiently a company uses its fixed assets to generate
revenue. It is calculated by dividing revenue by the net value of fixed assets.
5. Accounts payable turnover ratio: This measures how quickly a company pays its suppliers. It is calculated by
dividing total purchases by the average accounts payable during the same period.
 These ratios are important because they provide insights into a company's efficiency and can help investors
identify potential issues or opportunities for improvement.

Profitability ratios are financial metrics used to measure a company's ability to generate profits relative to
its revenue, assets, and equity. These ratios are important for investors, creditors, and management to
assess a company's financial health and performance.

Some common profitability ratios include:

1. Gross Profit Margin: This measures the percentage of revenue that remains after deducting the cost of
goods sold (COGS). A high gross profit margin indicates that the company is able to generate a significant
profit from its sales.
2. Net Profit Margin: This measures the percentage of revenue that remains after deducting all expenses,
including COGS, operating expenses, interest, and taxes. A high net profit margin indicates that the
company is generating a strong profit from its operations.
3. Return on Assets (ROA): This measures how efficiently a company is using its assets to generate profit. ROA
is calculated by dividing net income by total assets. A high ROA indicates that the company is generating a
strong return on its investments in assets.
4. Return on Equity (ROE): This measures how efficiently a company is using shareholder equity to generate
profit. ROE is calculated by dividing net income by shareholder equity. A high ROE indicates that the
company is generating a strong return on its investments in shareholder equity.

Overall, profitability ratios can provide valuable insights into a company's financial performance and help
investors and managers make informed decisions about the company's future.
 II- Fund flow analysis is a technique used in financial analysis to analyze the movement of money within an
organization or a market. It involves the study of the inflow and outflow of funds over a specific period of
time to understand the financial health of an entity.

The analysis can be conducted on a macro or micro level, depending on the focus of the study. At the macro
level, fund flow analysis can be used to evaluate the performance of a country's economy or a particular
industry. At the micro level, fund flow analysis can be used to assess the financial health of a company or a
particular investment.

The analysis typically involves examining the sources of funds (such as income, investments, loans) and the
uses of funds (such as expenses, debt repayment, investments). By examining the net movement of funds
over time, analysts can identify trends, assess financial performance, and make predictions about future
performance.

Fund flow analysis is often used in conjunction with other financial analysis techniques, such as ratio
analysis and cash flow analysis, to provide a more complete picture of an entity's financial health.
Fund flow analysis is a method used by investors, analysts, and financial managers to analyze the
movement of money into and out of an organization. The primary objectives of fund flow analysis are:

1. Identifying the sources and uses of funds: Fund flow analysis helps to identify the sources of funds, such as
cash inflows from operations, investments, and financing activities, and the uses of funds, such as payments
for expenses, investments, and debt repayments.
2. Analyzing cash flow patterns: Fund flow analysis helps to analyze cash flow patterns over a period of time.
This can help identify trends in the cash flow, such as fluctuations in revenue, changes in operating
expenses, and shifts in investment and financing activities.
3. Evaluating liquidity and solvency: Fund flow analysis can help evaluate an organization's liquidity and
solvency by looking at its ability to generate cash from operations, invest in new opportunities, and meet its
debt obligations.
4. Assessing the financial performance: Fund flow analysis can help assess an organization's financial
performance by analyzing the sources and uses of funds and comparing them to the organization's financial
goals and objectives.
5. Making investment decisions: Fund flow analysis can help investors make investment decisions by providing
insight into the financial health of an organization, its ability to generate cash, and its future prospects.

Performa:

Fund flow analysis is a technique used to analyze the movement of funds within an organization. It involves
examining the changes in the financial position of an entity between two accounting periods. The following
are the steps in the preparation of fund flow analysis:

1. Identify the accounting periods: Determine the two accounting periods for which you want to prepare the
fund flow analysis.
2. Gather financial statements: Collect the balance sheets and cash flow statements for both the accounting
periods. These statements should provide a detailed breakdown of the company's assets, liabilities, and
equity, as well as its cash flows.
3. Calculate changes in working capital: Working capital refers to the company's current assets minus its
current liabilities. Calculate the change in working capital between the two accounting periods. Positive
changes indicate an increase in the company's ability to meet its short-term obligations, while negative
changes indicate a decrease.
4. Analyze non-current assets: Non-current assets are long-term investments made by the company, such as
property, plant, and equipment. Determine any changes in non-current assets between the two accounting
periods. Positive changes indicate an increase in the company's investment in fixed assets, while negative
changes indicate a decrease.
5. Analyze non-current liabilities: Non-current liabilities are long-term obligations, such as loans or bonds.
Determine any changes in non-current liabilities between the two accounting periods. Positive changes
indicate an increase in the company's debt, while negative changes indicate a decrease.
6. Determine cash flow from operations: Calculate the cash flow from operations for each of the accounting
periods. This indicates the amount of cash generated by the company's core business operations.
7. Prepare the fund flow statement: Using the information gathered in the previous steps, prepare the fund
flow statement. This statement summarizes the inflows and outflows of funds between the two accounting
periods and provides an overview of the changes in the company's financial position.

By following these steps, you can prepare a comprehensive fund flow analysis that will help you better
understand your company's financial performance over time.

Fund flow analysis is a financial statement analysis technique used to analyze changes in a company's
financial position over a period of time. The analysis focuses on the flow of funds, both incoming and
outgoing, and helps investors and analysts understand how a company generates and uses its cash. Here are
some advantages and disadvantages of fund flow analysis:

Advantages:

1. Helps to identify the sources and uses of funds: Fund flow analysis helps to identify the sources of funds and
how they are utilized by the company. This provides insight into the company's financial structure and helps
investors and analysts make informed decisions.
2. Provides a clear picture of cash flow: Fund flow analysis provides a clear picture of cash flow, which is an
essential element of financial analysis. This helps investors and analysts to identify potential financial
issues, such as cash flow problems, and take appropriate actions.
3. Helps in financial planning: Fund flow analysis helps companies to plan their finances effectively by
identifying the cash inflows and outflows. This helps them to make informed decisions about investments,
capital expenditures, and other financial activities.
4. Helps in comparison with competitors: Fund flow analysis helps to compare a company's financial position
with its competitors. This provides insight into the company's competitive position and helps investors and
analysts make informed investment decisions.
A cash flow statement is a financial statement that shows the inflows and outflows of cash during a specific
period of time. It typically consists of three sections: operating activities, investing activities, and financing
activities. The purpose of a cash flow statement is to provide insight into how much cash a company has
generated or used during a given period, and where that cash has come from or gone to.

The operating activities section shows the cash flows related to the day-to-day operations of the business,
such as cash received from customers and cash paid to suppliers. The investing activities section shows cash
flows related to the purchase or sale of long-term assets, such as property, plant, and equipment, or
investments in other companies. The financing activities section shows cash flows related to the financing of
the business, such as cash received from the issuance of debt or equity, or cash paid out as dividends to
shareholders.

A cash flow statement can be used to evaluate the liquidity of a company and its ability to generate cash in
the short term. It can also be used to analyze the company's capital expenditures, investment activities, and
financing activities, and to identify potential cash flow problems. In general, a positive cash flow from
operating activities indicates that a company is generating cash from its core business operations, while a
negative cash flow from investing or financing activities may indicate that the company is investing heavily
or borrowing heavily to fund its operations.
 To prepare a cash flow statement, follow these steps:

There are two methods of preparing the statement of cash flows:

1. the indirect method and

2. the direct method

The indirect method derives cash flows from accrual basis statements.

The direct method determines cash flows directly for each source or use of cash.

1. Determine the period for which you want to prepare the cash flow statement. Typically, cash flow
statements cover a period of one year, but you can choose a shorter or longer period depending on your
needs.
2. Collect the financial information for the period you have chosen. You will need information on cash inflows
and outflows, which can be found in your company's income statement and balance sheet.
3. Identify the three types of cash flows: operating, investing, and financing. Operating cash flows relate to the
main activities of the business, such as revenue from sales and payments to suppliers. Investing cash flows
relate to the purchase or sale of long-term assets, such as property, equipment, and investments. Financing
cash flows relate to the issuance or repayment of debt and equity, such as loans, dividends, and stock
issuances.
4. Organize the cash inflows and outflows into categories according to their type: operating, investing, and
financing. This will allow you to calculate the total cash inflows and outflows for each category.
5. Calculate the net cash flow for each category by subtracting the total cash outflows from the total cash
inflows. This will give you the net operating cash flow, net investing cash flow, and net financing cash flow.
6. Add up the net cash flows for each category to get the total net cash flow for the period.
7. Finally, add the beginning cash balance to the total net cash flow and subtract any ending cash balance to
get the cash balance for the period.
8. Prepare the cash flow statement by presenting the information in a format that shows the beginning cash
balance, the net cash flow for each category, the total net cash flow, and the ending cash balance.

Remember to use clear and concise language and present the information in a logical order that makes it
easy to understand. A cash flow statement is an important tool for understanding a company's financial
health and should be prepared with care and accuracy.

Uses of CFS
 A cash flow statement is a financial statement that shows the inflows and outflows of cash in a business
over a specific period of time. The statement is divided into three sections: operating activities, investing
activities, and financing activities. The uses of cash flow statement include:

1. Helps in forecasting future cash flows: By analyzing past cash flows, a company can forecast future cash
flows and determine if it has enough cash to fund its operations.
2. Assists in managing working capital: The cash flow statement helps a company manage its working capital
by tracking the cash inflows and outflows related to its day-to-day operations.
3. Provides insight into a company's financial health: By analyzing the cash flow statement, investors can gain
insight into a company's financial health and its ability to generate cash from operations.
4. Helps in making investment decisions: The cash flow statement provides information on a company's capital
expenditures and financing activities, which can help investors make informed investment decisions.
5. Facilitates decision making for lenders: Lenders use the cash flow statement to determine a company's
ability to repay loans and interest on time.
6. Helps in identifying potential liquidity problems: The cash flow statement helps in identifying potential
liquidity problems by showing the timing and amount of cash inflows and outflows.

In summary, the uses of cash flow statement include forecasting future cash flows, managing working
capital, providing insight into a company's financial health, making investment decisions, facilitating
decision making for lenders, and identifying potential liquidity problems.

A cash flow statement is a financial statement that shows the inflow and outflow of cash in a business over
a period of time. Here are some advantages and disadvantages of using a cash flow statement:

Advantages:

1. Provides a clear picture of a company's liquidity position: A cash flow statement provides an accurate view
of a company's cash position, which is crucial for making decisions about investments, financing, and day-
to-day operations.
2. Helps identify potential cash shortages: By examining the cash flow statement, a company can identify
potential cash shortages well in advance, which can help them take corrective action and avoid a liquidity
crisis.
3. Helps in budgeting and planning: A cash flow statement can help a company to make more informed
decisions when it comes to budgeting and planning for the future. It can also help in forecasting future cash
flows.
4. Helps in financial analysis: A cash flow statement can be used in conjunction with other financial statements
to perform a thorough financial analysis of a company.

Disadvantages:

1. Limited information: A cash flow statement only provides information about cash flows, and does not give
any information about non-cash items such as depreciation and amortization.
2. May not provide a complete picture: While a cash flow statement provides information about cash inflows
and outflows, it may not give a complete picture of a company's financial health.
3. Prone to manipulation: Like any financial statement, a cash flow statement can be manipulated to present a
more favorable picture of a company's financial health.
4. May not reflect current economic conditions: A cash flow statement is based on historical data and may not
reflect current economic conditions, which can affect future cash flows.

Break-Even Analysis

A break-even analysis is an economic tool that is used to determine the cost structure of a company or the
number of units that need to be sold to cover the cost. Break-even is a circumstance where a company
neither makes a profit nor loss but recovers all the money spent.
The break-even analysis is used to examine the relation between the fixed cost, variable cost, and revenue.
Usually, an organisation with a low fixed cost will have a low break-even point of sale.

Importance of Break-Even Analysis

 Manages the size of units to be sold: With the help of break-even analysis, the company or the
owner comes to know how many units need to be sold to cover the cost. The variable cost and the
selling price of an individual product and the total cost are required to evaluate the break-even
analysis.
 Budgeting and setting targets: Since the company or the owner knows at which point a company can
break-even, it is easy for them to fix a goal and set a budget for the firm accordingly. This analysis
can also be practised in establishing a realistic target for a company.
 Manage the margin of safety: In a financial breakdown, the sales of a company tend to decrease. The
break-even analysis helps the company to decide the least number of sales required to make profits.
With the margin of safety reports, the management can execute a high business decision.
 Monitors and controls cost: Companies’ profit margin can be affected by the fixed and variable cost.
Therefore, with break-even analysis, the management can detect if any effects are changing the cost.
 Helps to design pricing strategy: The break-even point can be affected if there is any change in the
pricing of a product. For example, if the selling price is raised, then the quantity of the product to be
sold to break-even will be reduced. Similarly, if the selling price is reduced, then a company needs to
sell extra to break-even.

Components of Break-Even Analysis

 Fixed costs: These costs are also known as overhead costs. These costs materialise once the financial
activity of a business starts. The fixed prices include taxes, salaries, rents, depreciation cost, labour
cost, interests, energy cost, etc.
 Variable costs: These costs fluctuate and will decrease or increase according to the volume of the
production. These costs include packaging cost, cost of raw material, fuel, and other materials
related to production.

Uses of Break-Even Analysis

 New business: For a new venture, a break-even analysis is essential. It guides the management with
pricing strategy and is practical about the cost. This analysis also gives an idea if the new business is
productive.
  Manufacture new products: If an existing company is going to launch a new product, then they still
have to focus on a break-even analysis before starting and see if the product adds necessary
expenditure to the company.
 Change in business model: The break-even analysis works even if there is a change in any business
model like shifting from retail business to wholesale business. This analysis will help the company to
determine if the selling price of a product needs to change.

Break-Even Analysis Formula

Break-even point = Fixed cost/-Price per cost – Variable cost

Example of break-even analysis

Company X sells a pen. The company first determined the fixed costs, which include a lease, property tax,
and salaries. They sum up to ₹1,00,000. The variable cost linked with manufacturing one pen is ₹2 per unit.
So, the pen is sold at a premium price of ₹10.
Therefore, to determine the break-even point of Company X, the premium pen will be:
Break-even point = Fixed cost/Price per cost – Variable cost
= ₹1,00,000/(₹12 – ₹2)
= 1,oo,000/10
= 10,000
Therefore, given the variable costs, fixed costs, and selling price of the pen, company X would need to sell
10,000 units of pens to break-even.