Financial Statement Analysis
What is Financial Statement?
Financial statements, i.e., Income Statement and Balance Sheet are summarised financial reports which shows the operating results and financial position of companies. The detailed information of financial statements is useful for assessing the operational efficiency and financial soundness of a company. A number of techniques are used for proper analysis and interpretation of such information.
Meaning of (FSA) Financial Statements Analysis
The term ‘financial analysis’ includes both ‘analysis and interpretation’. Analysis means simplification of financial data by methodical classification given in the financial statements. Interpretation means explaining the meaning and significance of the data. These two are complimentary to each other. Analysis is useless without interpretation, and interpretation without analysis is difficult or even impossible.
‘Financial Statement Analysis’ is the critical evaluation of financial information contained in the financial statements in order to understand and make decisions regarding the operations of the firm. It is basically a study of relationship among various financial facts and figures given in a set of financial statements. Then, interpretation to gain an insight into the profitability and operational efficiency of the firm to assess its financial health and future prospects.
Significance of Financial Statements Analysis
- FSA identify the financial strengths and weaknesses of the firm by properly establishing relationships between the various items of the balance sheet and the statement of profit and loss.
- The nature of analysis may differ depending on the purpose of the analyst; hence it can be useful and significant to different users, for example-
- Finance manager: A finance manager is responsible to make rational decisions for the firm. The techniques are important in the area of financial control, enabling the finance manager to make constant reviews of the actual financial operations of the firm to analyse the causes of major deviations, which may help in corrective action wherever indicated.
- Top management: They have to see that the resources of the firm are used most efficiently and that the firm’s financial condition is sound. Financial analysis helps the management in measuring the success of the company’s operations, appraising the individual’s performance and evaluating the system of internal control.
- Trade payables: It appraises the ability of the company to meet its short-term obligations and also judges the probability of its continued ability to meet all its financial obligations in future. Trade payables are particularly interested in the firm’s ability to meet their claims over a very short period of time. Their analysis will, therefore, evaluate the firm’s liquidity position.
- Lenders: Long-term lenders are concerned with the firm’s long-term solvency and survival. They analyse the firm’s profitability over a period of time, its ability to generate cash, to be able to pay interest and repay the principal and the relationship between various sources of funds. Long-term lenders analyse the historical financial statements to assess its future solvency and profitability.
- Investors: Investors are interested about the firm’s earnings. They concentrate on the analysis of the firm’s present and future profitability. They are also interested in the firm’s capital structure to ascertain its influences on firm’s earning and risk.
- Labour unions: They analyse the financial statements to assess whether it can presently afford a wage increase and whether it can absorb a wage increase through increased productivity or by raising the prices.
- Others: The economists, researchers, etc., analyse the financial statements to study the present business and economic conditions. The government agencies need it for price regulations, taxation and other similar purposes.
Objectives of Financial Statements Analysis
- To assess the current profitability and operational efficiency of the firm as a whole as well as its different departments so as to judge the financial health of the firm.
- To ascertain the relative importance of different components of the financial position of the firm.
- To identify the reasons for change in the profitability/financial position of the firm.
- To judge the ability of the firm to repay its debt and assessing the short-term as well as the long-term liquidity position of the firm.
Tools of Financial Statements Analysis
The most commonly used techniques of financial analysis are:
- Comparative Statements: These statements show the profitability and financial position of a firm for different periods of time in a comparative form. It usually applies to the two important financial statements, namely, balance sheet and statement of profit and loss prepared in a comparative form. The financial data will be comparative only when same accounting principles are used in preparing these statements. Comparative figures indicate the trend and direction of financial position and operating results. This analysis is also known as ‘Horizontal Analysis’.
- Common Size Statements: These statements indicate the relationship of different items of a financial statement with a common item by expressing each item as a percentage of that common item. The percentage thus calculated can be easily compared with the results of corresponding percentages of the previous year or of some other firms, as the numbers are brought to common base. Such statements also allow an analyst to compare the operating and financing characteristics of two companies of different sizes in the same industry. Thus, common size statements are useful, both, in intra-firm comparisons over different years and also in making inter-firm comparisons for the same year or for several years. This analysis is also known as ‘Vertical Analysis’.
- Trend Analysis: This technique studies the operational results and financial position over a series of years. Using the previous years’ data of a business enterprise, trend analysis can be done to observe the percentage changes over time in the selected data. By looking at a trend in a particular ratio, one may find whether the ratio is falling, rising or remaining relatively constant. From this observation, a problem is detected or the sign of good or poor management is detected.
- Ratio Analysis: It describes the relationship exists between various items of a balance sheet and a statement of profit and loss of a firm. Accounting ratios measure the comparative significance of the individual items of the income and position statements. The technique of ratio analysis is useful to assess the profitability, solvency and efficiency of an enterprise.
- Cash Flow Analysis: It refers to the analysis of actual movement of cash into and out of an organisation. The flow of cash into the business is called as cash inflow or positive cash flow and the flow of cash out of the firm is called as cash outflow or a negative cash flow. The difference between the inflow and outflow of cash is the net cash flow. Cash flow statement is prepared to project the manner in which the cash has been received and has been utilised during an accounting year as it shows the sources of cash receipts and also the purposes for which payments are made. Thus, it summarises the causes for the changes in cash position of a business enterprise between dates of two balance sheets.
Limitations of Financial Analysis
Though financial analysis is quite helpful in determining financial strengths and weaknesses of a firm, it is based on the information available in financial statements.
But financial analysis also suffers from various limitations of financial statements. Hence, the analyst must be conscious of the impact of price level changes, window dressing of financial statements, changes in accounting policies of a firm, accounting concepts and conventions, personal judgement, etc.
Some other limitations of financial analysis are:
- Financial analysis does not consider price level changes.
- It may be misleading without the knowledge of the changes in accounting procedure followed by a firm.
- It is just a study of reports of the company.
- Monetary information alone is considered in financial analysis while non-monetary aspects are ignored.
- The financial statements are prepared on the basis of accounting concept, as such, it does not reflect the current position.