Interpretation of Financial Statements

Every business concern wants to know the various financial aspects for effective decision-making. The preparation of a financial statement is required to achieve the objectives of the firm as a whole. The term financial statement refers to an organised collection of data based on accounting principles and conventions to disclose financial information. Financial statements are broadly grouped into two statements.

• Income statement (trading, profit, and loss account).
• Balance sheet.

In addition to the above financial statements supported by the following statements are prepared to meet the needs of the business concern:

• Statement of retained earnings.
• Statement of changes in financial position.

 

The Meaning and Importance of the Financial Statements

1. Income Statements:

The term ‘Income Statements’ is also known as Trading, Profit and Loss Accounts. This is the first stage of preparation of final accounts in the accounting cycle. The purpose of preparing Trading, Profit and Loss Accounts is to ascertain the Net Profit or Net Loss of a business concern during the accenting period.

 

2. Balance Sheet:

A balance Sheet may be defined as “a statement of financial position of any economic unit disclosing as at a given moment its assets, at cost, depreciated cost, or other indicated value, its liabilities and its ownership equities.” In other words, it is a statement which indicates the financial position or soundness of a business concern at a specific period. A balance Sheet may also be described as a statement of source and application of funds because it represents the source where the funds for the business were obtained and how the funds were utilised in the business.

 

3. Statement of Retained Earnings:

This statement is considered to be the connecting link between the Profit and Loss Account and Balance Sheet. The accumulated excess of earnings over losses and dividends is treated as Retained Earnings. The balance of retained earnings is shown on the Profit and Loss Accounts and it is transferred to the liability side of the balance sheet.

 

4. Statement of Changes in Financial Position:

Income Statements and Balance sheets do not disclose the operational efficiency of the concern. To measure the operational efficiency of the concern it is essential to identify the movement of working capital or cash inflow or cash outflow of the business concern during the particular period.

To highlight the changes in the financial position of a particular firm, the statement prepared may emphasise the following aspects:

• The fund flow statement is prepared to know the changes in the firm’s working capital.
• The cash flow statement is prepared to understand the changes in the firm’s cash position.
• A statement of changes in financial position is used for the changes in the firm’s total financial position.

 

Nature of Financial Statements

Financial Statements are prepared based on business transactions recorded in the books of Original Entry or Subsidiary Books, Ledger, and Trial Balance. Recording the transactions in the books of primary entry supported by document proofs such as Vouchers, Invoice notes, and so on. According to the American Institute of Certified Public Accountants, “Financial Statement reflects a combination of recorded facts, accounting conventions and personal judgments and conventions applied which affect them materially.” It is, therefore, the nature and accuracy of the data included in the financial statements which are influenced by the following factors:

• Recorded facts.
• Generally accepted accounting principles.
• Personal judgments.
• Accounting conventions.

A. Objectives of Financial Statements

The following are the important objectives of financial statements:

• To provide adequate information about the source of finance and obligations of the finance firm.
• To provide reliable information about the financial performance and financial soundness of the concern.
• To provide sufficient information about the results of operations of the business over a period.
• To provide useful information about the financial conditions of the business and the movement of resources in and out of business.
• To provide necessary information to enable the users to evaluate the earning performance of resources or managerial performance in forecasting the earning potentials of business.

B. Limitations of Financial Statements

• Financial Statements are normally prepared based on accounting principles, conventions, and past experiences. Therefore, they do not communicate much about the profitability, solvency, stability, liquidity, and so on, of the undertakers to the users of the statements.
• Financial Statements emphasise disclosing only monetary facts, i.e., quantitative information and ignore qualitative information.
• Financial Statements disclose only historical information. It does not consider changes in money value, fluctuations in price levels, and so on. Thus, correct forecasting for the future is not possible.
• Influences of personal judgments lead to opportunities for manipulation while preparing financial statements.
• Information disclosed by financial statements is based on accounting concepts and conventions. It is unrealistic due to differences in terms and conditions and changes in economic situations.

 

Analysis and Interpretations of Financial Statements

The presentation of financial statements is an important part of the accounting process. To provide more meaningful information to enable the owners, investors, creditors, or users of financial statements to evaluate the operational efficiency of the concern during a particular period. More useful information is required from the financial statements to make purposeful decisions about the profitability and financial soundness of the concern. To fulfil the needs of the above. it is essential to consider the analysis and interpretation of financial statements.

A. Meaning of Analysis and Interpretations

The term “Analysis” refers to the rearrangement of the data given in the financial statements. In other words, simplification of data by methodical classification of the data given in the financial statements. The term “interpretation” refers to “explaining the meaning and significance of the data so simplified. “Both analysis and interpretations are closely connected and interrelated. They are complementary to each other. Therefore, the presentation of information becomes more purposeful and meaningful-both analysis and interpretations are to be considered.

Metcalf and Tigard have defined financial statement analysis and interpretations as a process of evaluating the relationship between parts of a financial statement to obtain a better understanding of a firm’s position and performance. The facts and figures in the financial statements can be transformed into meaningful and useful figures through a process called “Analysis and Interpretations. “In other words, financial statement analysis and interpretation refer to the process of establishing a meaningful relationship between the items of the two financial statements to identify the financial and operational strengths and weaknesses.

B. Types of Analysis and Interpretations

The analysis and interpretation of financial statements can be classified into different categories depending upon:

1. The materials used.
2. Modus operandi (methods of operations to be followed).

Based on materials used:

• External analysis
• Internal analysis.

On the basis of modus operandi:

• Vertical analysis.
• Horizontal analysis.

 

Financial Statement Analysis Illustration

The following chart shows the classification of financial analysis:

 
The chart shows the classification of financial analysis.

A. Based on Materials Used

Based on the materials used the analysis and interpretations of financial statements may be classified into External Analysis and Internal Analysis.

• External analysis.

This analysis is meant for the outsiders of the business firm. Outsiders may be investors, creditors, suppliers, government agencies, shareholders, and so on. These external people have to rely only on these published financial statements for important decision-making. This analysis serves only a limited purpose due to the non-availability of detailed information.

• Internal analysis.

Internal analysis is performed by the persons who are internal to the organisation. These internal people have access to the books of accounts and other information related to the business. Such analysis can be done to assist managerial personnel to take corrective action and appropriate decisions.

B. On the Basis of Modus Operandi

Based on Modus operandi, the analysis and interpretation of financial statements may be classified into Horizontal Analysis and Vertical Analysis.

• Horizontal analysis.

Horizontal analysis is also termed Dynamic Analysis. Under this type of analysis, a comparison of the trend of each item in the financial statements over the number of years is reviewed or analysed. This type of comparison helps to identify the trend in various indicators of performance. In this type of analysis, current year figures are compared with the base year for figures are presented horizontally over several columns.

 

• Vertical analysis.

Vertical Analysis is also termed Static Analysis. Under this type of analysis, several ratios are used for measuring the meaningful quantitative relationship between the items of financial statements during a particular period. This type of analysis is useful in comparing the performance, efficiency, and profitability of several companies in the same group or divisions in the same company.

 

Rearrangement of Income Statements

Financial statements should be rearranged for proper analysis and interpretation of these statements. It enables measuring the performance of operational efficiency and profitability of concern during a particular period.

The items of operation revenues, non-operating revenues, operating expenses and non-operating expenses are rearranged into different heads and sub-heads are given below:

The rearrangement of income statements.

Particulars		Amount Rs.	Amount Rs.
Opening Stock of Raw Materials
Add:	Purchases
Less:	Purchases Returns
	Freight and Carriage
Less:	Closing Stock of Raw Materials
Raw Materials Consumed (1)
Add:	Direct wages (Factory)
	Factory Rent and Rates
	Power and Coal
	Depreciation of Plant and Machinery
	Depreciation of Factory Building
	Work Manager’s Salary
	Other Factory Expenses
Add:	Opening Stock of Work in Progress
	Opening Stock of Finished Goods
Less:	Closing Stock of Work in Progress
	Closing Stock of Finished Goods
Cost of Goods Sold (2)
Less:	Net Sales (Fewer sales returns and Sales tax) (3)
Gross Profit: (4 = (3 – 2) (Net Sales – Cost of Goods Sold)
Less:	Operating Expenses : (5)
	Office Expenses
	Administrative Expenses
	Selling Expenses
	Distribution Expenses
Net Operating Profit : (6) = (4 – 5)
Add:	Non-Operating Income : (7)
	Interest Received
	Discount Received
	Dividend Received
	Income from Investment
	Interest on Debenture
	Any Other Non-Trading Income
Less:	Non-Operating Expenses : (8)
	Discount on Issue of Shares Written Off
	Interest on Payment on Loan and Overdraft
	Loss on Sale of Fixed Assets
Net Profit Before Interest and Tax (9)
Less:	Interest on Debenture (10)
Net Profit Before Tax (11) = (9 – 10) (Net Profit before Interest and Tax-Interest on Debenture)
Less:	Tax Paid (12)
	Net Profit after Interest and Tax (13)
	or Net Loss After Interest and Tax (Transferred to Capital Account)

A. Income Statement Equations

From the above rearrangement of operating statements, the following accounting equations may be used:

• Net Sale = Cost of Sales + Operating Expenses + Non-Operating Expenses.
• Gross Profit = Net sales – Cost of goods sold.
• Operating Expenses = Office and Administrative Expenses + Selling and Distribution Expenses.
• Operating Expenses = Gross Profit – Net Operating Profit.
• Sales – Net Operating Profit = Cost of Sales + Operating Expenses.
• Net Operating Profit = Gross Profit- Operating Expenses.
• Net Profit before Interest and Tax = Net Operating Profit – Non-Operating Expenses.
• Sales = Cost of Sales + Operating Expenses + Non-Operating Expenses.
• Net profit = Net sales – (Cost of sales + Operating Expenses + Non-operating Expenses).

 

Methods or Tools of Analysis and Interpretations

The following are the various techniques that can be adopted for the analysis and interpretation of financial statements.

1. Comparative financial statements.
2. Common size statements.
3. Trend analysis.
4. Ratio analysis.
5. Fund flow analysis.
6. Cash flow analysis.

A. Comparative Financial Statements

Under this form of comparative financial statements, both the comparative Profit and Loss Account and comparative Balance sheet are covered. Such comparative statements are prepared not only for the comparison of the various figures of two or more periods but also for the relationship between various elements embodied in the profit and loss account and balance sheet. It enables to measure of operational efficiency and financial soundness of the concern for analysis and interpretations.

The following information may be shown in the comparative statements:

• Figures are presented in the comparative statements side by side for two or more years.
• Absolute data in money value.
• Increase or Decrease between the absolute figures in money value.
• Changes or trends in various figures in terms of percentage.

B. Illustration 1

From the following Profit and Loss Account AVS Ltd., for the years 2002 and 2003, you are required to prepare a Comparative Income Statement

Statements of Profit and Loss account (illustration1).

Particulars		2002 Rs.	2003 Rs.
Net sales		4 000	5 000
Less:	Cost of goods sold	3 000	3 750
Gross Profit		1 000	1 250
Less:	Operating Expenses
	Office and Administrative Expenses	200	250
	Selling and Distribution Expenses	225	300
	Total Operating Expenses	425	550
Net Profit		575	700

 

Solution Illustration 1:

Solution statements of profit and loss account (illustration 1).

Particulars		2002 Rs.	2003 Rs.	Increase or Decrease in 2003
				Absolute in 2003 Rs.	Percentage (%)
Net sales		4 000	5 000	+ 1 000	+ 25
Less:	Cost of goods sold	5 000	3 750	+ 1 500	+ 25
Gross Profit		1 000	1 250	+ 250	+ 25
Less:	Operating Expenses
	Office and Administrative Expenses	200	250	+ 50	+ 25
	Selling and Distribution Expenses	225	300	+ 75	+ 33.33
	Total Operating Expenses	425	550	+ 125	+ 29.41
Net Profit		575	700	+ 125	+ 21.73

 

Interpretation Illustration 1:

From the above statement, it is observed that the sales have increased to the extent of 25%. The cost of goods sold, and its percentage increased by 25%. Administrative and selling & distribution expenses have been increased by 25% and 33.33% respectively. The rate of net profit is also increased to the extent of 21.73%. This indicates that the overall profitability of the concern is good.

 

C. Illustration 2

Profit and loss account (illustration 2).

Particulars	2002 Rs.	2003 Rs.	Particulars	2002 Rs.	2003 Rs.
To Cost of goods sold	118 000	147 000	By Net Sales	200 000	225 000
To Gross Profit c/d	82 000	78 000
	200 000	225 000		200 000	225 000
To General and Administrative Expenses	5 000	6 000	By Gross Profit b/d	82 000	78 000
To Selling and Distribution Expenses	7 000	8 000	By Non-Operating Income	10 000	15 000
To Non-Operating Expenses	5 000	7 000
To Net Profit c/d	75 000	72 000
	92 000	93 000		92 000	93 000

 

Solution Illustration 2:

Solution statements of profit and loss account (illustration 2).

Particulars		2002 Rs.	2003 Rs.	Increase or Decrease in 2003
				Absolute in 2003 Rs.	Percentage (%)
Net sales		200 000	225 000	+ 25 000	+ 12.5
Less:	Cost of goods sold	118 000	147 000	+ 29 000	+ 24.57
Gross Profit		82 000	78 000	– 4 000	– 4.87
Less:	Operating Expenses
	Office and Administrative Expenses	5 000	6 000	+ 1 000	+20
	Selling and Distribution Expenses	7 000	8 000	+ 1 000	+ 14.28
	Total Operating Expenses	12 000	14 000	+ 2 000	+ 16.66
Net Profit		70 000	64 000	– 6 000	– 8.57
Add:	Non-Operating Income	10 000	15 000	+ 5 000	+ 50
Total Income		80 000	79 000	– 1 000	– 1.25
Less:	Non-Operating expenses	5 000	7 000	+ 2 000	+ 40
Net Profit		75 000	72 000	– 3 000	– 4

 

Interpretation Illustration 2:

The rate of increase in sales is to the extent of (12.5%) while the cost of sales increased by (33.5%). The gross profit has declined by (- 4.87%). It indicates that the performance of operational efficiency is not much better, and the cost of sales has not been under control. The Operating Profit and Net Profit have declined by (- 8.57%) and (-4%) respectively. The increase in operating and non-operating expenses are to the extent of + 16.66 % and + 40%. This indicates that the overall profitability of the concern is not good.

D. Common Size Statements

To avoid the limitations of a Comparative Statement, this type of analysis is designed. Under this method, financial statements are analysed to measure the relationship of various figures with some common base. Accordingly, while preparing the Common Size Profit and Loss Account, total sales are taken as the common base and other items are expressed as a percentage of sales. This, to prepare the Common Size Balance Sheet, the total assets or total liabilities are taken as a common base and all other items are expressed as a percentage of total assets and liabilities.

E. Illustration 3

Statement of profit and loss account (illustration 3).

Particulars		2002 Rs.	2003 Rs.
Net sales		4 000	5 000
Less:	Cost of goods sold	3 000	3 750
Gross Profit		1 000	1 000
Less:	Operating Expenses
	Office and Administrative Expenses	200	250
	Selling and Distribution Expenses	225	300
	Total Operating Expenses	425	550
Net Profit		575	700

 

Solution Illustration 3:

Common size income statement (illustration 3).

Particulars		2002 Rs.	Percentage (%)	2003 Rs.	Percentage (%)
Net sales		4 000	100	5 000	100
Less:	Cost of goods sold	3 000	75	3 750	75
Gross Profit		1 000	25	1 000	25
Less:	Operating Expenses
	Office and Administrative Expenses	200	2.5	250	2
	Selling and Distribution Expenses	225	3.75	300	4
	Total Operating Expenses	425	6.25	550	6
Net Profit		575	18.75	700	19

F. Illustration 4

From the following balance sheet, prepare a common-size statement.

Balance sheet (illustration 4).

Liabilities	2002 Rs.	2003 Rs.	Assets	2002 Rs.	2003 Rs.
Share Capital	264 000	280 000	Cash in Hand	10 000	10 750
Current Liabilities	65 000	70 000	Cash at Bank	3 500	5 000
Long-term Debt	100 000	87 500	Bills Receivable	22 500	22 750
Bills Payable	12 500	–	Sundry Debtors	90 000	85 000
Sundry Creditors	10 000	16 000	Inventories	70 000	83 000
Bank Overdraft	50 000	71 500	Fixed Assets	300 000	307 500
			Prepaid Expenses	5 500	10 500
	501 500	525 000		501 500	525 000

Profit and loss account (illustration 4).

Particulars	2002 Rs.	2003 Rs.	Particulars	2002 Rs.	2003 Rs.
To opening Stock of Materials	25 000	30 000	By Net Sales	200 000	225 000
To Purchases	100 000	125 000	By Closing Stock	25 000	30 000
To Direct Wages	15 000	17 000	By Non-Operating Income	10 000	15 000
To Freight and Carriage	2 000	3 000
To Other Factory Expenses	1 000	2 000

 

Interpretation Illustration 4:

From the above statements, it is observed that the sales have gone up in 2003, the rate of increase to the extent of 34.67%. The cost of goods sold and its percentage increased by 65.33%. Administrative and selling and distribution expenses have been increased by 2.66% and 3.55% respectively. The rate of net profit is also increased to the extent of 32%. This indicates the overall profitability of the concern is good. The total current assets of the company have increased by 10.72%. While current liabilities have increased only to the extent of 7.14%. This indication of the liquidity position of the firm is highly satisfactory. The total fixed assets have increased by 89.28% but at the same time long-term liabilities, capital and reserves have increased by 48.57%. It is observed that the overall financial position of the business concern is good.

G. Trend Analysis

Trend analysis is one of the important techniques which is used for the analysis and interpretation of financial statements. While applying this method, it is necessary to select a period for several years to ascertain the percentage relationship of various items in the financial statements compared with the items in the base year. When a trend is to be determined by applying this method, the earliest year or first year is taken as the base year. The related items in the base year are taken as 100 and based on this trend percentage of corresponding figures of financial statements in the other years are concluded. This analysis is useful in framing suitable policies and forecasting in future also.

H. Illustration 5

Calculate the trend percentage from the following figures of Ram and CO LTD. The year 1999 is taken as the base year.

Data figures of Ram & Co Ltd.

Year	Sales	Cost of Goods Sold Rs.	Gross Profit Rs.
1999	2 000	1 400	600
2000	2 500	1 800	700
2001	3 000	2 200	800
2002	3 500	2 600	900
2003	4 000	3 000	1 000

 

Solution Illustration 5:

Trend percentage.

Year	Sale		Cost of Goods Sold		Gross Profit
	Amount Rs.	Trend Percentage (%)	Amount Rs.	Trend Percentage (%)	Amount Rs.	Trend Percentage (%)
1999	2 000	100	1 400	100	600	100
2000	2 500	125	1 800	128.57	700	116.66
2001	3 000	150	2 200	157.14	800	133.33
2002	3 500	175	2 600	185.71	900	150
2003	4 000	200	3 000	214.28	1 000	166.66

 

I. Fund Flow Analysis

Fund Flow Analysis is one of the important methods for the analysis and interpretation of financial statements. This is the statement which acts as a supplementary statement to the profit and loss account and balance sheet. Fund Flow Analysis helps to determine the changes in financial position on a working capital basis and cash basis. It also reveals information about the sources of funds that have been utilised or employed during a particular period.

J. Ratio Analysis

Ratio Analysis is one of the important techniques which is used to measure the establishment of a relationship between two interrelated accounting figures in financial statements. This analysis helps Management in decision-making. Ratio Analysis is an effective tool which is used to ascertain the liquidity and operational efficiency of the concern.