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Financial Statement Analysis

Essay by   •  December 16, 2011  •  Research Paper  •  4,704 Words (19 Pages)  •  1,230 Views

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3.1 Introduction

Financial Statement analysis must be made in order to understand the financial position of the enterprise. This is done with the help of the following criteria of statement analysis.

3.2 Importance of Statement Analysis

Financial analysis is one of the important elements of the management control system and management control is the process by which managers assure that resources are obtained and used effectively and efficiently in the accomplishment of the organization's objects. The management control system is concerned with planning and control function of management and exercised through asset of policies, procedures and process that the managers used to determine whether or not operations are going as planned.

3.3 Types of Statements analysis

Statement analysis can be two types:

* Trend Appraisal:

This type of analysis is made by evaluating a simple set of financial statements over a period of years. It indicates the trend of variables as sales, cost of production, profits, assets and liabilities. For this analysis, competitive financial statement is prepared horizontally.

* Structural Analysis:

Evaluating a simple set of financial statement prepared on a particular date makes this type of analysis. It is called structural analysis, because the relationship different accounting variable is studied for example, the ratio of liquid assets to current liabilities.

3.4 Shortcomings of Statement analysis Criteria:

As mentioned earlier, the key to statement analysis is ratios, i.e. accounting ratios. However, this ratio analysis technique suffers from various limitations, which can be classified as follows.

* Difficulty in Comparison

One of the limitations of ratio analysis is the difficulty associated with their comparison to draw conclusion. Some of the differences in adoption of accounting polities are.

 Differences in methods of inventory valuation (FIFO, LIFO, Average etc)

 Differences in the use of depreciation methods and adoption of depreciation policies.

 Differences in accounting period.

* Impact of Inflation:

The second major limitation of ratio analysis is associated with the price-level changes. This is the most important limitation of financial statements prepared based on historical data. If historical statements adjusted to the price levels changes, any analysis based on these statements will be misleading and distorted.

Financial Ratio Analysis:

Financial ratios are used to compare the risk & return of different firms in order to help equity investors & creditors make intelligent investment & credit decisions. Such decisions require both an evaluation of changes in performance over time of a particular investment & a comparison among all firms within a single industry at a specific point in time. Term ratio means one number expressed in terms of another. Ratio analysis is the process of determining and interpreting numerical relationships based on financial statements. A ratio is a statistical yardstick that provides a measure of the relationship between variable and figures. This relationship can be expressed as percent or as a time. Ratio analysis is based on the notion that the analysis of absolute figures may not be the best means available of assessing an organizations performance and prospects.

Ratio Analysis is used by all business and industrial concerns in their financial analysis. Ratios are considered to be the best efficient execution of managerial function like planning, forecasting, control etc.

Ratio analysis is essential to comprehensive financial analysis. However, ratios are based on implicit assumptions that do not always apply. Ratio computations and comparisons are further confounded by the lack or inappropriate use of benchmarks, the timing of transactions, negative numbers, and differences in reporting methods. This section presents some important caveats that must be considered when interpreting ratios.

Economic Assumptions:

Ratio analysis is designed to facilitate comparisons by eliminating size differences across firms and over time. Implicit in this process is the proportionality assumption that the economic relationship between numerator and denominator does not depend on size. This assumption ignores the existence of fixed costs. When there are fixed costs, changes in total costs (and thus profits) are not proportional to changes in sales.

Benchmarks

Ratio analysis often lacks appropriate benchmarks to indicate optional levels. The evaluation of a ratio often depends on the point of view of the analyst. For example. For a short-term lender, a high liquidity ratio may be a positive indicator. However, from the perspective of an equity investor. It may indicate poor cash or working capital management.

Timing & Window Dressing

Data use to compute ratios are available only at specific points in time when financial statements are issued. For annual reports, the fiscal year-end may correspond to the low point of a firms operating cycle. When reported levels of assets & liabilities may not reflect the levels typical of normal operations.

Purpose & Use of Ratio Analysis

A primary advantage of ratios is that can be use to compare the risk & return relationships of firms of different sizes. Ratios can also provide a profile of a firm, its economic characteristics & competitive strategies & its unique operating, financial & investment characteristics. Four broad ratio categories measure the different aspects of risk & return relationships:

1. Activity analysis: Evaluates revenue & output generated by the firm's assets.

2. Liquidity analysis: Measure the adequacy of a firm's cash resources to meet its near-term cash obligations.

3. Long-term & solvency analysis: Examines the firm's capital structure, including the mix of its financing sources & the ability of the firm to satisfy its longer term debt & investment obligations.

4. Profitability analysis: Measure

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