OBJECTIVES OF FINANCIAL ANALYSIS
The following are the main objectives of the analysis of financial statements:
1. To estimate the earning capacity of the firm,
2. To gauge the financial position and financial performance of the firm,
3. To determine the long term liquidity of the funds as well as solvency,
4. To determine the debt capacity of the firm,
5. To decide about the future prospects of the firm, etc.
As a matter of fact, the objectives of analysis of these statements, depend to a large extent on the point of the view of the analyst, the degree of interest in the company and the need for depth of enquiry and finally on the amount and quality of the data available.
A trade creditor considering what action to take on a long overdue accounts may well focus his inquiry on the immediate financial condition of the firm and its liquidity. In contrast, a security analysis considering a purchase of equity shares may tend to centre his effort on the measurement of financial condition and future profitability of the firm.
If a thorough analysis is desired and the full data needed are not available or if the suspicion exists that the firm is trying to hides or confuse its real position, the financial analyst must be virtual detective in order to find out the truth.
LIMITATIONS OF FINANCIAL STATEMENTS
Financial statements are prepared with the object of presenting a periodical review or report on the progress by the management and deal with the (i) status of the investments in the business, and (ii) results achieved during the period under review. However, these objectives are subject t ) certain limitations as given below:
1. FINANCIAL STATEMENTS ARE ESSENTIALLY INTERIM REPORTS
The profit shown by the Profit and Loss Account and the financial position as, depicted by the Balance Sheet is not exact. The exact position can be known only when the business is closed down. Again, the existence of contingent liabilities, deferred revenue expenditure do not make them to be precise.
2. ACCOUNTING CONCEPTS AND CONVENTIONS
Financial statements are prepared on the basis of certain accounting concepts and conventions. On account of this reason the financial position as disclosed by these statements may not be realistic. For example, fixed assets in the balance sheets are shown on the basis of 'going concern concept'.
This means that value placed on fixed assets may not be same which may be same which may be realised on their sale. On account of convention of conservatism the income statement may not disclose true income of the business since probable losses are considered while probable incomes are ignored.
3. INFLUENCE OF PERSON AL JUDGEMENT
Many items are left to the personal judgement of the accountant. For example, the method of depreciation, mode of amortisation of fixed assets, treatment of deferred revenues expenditure-all depend on the personal judgement of the accountant. The soundness of such judgement will depend upon his competence and integrity. However, the convention of consistency acts as a controlling factor on making indiscreet personal judgements.
4. DISCLOSE ONLY MONETARY FACTS
Financial statements do not depict those facts which cannot be expressed in terms of money. For example, development of a team of loyal and efficient workers, enlightened management, the reputation prestige of management with the public, are matters which are of considerable importance for the business, but they are new -where depicted in financial statements.
NATURE OF FINANCIAL STATEMENTS
According to the American Institute of Certified Public Accountants/financial statements reflect 'a combination of recorded facts, accounting conventions and personal judgments and the judgments and conventions applied affect the materially.
1. RECORDED FACTS
The term recorded facts means facts which have been recorded in the accounting hooks. Facts which have not been recorded in financial books are not depicted in the financial statements, however material they might be. For example, fixed assets are shown at cost irrespective of their market or replacement price since such price is not recorded in the books.
2. ACCOUNTING CONVENTIONS
Accounting conventions imply certain fundamental accounting principles. Which have been sanctified by long usage. For example, on account of the convention of 'Conservatism' provision is made for expected losses but expected profits are ignored. This means that the real financial position of the business may be much better than what has been shown by the financial statements.
3. PERSONAL JUDGEMENTS
Personal judgements have also an important beaming on the financial statements. For example, the choice of selecting methods of depreciation lies on the accountant. Similarly, the mode of amortisation of fictitious assets also depends on the personal judgements of the accountant.
Joint Stock Companies.
In case of Joint Stock Companies, the Balance Sheet and Profit and Loss Account are required to be prepared in accordance with the provisions of Section 211 and Schedule VI to the Companies Act,. 1956.
(a) Every balance sheet of a company shall give a true and fair view of the state of affairs of the company as at the end of financial year and shall be in the form set out in part I of Schedule VI, or near thereto as Circumstances admit or in such other form as may be approved by the Central Government either generally or in a particular case.
(b) Every Profit and Loss Account of a company shall give a true and fair view of the profit or loss of the company for the financial year and shall comply with the requirements of Part II of Schedule VI so far as they are applicable thereto.
Part II of Schedule VI provides regarding matters which are to be disclosed in the Profit and Loss Account.
(a) It shall be so made out as clearly to disclose the result of working of the company during the period covered by the account.
(b) It shall also disclose every material feature, including credits or debits or receipts and debits or expenses in respect of non-recurring transaction or transactions of an exceptional nature.
The Central Government has the power to exempt any class of companies from the format of Balance Sheet as required by Part I of Schedule VI to the Companies Act.
BALANCE SHEET
'There is no prescribe_d form of Balance Sheet as the assets and liabilities may be shown in any of the following order:
i. Liquidity order.
ii. Permanency order.
In case the concern adopts liquidity order, the assets which are more readily convertible into cash come first, and those which cannot be so readily convertible, come next and so on.
Similarly those liabilities which are payable first, come next and so on. Similarly those liabilities which are payable first, come first and those payable later on, come next and so on. Increase of permanency order, the reverse order will be followed. A specimen of Balance Sheet according to 'liquidity order' is given below:
PROFIT AND LOSS APPROPRIATION ACCOUNT
for the year ending....
To Transfer to By Balance b/d
General Reserve (i.e. balance of profit
from last year)
Debentures Sinking By Net Profit (as per.
Fund current year's Profit
and Loss a/c)
Proposed Dividends:
Preference shares ...
Equity Shares
To Balance c/d
MANUFACTURING ACCOUNT for the year ending
To Opening Stock:
Raw Materials ... Work-is-Progress
To Purchases of Raw To Carriage isms*
To Salary of Works
Manager
To Factory Rent
To Depreciation: Factory Building ... Factory Plant ...
TRADING AND PROFIT AND LOSS ACCOUNT for the year ending To Opening stock of By Sales
finished goods
To Cost of goods By Closing stock of
produced (transferred finished goods
from manufacturing
a/c)
To Gross Profit c/d By Gross Loss c/d
PROFIT AND LOSS APPROPRIATION ACCOUNT
In case of Joint Stock Companies, a Profit and Loss Appropriation account is also prepared. It explains how the profit earned during the period has been distributed. It may be prepared in the following form:
By Cost of Finished goods transferred to Trading Account
By Closing Stock:
Raw Materials ...
Work-in-progress ...
FORMATS OF FINANCIAL STATEMENTS
INCOME STATEMENTS
In case of sole-proprietary and partnership concerns there are no prescribed forms of the Income Statement and Balance Sheet.
Theirpreparation, is also desirable but not compulsory. However, they arc irt.411111) eared. In case of a trading concern, a 'Trading Account' and in case of manufacturing concern, a 'Manufacturing Account' and a Trading Account may also be prepared.
The account beading may be given as follows:
Trading and Profit & Loss A/c for the year ending on . . . In case of Joint Stock Companies preparation of the Profit and Loss Account and Balance Sheet every year is compulsory.
There is no tire:scribed form (Except in case of Banking and Insurance Companies) of the Income Statement of Profit and Loss Account, but part II of the Schedule Vi to the Companies Act, specifies the matters to the disclosed in the Profit and Loss Account. The account is titled as: 'Profit and Loss Account for the year ending ....
The results of manufacturing and trading activities may, however, be shown separately in the account.
The Profit and Loss Account is usually prepared in 'T' shape.
STATEMENT OF CHANGES IN FINANCIAL POSITION
The Balance Sheet shows the financial condition of the business at a particular moment of time Mile the Income Statement discloses the results of operations of business over a perioJ of time However, for a better undersavnimg of working capital or cash in and out of thebasin' ess.
This informatios is available in the samosas of changes in financial position of the business.
The statement may emphasize any of the following aspects relating to change is fitmecial position of the business.
i. Change i the firm's working capital
ii. Change in the firm's cash position
iii. Change in the firm's total financial position
The terms 'funds flow statement' and 'cash flow statement are popularly used for the 1. and ii type of statements while the term `statement of changes amancial position' is used for the iii. type of stater.
STATEMENT OF RETAINED EARNINGS
The term retained earnings means the accumulated excess of earnings over losses and dividends.
The balance shown by the Income Statement is transferred to the Balance Sheet through this statement, after making necessary appropriations, thus, a connection link between the Balance Sheet and the Income Statement.
The statement ia also termed as 'profit and loss appropriation account' in case of ctopanies.