Analysis of Financial Statements
Published financial statements are the only source of information about the activities and affairs of a business entity available to the public, shareholders, investors and creditors, and the governments. These various groups are interested in the progress, position and prospects of such entity in various ways. But these statements howsoever, correctly and objectively prepared, by themselves do not reveal the significance, meaning and relationship of the information contained therein. For this purpose, financial statements have to be carefully studied, dispassionately analysed and intelligently interpreted. This enables a forecasting of the prospects for future earnings, ability to pay interest, debt maturities both current as well as long-term, and probability of sound financial and dividend policies. According to Myers, “financial statement analysis is largely a study of relationship among the various financial factors in business as disclosed by a single set of statements and a study of the trend of these factors as shown in a series of statements”.
Thus, analysis of financial statements refers to the treatment of information contained in the financial statement in a way so as to afford a full diagnosis of the profitability and financial position of the firm concerned.
The process of analysing financial statements involves the rearranging, comparing and measuring the significance of financial and operating data. Such a step helps to reveal the relative significance and effect of items of the data in relation to the time period and/or between two organisations.
Interpretation, which follows analysis of financial statements, is an attempt to reach to logical conclusion regarding the position and progress of the business on the basis of analysis. Thus, analysis and interpretation of financial statements are regarded as complimentary to each other.
Objectives of Financial Statement Analysis
Financial statement analysis is very much helpful in assessing the financial position and profitability of a concern. The main objectives of analysing the financial statements are as follows:
Limitations of Financial Statement Analysis
Types of Financial Statement Analysis
A distinction may be drawn between various types of financial analysis either on the basis of material used for the same or according to the modus operandi or according to the objective of the analysis.
1. According to Nature of the Analyst
1.1. External Analysis: It is made by those who do not have access to the detailed records of the company. This group, which has to depend almost entirely on published financial statements, includes investors, credit agencies and governmental agencies regulating a business in nominal way. The position of the external analyst has been improved in recent times owing to the governmental regulations requiring business undertaking to make available detailed information to the public through audited accounts.
1.2. Internal Analysis: The internal analysis is accomplished by those who have access to the books of accounts and all other information related to business. While conducting this analysis, the analyst is a part of the enterprise he is analysing. Analysis for managerial purposes is an internal type of analysis and is conducted by executives and employees of the enterprise as well as governmental and court agencies which may have regulatory and other jurisdiction over the business.
2. According to Modus Operandi of Analysis
2.1. Horizontal Analysis: When financial statements for a number of years are reviewed and analysed, the analysis is called ‘horizontal analysis’. As it is based on data from year to year rather than on one date or period of time as a whole, this is also known as ‘dynamic analysis’. This is very useful for long term trend analysis and planning.
2.2. Vertical Analysis: It is frequently used for referring to ratios developed for one date or for one accounting period. Vertical analysis is also called ‘Static Analysis’. This is not very conducive to proper analysis of the firm’s financial position and its interpretation as it does not enable to study data in perspective. This can only be provided by a study conducted over a number of years so that comparisons can be effected. Therefore, vertical analysis is not very useful.
3. According to the Objective of the Analysis
On this basis the analysis can be long-term and short-term analysis:
3.1. Long-term Analysis: This analysis is made in order to study the long-term financial stability, solvency and liquidity as well as profitability and earning capacity of a business. The objective of making such an analysts is to know whether in the long-term the concern will be able to earn a minimum amount which will be sufficient to maintain a reasonable rate of return on the investment so as to provide the funds required for modernisation, growth and development of the business.
3.2. Short-term Analysis: This analysis is made to determine the short-term solvency, stability, liquidity and earning capacity of the business. The objective is to know whether in the short-run a business enterprise will have adequate funds readily available to meet its short-term requirements and sufficient borrowing capacity to meet contingencies in the near future.