What is Financial Statement Analysis? Types, Limitations, Objectives

What is Financial Statement Analysis?

Financial Statement Analysis is largely a study of the relationship among the various financial factors in a business as disclosed by a single set of statements and a study of the trends of these factors as shown in series of statement

Financial Statement Analysis Definition

Financial Statement Analysis is an information processing system designed to provide data for decision-making models, such as the portfolio selection model, bank lending decision models, and corporate financial management models Lev
Financial Statements thus are organised summaries of detailed information and are thus a form of analysis. The type of statements accountants prepare, the way they arrange items on these statements and their standards of disclosure are all influenced by a desire to provide information in a convenient form W.B Meig

Objectives of Financial Statement Analysis

Financial Statement analysis can be used by different users and decision makers to achieve the following objectives:

  1. Assessment of Past Performance and Current Position
  2. Loan Decision by Financial Institutions and Banks
  3. Prediction of Net Income and Growth Prospects
  4. Prediction of Bankruptcy and Failure
  5. Interpretation of Financial Statements

Assessment of Past Performance and Current Position

Past performance is often a good indicator of future performance. Therefore, an investor or creditors in interested in the trend of past sales, expenses, net income, cash flow and return on investment. These trends offer a means for judging management’s past performance and are possible indicators of future performance. Similarly, the analysis of the current position indicates where the business stands today. For instance, the current position analysis will show the types of assets owned by a business enterprise and the different liabilities due against the enterprise. It will tell what the cash position is, how much debts the company has in relation to equity and how reasonable the inventories and receivables are.

Loan Decision by Financial Institutions and Banks

Financial statement analysis is used by financial institutions, loaning, agencies, banks, and others to make sound loan or credit decisions. In this way, they can make proper allocation of credit among the different borrowers. All lenders are primarily concerned with the repayment of loans and payment of interest on the due dates. This requires comprehensive investigation and analysis of the financial statements submitted by the borrowers. Financial statement analysis help in determining credit risk, deciding terms and conditions of loan if sanctioned, interest rate, maturity date etc

Prediction of Net Income and Growth Prospects

Financial Statement analysis helps in predicting the earning prospects and growth rate in the earnings which are used by investors while comparing investment alternatives and other users interested in judging the earning potential of business enterprises. Investors also consider the risk or uncertainty associated with the expected return. The decision-makers are futuristic and are always concerned with the future financial statements which contain information on past performances analyzed and interpreted as a basis for forecasting future rates of return and for assessing risk.

Prediction of Bankruptcy and Failure

Financial statement analysis is a significant tool in predicting the bankruptcy and failure probability of business enterprises. Financial Statement analysis accomplishes this through the evaluation of solvency position. After being aware of probable failure, mangers and investors both can take preventive measures to avoid or minimize losses. Corporate management can effect changes in operating policy, reorganise financial structure or even go for voluntary liquidation to shorten the length of time losses

Interpretation of Financial Statements

The analysis of financial statements means a critical examination of statements for better understanding and drawing fruitful conclusions. It is only an analytical study of statements that can help draw dependable conclusions. Therefore, analysis becomes a pre-requisite for the interpretation of financial data in the form of an annual account and statement. The technique of analysis depends upon the objectives of analysis

Steps involved in Financial Statement Analysis

There are three steps involved in the financial statement analysis and they are:

  • Selection: The first step involved refers to the selection of information relevant to the purpose of evaluation from the total of information contained in the financial statements

  • Classification of Information: The second step involved is the classification or grouping of information in such a manner to focus on the significant relationships.

  • Selection of Information: The final step is the interpretation which includes drawing of inferences and conclusions

Limitations of Financial Statements

The Financial Statements suffer from certain limitations, which are mentioned below :

  • The financial statements do not show qualitative change which undoubtedly affects greatly the performance of an undertaking. The financial accounts do not account for events such as changes in management, labor strikes, changes in government policies affecting enterprise, etc. The financial analyst should try to assess the impact of qualitative changes on the profitability of the concerning enterprise.

  • Financial statements are historical in nature. They tell nothing about the future. Since the financial analyst is concerned with analysis and interpretation for the formulation of future business policies, he should restructure the statements in such a manner, that they become more intelligible and useful for projections for the future.

  • Generally, the audited Profit and Loss Account and Balance Sheet are considered dependable statements. If the analyst is compelled to use the unaudited accounting statements, he should first ascertain their truth. It is very difficult to verify the correctness of the Income Statement and Position Statement without the basic information in the form of ledger accounts and other records.

  • The concept of the accounting period is not technically correct. The Profit and loss Account is prepared for an accounting year which is generally a period of one year. This gives rise to the problem of cost and income allocation. In fact, real profit or loss can be calculated only at the end with the units is closed down. The annual accounts can best be considered interim reports.

  • The Profit or loss figure as shown by a Profit and Loss Account is not necessarily a correct figure which is influenced by the personal judgment of the management regarding depreciation, inventory valuation and provisions for various reserves and contingencies. The management can manipulate profit/loss figures to serve their interests. The financial analyst should see that the income has been rightly computed by following consistent accounting policies.

  • The balance sheet is a static document, which means, documents showing the economic position of an enterprise on one given date. The Balance sheet is prepared on the last day of a financial year. i.e on 31st December, 31st March, or 30th June. Generally, the Balance Sheet is prepared and published very late after the close of the accounting year. The Balance sheet loses much of its significance and practical utility due to a long time gap between the close of an accounting year and the actual publication of the same. financial analysts should always bear this limitation in mind.

  • Assets shown in the Balance Sheet might not be shown at their fair or current values. Goodwill is an item that is closely related to profits. If a company suffers loss continuously for the last few years, that it no more enjoys the goodwill as shown in the books of the company. But the companies continue to show goodwill at the usual figure despite continuous losses

Types of Financial analysis

The classification of financial analysis can be made either on the basis of material used for the same or according to modus operandi of the analysis

According to Material Used

External Analysis

This is effected by those who do not have access to the detailed accounting records of the concern. This group comprising investors, credit agencies, government and public, depends almost entirely or publishes financial statements. With the recent development in the Government regulation requiring business concern to make available detailed information to the public through audited accounts, the position of the external analysis has been considerably improved.

Internal Analysis

This is effected by those who have access to the books of accounts and other information relating to the business concern. Any financial analysis is conducted with reference to a part of the whole unit. This type of analysis meant for managerial purpose, is conducted by executives and employees of the business concerns as well as governmental agencies which have statutory control and jurisdiction over such units.

According to Modus Operandi of Analysis

Horizontal Analysis

When financial statements for a certain number of years are examined and analysed, the analysis is called horizontal analysis. It is also called “Dynamic Analysis.” This is based on the data or information spread over a period of years rather than on one date or period of time as a whole.

Vertical Analysis

This refers to the analysis of ratios developed for one date for one accounting period. This is also known as “Static Analysis” But the vertical analysis does not facilitate a proper analysis and interpretation of figures in perspective and also comparisons over a period of years. As such this type of analysis does not resort to the financial analysts

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