What is Financial Statement Analysis?

Ashish M. Shaji

06 Mar, 2021

Financial Statement Analysis involves analyzing the entity’s financial situation by determining the financial statements of the company. Analysis of the financial statement is submitted to the board of directors and to senior management committees. In this article, we shall discuss about Analysis of the Financial Statement in detail. 

Meaning of Financial Statement Analysis (FSA)

Financial analysis can be called as analysis and interpretation of financial statements. It refers to the process of determining the financial strengths and weakness of the firm by building a strategic relationship between the item of the balance sheet, profit and loss account, and other operative data.

In the word of Myers, it is explained as a study of the relationship among the different financial sectors in a business as disclosed by a single statement and the study of the trend of these factors as shown in the series of statements.

Significance of Financial Statement Analysis (FSA)

Through financial analysis, the information in the financial statements is diagnosed so as to judge the profitability and financial soundness of the firm. Just as a doctor examines a patient’s body before coming to a conclusion regarding an illness and before executing treatment on the patient, a financial analyst analysis the financial statements with different tools before reaching upon a conclusion of the financial health or weakness of the enterprise.

The analysis and interpretation of the financial statement is critical to clear the picture regarding the figures in financial statements. It is also an attempt to determine the importance and the meaning of financial statement data so that a forecast can be made of the future earnings etc.

Objective of FSA

The following objectives may be noted:

• To determine the earning capability or profitability of firm;
• To determine the operational efficiency and managerial effectiveness;
• To determine the short as well as long term solvency position of the firm;
• To know the reasons for the change in profitability and the financial position of the firm;
• To make inter-firm comparison;
• To make anticipations regarding the future prospects of the firm;
• To analyse and assess the progress of the firm over a period of time;
• To assist in decision making and control;
• To determine the dividend action; and
•  To provide essential information for granting credit.

Users of FSA

There are various users of this, and they are discussed below.

• Management of the Company

A finance controller in a company does the analysis of financial statements of the company, especially operational metrics like profit by product, cost per delivery, etc.

• Investors

The present and prospective investors examine the financial health of an organization by analysing the financial statements. They perform this in order to know the ability of the company to issue dividends, generate cash flows, and to ensure that the company grows at least at the historical rate.

• Creditors

A creditor who has provided funds to the company would be interested to know the company’s ability to pay back the debts and their cash management measures.

• Regulatory authorities

The regulatory authority, SEBI^[1], examines the financial statements of publicly held companies to know if the statements conform to the accounting standards and SEBI rules.

How to perform Financial Statement Analysis?

There are various ways of performing analysis of Financial Statement. However, we have discussed the most common methods.

• Horizontal Analysis

It involves two year comparison of analysis of the financial statements and its elements. It is also called as trend analysis. This provides the analysts with insight into the aspects that can contribute to the profitability of an organization.

• Vertical Analysis

It is a technique where every line items of the financial statements are listed as %. The line items on the income statement can be stated as % of gross sales, whereas the line items on the balance sheet can be stated as % of the total assets or liabilities. By employing this technique, insight shall be created regarding the changes in the total assets allocation and distribution. The vertical analysis method is also used for comparing one company to the other in the form of benchmarking.

• Ratio Analysis

It is the form of analysis that is employed for obtaining a quick indication of the financial performance of the organization in key areas. Ratio analysis as a financial tool has many different features. The data given by the financial statements are available easily.

Are there any Limitations of FSA?

As stated earlier financial analysis is a useful mechanism to know the financial strengths as well as weaknesses of a firm. However, the analysis is based upon the information provided in the financial statements. Therefore it is apparent that financial analysis has some limitations of financial statements.

Here the role of a financial analyst also becomes critical. He has to be careful about the impact of the price level changes, changes in the accounting policies, accounting concepts, and convention, personal judgement, etc.

Some of the critical limitations associated with it can be summed as under:

• It involves only a study of interim reports;
• It doesn’t consider the changes to price levels;
• Financial analysis is just based upon monetary information, and non-monetary factors are not taken into consideration;
• As financial statements are prepared on going concern, it barely provides exact position. Thus it causes a serious limitation to financial analysts;
• Changes in the procedure of accounting firm can make financial analysis misleading;
• The financial analyst makes interpretation and draws his own conclusion, which can be different if done by different people in different ways.

Conclusion

There are a number of methods of doing Financial Statement Analysis, and every method has its own benefits as well. Each of the methods provides visibility of variances, market trends, etc. However, its limitations cannot be ignored. Therefore the role of a financial analyst becomes very critical in this regard.

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