Financial Statement Analysis

What is Financial Statement Analysis ?

Meaning of Financial Statement Analysis 

The in-depth study and interpretation of the data provided in the 'Financial Statement' is known as 'Financial Analysis'. With the help of various items provided in the 'Profit and Loss Account', 'Balance sheet' and other operative data and their strategics inter-relationships, it is possible to ascertain the financial strength and weaknesses of an organization, through the process of 'Financial Analysis'.

Definitions of Financial Statement Analysis 

According to Myers :
"Financial Statement Analysis is largely a study of relationship among the various financial factors in a business as disclosed by single set of statements, and study of the trend of these factors as shown in a series of statement".

According to Hampton :
"Analysis of Financial Statement is the process of determining the significant operating and financial characteristics of a firm from accounting data".

Objectives of Financial Statement Analysis 

Objectives of financial statement analysis are enumerated in a nutshell as follows :

1) Assessment of Past Performance :
Trend revealed through the various financial data, like Sales, Cost of Goods Sold, Operating Expenses, Net Income, Cash Flow etc. If an organization past performance may be a good pointer to it's future performance. Prospective investors and current creditors rely on such past data to predict the future prospective of an organization.

2) Assessment of Current Position :
Through the exercise of financial statement analysis, the current status of an organization with regard to the type of assets held by it and the nature of it's liabilities, etc. can be ascertained.

3) Prediction of Profitability and Growth Prospects :
The assessment of forecasting of the earning prospects of a business organisation can be made through the exercise of ''Financial Statement Analysis". It helps the prospective investors in comparing and choosing an investment out of the many investment opportunities available before them. It is also used by other stakeholders for various other purposes.

4) Prediction of Bankruptcy and Failure :
'Financial Statement Analysis' is a vital technique, through which the possibilities of an organization going bankrupt in future or the chances of failure of a business can be predicted.

5) Assessment of the Operational Efficiency :
'Financial Statement Analysis' facilitates the assessment of the Operational Efficiency of an organization management. It can be done through setting standard of performance of a basis of  certain parameter and comparing them with the actual performance of the organization. Any deviation between the 'Set Standards of Performance' and 'Actual Performance' may be used as an indicator of 'Management Efficiency'.

Importance/Advantages of Financial Statement Analysis

The importance/advantage of financial statement analysis is as follows :

1) Measurement of Short Term Solvency :
An organisation ability to pay its short term liabilities, is refereed to as it "short term solvency" , assessment of which can be made through the 'financial statement analysis'. If an organisation has a positive "short term solvency", its creditors would not hesitate in leading funds to it. On the other hand, if an organisation suffers from the lack of 'short term solvency' , the creditors would refrain from leading funds to it. 

2) Measurement of Long Term Solvency :
An Organisation ability to repay its ' long-term liabilities ' e.g. bonds and debentures issued by it and other secured liabilities, is referred to as its 'long term solvency'. A company having such capability is said to be "solvent". Thus, status of an organisation in terms of long term solvency is revealed through the analysis of financial statement.

3) Measurement of Operating Efficiency :
Through the analysis of 'financial statement' of an Organisation, the position with regard to its profitability can easily be ascertained. If a business organisation is incurring losses, the reason there of may also be found out through such analysis and necessary corrective actions may be taken to curb losses and turn the loss incurring  organisation into a profit earning organisation.

4) Measurement of Profitability :
The existing earning capacity of an organisation as well as forecasting in respect of its future earning can be gathered through the earning ratio analysis, inputs for which are provided by the 'financial statements'. 'Measurement of profitability' is an important indicator, which helps in taking decisions by the investor's and lender's.

5) Comparison of Inter-Firm Position :
The comparison of the financial position of one organisation with that of another organisation is an exercise undertaken through the 'financial analysis'. Such a comparative study is useful in deciding the course of action to be taken by investors and other stakeholders.

Limitations of Financial Statement Analysis

The Limitation/Disadvantages of financial statement analysis are as follows :

1) Absence of Standard Universally Accepted Terminology :
The financial statement analysis is part of accounting, which is not an exact science. The terminology used in it is, therefore not the one which is standardized or  universally accepted.

2) Overlooking Qualitative Aspects :
Under the financial statement analysis there is no consideration for qualitative aspects of a business. The entire exercise focused on the quantitative aspects of the business while the quantitative aspects, some of which may be quite significant, are totally overlooked.

3) Result in Absence of Absolute Data :
As there is lack of the Absolute Data, the conclusion arrived at through the financial statement analysis may not be correct in absolute terms.

4) Overlooks Price Level Changes :
As the price of same commodity differ from one year to another, the cost of production, sales as well as the value of asset are affected. Therefore the compatibility of ratios decided on the presumption that the prices of the commodities is two different years remain the same, may not hold good.

5) Suffering from Limitations of Financial Statement ;
There are some inherent weaknesses prevailing in the financial statement, due to the fact that the books of accounts are maintained on the basis of historical data.  Analysis carried out on the basis of such financial statements may not reflect the true picture.

Types of Financial Statement Analysis

Various Tools and techniques used for the analysis of financial statements are as under :

1) Funds Flow Statement :
Fund flow statement is a statement, which depicts the sources and application of fund for a specific time period. Through the fund flow statement an analysis with regard to the changes in the financial position of an organisation from the beginning of time period to its end is undertaken.

2) Cash Flow Statement :
A cash flow statement is a financial statement, which shows how 'cash' and 'cash equivalents' in a business are affected by the changes in various components of balance sheet and profit and loss account. It summarizes the reasons behind the changes in cash position of a business entity between the dates of two balance sheets.

3) Ratio Analysis :
Ratio analysis is a technique of quantitative analysis by establishing relationships between two or combination of more than two items of financial statement. Viz. balance sheet, income statement and / or cash flow statement. It  is used to evaluate various aspects of a company operating a financial performance such as its efficiency, liquidity, profitability and solvency which is helpful for the management in making certain decisions.

4) Common-Size Statement :
A company financial statement, which displays all the items percentage of a common base figure (for example, total assets,  total liabilities and total sales ) is known as common size statement. It facilities comparative analysis between two or more companies, or between two or more time period of a company.

5) Comparative Statement :
The financial statement of an organisation for different time periods are referred to as comparative financial statement. Various items of financial statement are presented in a comparative form, which may be in the form of a table. This enables one to have a comparative view of various parameter for two or more time period at a glance.

6) Trend Analysis :
Trend analysis is a technique based on the underlying premise that what was happened in the past gives an indication as to what will happen in the future. It may be defined as a mathematical techniques that used historical data to forecasts future outcome. Trend analysis may be undertaken in respect of two organisation for the same time period of two Organisation for different time period ( two or more years). A trend is a series of information from the financial statement, analysed to arrive at some meaningful conclusion.