How to interpret and infer a financial statement?

The analysis of financial statements means identifying a business establishment’s financial strengths and weaknesses by interpreting and inferring the financial statements of the establishment. These statements cannot be analysed by the mechanical method as a financial statement is designed to give a fair, inaccurate view. Interpreting financial statements requires analysis and appraisal of the performance and position of an entity.

Financial analysis refers to an assessment of the viability, stability, and profitability of a business, sub-business, or project. Interpreting the data is a process of trying to explain the patterns that were discovered. The appraiser requires good interpretation skills and a good understanding of what the information means in the context of project appraisal. 
A careful, patient, and informed analysis is a must to ascertain qualitative appraisal of financial statements. Balance sheets and Profit and Loss accounts are the two most important financial data available to an establishment. A balance sheet informs us how a business stands at a particular point in time. Comparison of figures of reporting period with previous years tells us the changes in the position of owner’s investment in the business year by year. It shows how the capital is distributed, and how much of the investment is identified with various accounts. The business trend can be examined by comparing various items in a series of balance sheets that show changes in those items either increasing or decreasing. The successive increase of proportionate receivables to sales indicates that the company is in a relaxed period of credit to the customers. Similarly, if creditors are increasing year by year the company has earned the confidence of suppliers of materials for prompt payments for credit extended by them. It may also be inferred as the company’s inability to make payments to suppliers on time.

The income statement communicates how much revenue the company generated during a period and what costs it incurred in connection with generating that revenue. The basic equation underlying the income statement, ignoring gains and losses, is Revenue minus Expenses equals Net income. The profit and Loss statement (income statement) sums up the results of the operation till that time. It reveals the volume of sales for a given period. The total expenses income and net profit earned after allowing for all the costs can be found in the Profit and Loss statement. By comparison of Profit & Loss statements with the corresponding period of previous years gives us a fair idea of an increase or decrease in sales, increase or decrease in manufacturing cost, increase or decrease in overhead charges, financing charges, etc. A careful study of the statement reveals whether the business was overstocked. If it is so, further investigation is required to find out whether an overstocked stock is due to the accumulation of unsalable/obsolete stock.

The term ratio means a simple division of one number by another. It is measured by the number of times one number is contained by the other, either integrally or in fractions. The ratio analysis of financial statements is the process of calculating the structural relations of different items and groups in the financial statements. Generally, the ratios are classified into three broad categories viz. Structural ratios, Profitability ratios, and turnover ratios. These ratios are used by analyst to evaluate significant relationships in financial statements which will be of immense use to financial analysts for further investigation and in making final decisions. This is because; ratios provide financial analysts certain yardstick to evaluate the financial condition and performance of a firm, as ratios reduce large figures to an easily understandable relationship. Therefore, ratio analysis has gained wide acceptance as a quantitative technique of financial management. However, the ratios may not conclude themselves. 

Ratio analysis is only a beginning and gives just a fraction of the information needed for decision-making. We have to accept that the information provided in the financial statements is not an end in itself, as no meaningful conclusions can be inferred from the analysis of statements alone. Therefore banker builds up on his judgment by appraising credit proposals to have a comprehensive analysis of financial statements; ratios should be used along with other methods of analysis.

(Read: limitation of ratio analysis)

How are they interlinked?

The figures in the income statement and balance sheet are interlinked. For example, in a financial year, the earning of the company goes up and the same is reflected in the balance sheet increasing in net worth of the company. When higher provisions for income tax are made in the expense account, it would increase the level of current liabilities of the company on the balance sheet. The large operating and other expenses appearing in the profit and loss account are linked to the higher amount of ‘accounts payable’ in the balance sheet ( possibly due to current assets purchased under credit). If the interest expenses of the company are high, it means the outside liability of the company is high because a high net-worth company is not required to borrow at the cost of high interest expenses. If the balance sheet shows a large amount of fixed assets at the asset side of the balance sheet, it is reflected in the profit and loss account by way of higher nondepreciating expenses and the link between the balance sheet and profit and loss account can be similarly established.

Audit report and Director’s report: Along with balance sheet and profit and loss accounts, the examination of the Audit report and Director’s report are important to bankers.  The auditor’s report reveals whether the company’s financial position and P&L a/c show a free and fair view of the state of affairs. Any unauthorised payments not connected with business or diversion of funds etc., if existed would be reported in the auditor’s report. Any understatement/overstatement of liability or income would be reported/ qualified by the auditors. As per the ‘manufacturing and other companies order 75’, the auditor is required to make a statement on any matter that has a direct significance to the banker for monitoring the advance.

The Director’s report touches upon many important aspects of the working of the company and its prospects. More importantly, the director’s report is required to reply to every qualification appearing in the auditor’s report.

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