MEANING OF FINANCIAL STATEMENT ANALYSIS
Analysis of Financial Statements is a systematic process of analysing the financial information in the financial statements to understand and take economic decisions.
The term ‘Financial Analysis’ includes both ‘Analysis’ and ‘Interpretation’. ‘Analysis’ is concerned with simplification of financial data given in the financial statements by proper classification. ‘Interpretation’ is concerned with explaining the meaning and significance of the financial data. These two terms are complementary to each other, i.e., analysis is not of much use without interpretation of analysis. Financial Statement Analysis is undertaken by creditors, investors and other users of financial statements to assess credit worthiness, financial soundness and earning potential of the business.
TOOLS AND TECHNIQUES OF FINANCIAL STATEMENT ANALYSIS
Comparative Statements
Comparative Statements or Comparative Financial Statements mean a comparative study of individual items or components of financial statements, i.e., Balance Sheet and Statement of Profit and Loss of two or more years of the enterprise itself.
This technique of financial analysis is also known as Horizontal Analysis. This technique is used for intra-firm analysis (i.e., comparison of actual values of one period with those of another period for the same firm) as well as for inter-firm analysis (i.e., comparison of actual values of one firm with another firm of similar nature and size).
Common-size Statements
Common-size Statements or Common-size Financial Statements mean statements in which individual items of financial statements of two or more years are placed side by side and thereafter converted into percentages taking a common base. Common base taken is Total Assets or Total of Equity and Liabilities, in the case of Common-size Balance Sheet and Revenue from Operations, in the case of Common-size Statement of Profit and Loss.
This technique of financial analysis is also known as Vertical Analysis.
Ratio Analysis
Ratio is an arithmetical expression of relationship between two related components of financial statements of an accounting period. An analysis of financial statements with the help of accounting ratios is termed as Ratio Analysis. Ratio Analysis is an important tool or technique for analysing financial statements, i.e., Balance Sheet and Statement of Profit and Loss. It helps in assessing the profitability, solvency, liquidity and efficiency of an enterprise.
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 Activity.
TYPES OF FINANCIAL STATEMENT ANALYSIS
1. External Analysis
External Analysis is conducted by those who do not have access to the detailed records of an enterprise and, therefore, have to depend on published accounts, i.e., Statement of Profit and Loss, Balance Sheet, Directors’ and Auditor’s Reports. Such type of analysis is made by investors, lenders, creditors, government agencies and research scholars.
2. Internal Analysis
Internal Analysis is conducted by the management to know the financial position and operational efficiency of the organisation. The important feature of such analysis is that the management has access to all information of the enterprise and, therefore, the analysis is more detailed, extensive and accurate.
3. Horizontal (or Dynamic) Analysis
This analysis is made to review and analyse financial statements for a number of years. It is a Time Series Analysis. It shows comparison of financial data for several years against a chosen base year. It is useful for trend analysis and long-term planning. Comparative Statements or Comparative Financial Statements are examples of horizontal analysis.
4. Vertical (or Static) Analysis
This analysis is made to review and analyse the financial statements of one year only. It is a Cross-sectional Analysis. Ratio Analysis of the financial statement relating to a particular accounting year is an example of this type of analysis. Such an analysis is useful in comparing the performance of several companies of the same type or divisions or departments in one enterprise.
Intra firm comparison and inter firm comparison
Intra firm comparison–
a comparison of financial variable of an enterprise over a period of a time known as a intrafirm comparison it is also called time series analysis or trend analysis
Inter-firm Comparison:
A comparison of two or more enterprises or firms is known as Inter-firm Comparison. It compares financial variables of two or more enterprises or firms to determine their competitive position. When single set of statements of two firms is compared, it is known as Cross-sectional Analysis.
Objective of financial statement analysis
Financial statement are used by various interested groups for various purposes. Financial analysis serves the following purposes and brings out the significance of such analysis:
1.Assessing the Earning Capacity or Profitability
On the basis of financial analysis, the earning capacity or profitability of an enterprise can be assessed. In addition, the earning capacity of the enterprise, in coming years, may also be forecast. All the external users of financial statements, especially investors and potential investors, are interested in earning capacity and forecast.
2.Assessing the Managerial Efficiency
The financial statement analysis helps to identify the areas where the managers have bee efficient and the areas where they have been inefficient. For example, by using accounting ratios, it is possible to analyses relative proportion of production, administrative an marketing expenses. Any favorable or unfavorable variation can be identified and reason thereof can be ascertained to pinpoint managerial efficiency or inefficiency.
3. Assessing the Short term and Long-term Solvency of the Enterprise
Long-term and short-term solvency of an enterprise can be assessed on the basis of financial statement analysis. Creditors or suppliers are interested to know the short-term solver or liquidity of the enterprise, its ability to meet short-term liabilities.
4.Inter-firm Comparison
Inter-firm comparison becomes easy with the help of financial analysis. It helps an enterprise in assessing its own performance as well as that of others, if mergers and acquisit are to be considered.
5.Forecasting and Preparing Budgets
Past financial statement analysis helps in assessing developments in future, especial the next year. For example, given a certain investment, it may be possible to foreca next year’s profit on the basis of earning capacity shown in the past. An analysis helps in forecasting and preparing the budgets.
Uses of financial statement analysis
1.Security analysis
2.Credit analysis
3.Debt analysis
4.Dividend decision
5.General business analysis
Parties interested in financial statement analysis
1.Management
2.Employee and trade unions
3.Shareholders or owners
4.Potential investors
5.Supplier and creditors
6.Banker and lenders
7.Researchers
LIMITATIONS OF FINANCIAL STATEMENT ANALYSIS
1. Historical Analysis
Financial statement analysis is a historical analysis. It analyses what has happened til date. It does not reflect the future. Persons like shareholders, investors, etc., are more interested in knowing the likely position in future.
2.Ignores Price Level Changes
Price level changes and purchasing power of money are inversely related. A change in the price level makes analysis of financial statements of different accounting years invalid because accounting records ignore change in value of money.
3.Qualitative Aspect Ignored
Since the financial statements are confined to monetary matters alone, the qualitative aspects like quality of management, quality of staff, public relations are ignored while carrying out the analysis of financial statements.
4.Suffers from the Limitations of Financial Statements
Analysis of financial statements is based on the information given in the financial statements. Hence, this analysis suffers from all such limitations from which the financial statements suffer. Therefore, unless the basic data given in the financial statements is reliable, the conclusions derived on the basis of the analysis of this data cannot be reliable.
5. Not Free from Bias
In many situations, the accountant has to make a choice out of alternatives available, eg. choice in the method of inventory valuation, choice in the method of depreciation (straight line or written down value), etc. Since the subjectivity is inherent in personal judgment, the financial statements are, therefore, not free from bias.
6.Variation in Accounting Practices
For inter-firm comparison, it is necessary that accounting practices followed by the firms do not vary significantly. As there may be variations in accounting practices followed by different firms, a meaningful comparison of their financial statements is not possible.
7.Window Dressing
Window dressing refers to the presentation of a better financial position than what it actually is by manipulating the books of account. On account of such a situation, financial analysis may give false information to the users.