What are Financial Statement Analysis ?

Meaning Of Financial Statements Analysis

Financial Statements Analysis is a systematic process of analysing the financial information is the financial statements to understand and take economic decisions.

Significance Of Financial Statement Analysis

Analysis of financial statements helps the finance managers in:

  • Assessing the operational efficiency and managerial effectiveness of the company.
  • Analyzing the financial strengths, weakness and creditworthiness of the company.
  • Analyzing the current position of financial analysis.
  • Assessing the types of assets owned by a business enterprise and the liabilities which are due to the enterprise.
  • Providing information about the cash position company is holding and how much debt the company has in relation to equity.
  • Studying the reasonability of stock and debtors held by the company.

Objectives Of Financial Statement Analysis

  • Assessment of Past Performance and Current Position.
  • Prediction of Net Income and Growth Prospects.
  • Assessing the Managerial Efficiency.
  • Assessing the Short-term and Long-term solvency of the enterprise.
  • Inter-firm Comparison
  • Make Financial Statements Explainable and Understandable.

Importance Of Financial Statement Analysis

  • Importance to Management: Increase in size and complexities of factors affecting the business operations necessitate a scientific and analytical approach in the management of modern business enterprises.
  • Importance to Shareholders or Investors: Management is separated from ownership in the case of companies. Shareholders cannot, directly, take part in the day-to-day activities of business. Through analysis of financial statements shareholders are interested to know profitability and safety of their investments.
  • Importance to Lenders/Creditors: The financial statements serve as a useful guide for the present and future suppliers and probable lenders of a company. Suppliers or Creditors are interested to know the short-term solvency position of the firm through analysis of financial statements.

Limitations Of Financial Statement Analysis

  • Financial Statements Mainly Show Historical Information: As the financial statements are compiled on the basis of historical costs, they fail to take into account such factors as the decrease in money value or increase in the price level changes.
  • Qualitative Information is Ignored: Financial statements depict only those items of quantitative information that are expressed in monetary terms.
  • Ignores Price Level Changes: A change is the price level makes analysis of financial statements of different accounting years is valid, as accounting records ignore change in value of money.
  • Window Dressing: In the situation of window dressing of books of accounts, financial analysis may give false information to the users.
  • Variation in Accounting Practices: For inter-firm comparison, it is necessary that accounting practices followed by the firms do not vary significantly.

Tools For Financial Statement Analysis

  • Comparative Statements: Comparative statements or comparative financial statements deal with the comparison of different items of the Statement of Profit and Loss and Balance Sheets of two or more periods. Separate comparative statements are prepared for Statement of Profit and Loss as Comparative Income Statement and for Balance Sheet as Comparative Balance Sheets. This analysis is also known as Horizontal Analysis.
  • Common (-) Size Statements: A vertical presentation of financial information is followed for preparing Common-Size Statements or Common-Size Financial Statements. Besides, the rupee value of financial statement contents are not taken into consideration. But only percentage is considered for preparing common size statement. In such statements individual items of financial statements of two or more years are placed side by side and thereafter converted into percentages taking a common base. This analysis is also known as Vertical Analysis.
  • Cash Flow Statement: Cash Flow Statement is a statement showing flow of cash and cash equivalents during the accounting period, classified under Operating Activities, Investing Activities and Financing Activities. It shows the changes in cash position from one period to another.
  • Ratio Analysis: Ratio analysis is an attempt of developing meaningful relationship between individual items (or group of items) in the Balance Sheet or Statement of profit and loss. Ratio analysis is not only useful to internal parties of business concern but also useful to external parties. Ratio analysis highlights the liquidity, solvency, profitability and capital gearing of an enterprise.