Selection, classification and interpretation. The first step involves selection of information (data) relevant to the purpose of analysis of financial statements. The second step involved is the methodical classification of the data and the third step includes drawing of inferences and conclusions.
The following procedure is adopted for the analysis and interpretation of financial statements.
1) The analyst should acquaint himself with the principles and postulates of accounting. He should know the plans and policies of the management so that he may be able to find out whether these plans are properly executed or not;
2) The extent of analysis should be determined so that the sphere of work may be decided. If the aim is to find out the earning capacity of the enterprise then analysis of income statement will be undertaken. On the other hand, if financial position is to be studied then the balance sheet analysis will be necessary;
3) The financial data given in the statements should be re-organized and rearranged. It involves the grouping of similar data under same heads, breaking down of individual components of statements according to nature. The data is reduced to a standard form.
4) A relationship is established among the financial statements with the help of tools and techniques of analysis such as ratios, trends, common size, funds flow etc.
5) The information is interpreted in a simple and understandable way and the significance and utility of financial data is explained for helping decision making. The conclusions drawn from the interpretation are presented to the management in the form of reports.
When it comes to financial statement analysis, the following methods of analysis are generally used namely; comparative statements, trend analysis, common size statements, funds flow analysis, cash flow analysis,