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Financial Statement Analysis: Purpose, Types, and Importance

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The “financial statement analysis is largely a study of relationships among the various financial sectors in a business, as disclosed by a single set of statements, and a study of trends of these factors, as shown in a series of statements”. The meaning of financial statement analysis is a systematic process of analysing the financial information in the financial statements to understand and take economic decisions. The term “financial analysis” includes both “analysis” and interpretation”.

The analysis is concerned with simplifying financial data given in the statement by proper classification, and interpretation is concerned with explaining the meaning and significance of the financial data. These two terms complement each other, i.e., and analysis is not much use within an interpretation of the analysis. Financial analysis helps business owners determine business sustainability, performance, and growth by reviewing various financial statements such as income and balance sheets.

Did you know?

Balance sheet analysis uses analytical techniques to assess a company’s financial position, risk, performance, and future potential. Even small businesses can benefit from financial statement analysis results as a guide for business owners—different types of financial statement analysis range from the most common to the most specific.

Also Read: What is the Definition of Financial Accounting and What Does it Deal With?

Purpose of Financial Analysis

  • Assessing the earning capacity: based on financial analysis. In addition, the earning capacity of the enterprise in the coming years may also be forecast. 
  • Assessing the managerial efficiency: The financial Analysis helps identify the areas where the managers have been efficient and the areas where they have been inefficient.
  • Assessing the solvency of the enterprise: It can help assess the long and short-term solvency of an enterprise. Creditors are interested to know the short-term solvency, i.e., its ability to meet liabilities. Debenture-holders and lenders are interested to know the long-term and short-term solvency of the enterprise to assess the ability of the company to repay the principal amount and interest thereon.

Documents for Financial Statement Analysis

1. Annual report: The company’s position and income statement reflect profits, losses, and potential profits over a period of time. Liability, assets, capital, debt positions, and such financial data are essential to budgeting, planning, and profitability.

2. Working capital statement: Using the current and current year’s current assets and working capital statements can track all costs and changes in working capital. Financial Analysis is an important tool in budgeting, valuation, and strategic planning.

3. Comparison statement: A comparative study of the components, elements or items of the balance sheet and income statement for more than two years. 

4. Financial analysis of key figures: This method is the most common tool for asset management, liquidity, debt management, market value, the financial performance of various departments, and profitability of business units.

Ways of Financial Statement Analysis

External Financial Analysis

  • It is conducted by those who do not have access to the detailed records of an enterprise and, therefore, have to depend on published accounts, i.e., statement of profit and loss, balance sheet, directors’ and auditor’s Reports.
  • External analysis is carried out by outsiders such as creditors, bankers, debenture holders, and government agencies.

Internal Financial Analysis

  • The management conducts internal analysis to know the position and operation efficiency of the organisation. 
  • Internal Analysis is meant for management.

Horizontal or Dynamic Financial Analysis

  • It requires financial statements of two or more accounting periods. 
  • It deals with the same items from different periods.
  • It provides information in absolute and percentage terms.
  • It is generally used for time-series analysis.
  • It is part of the comparison.

Vertical or Static Financial Analysis

  • It requires a financial statement for one period.
  • It deals with different items of the same period.
  • It provides information in percentage terms.
  • It is generally used for cross-sectional analysis.
  • It is a step toward comparison.

Profitability Financial Analysis

  • Profitability analysis is part of enterprise resource planning (ERP) and helps business leaders identify ways to optimise profitability related to various projects, plans, or products. 
  • It is the process of systematically analysing profits derived from the various revenue streams of the business.

Variance Financial Analysis

  • It evaluates the differences between a business’s budget and the actual costs incurred.
  • For instance, if a business budgeted their sales of ₹10,00,000 but sold goods worth ₹6,00,000, then the variance analysis would be a difference of ₹4,00,000.

Valuation Financial Analysis

  • It analyses the business’ present value and can be utilised for various instances such as mergers and acquisitions.
  • Once the company’s current ratios are determined, it can compare them to the past ratios, competitor’s ratios, etc.

Trend Financial Analysis

Trend analysis means identifying patterns over multiple periods and presenting them in a graphic format to derive practical information.

Liquidity Financial Analysis

  • The short-term analysis focuses on daily costs. Analyse the company’s short-term capabilities for regular creditor payments, short-term borrowing, statutory payments, salaries, and more. Its main purpose is to ensure that adequate cash flows are fully maintained over a given period and that all liabilities are fully maintained. They are filled without initials.
  • The short-time period evaluation is executed using the ratio evaluation technique that uses diverse ratios like liquidity, present-day, acid-check, etc.

Also Read: Accounting Ratios – Meaning, Types, Formulas

Types of Financial Analysis

1. External Analysis (Outsiders)

2. Internal Analysis ( Management) 

3. Horizontal Analysis ( Time series analysis)

4. Vertical Analysis ( Cross-section analysis) 

5. Profitability financial analysis

6. Variance analysis

7. Valuation financial analysis

Purpose of Financial Analysis

1. Assessing the earning capacity or profitability

2. Assessing the managerial efficiency

3. Assessing the short term and long term solvency of the enterprises

Importance of Financial Analysis

1. Forecasting and preparing a budget

2 . a Working capital statement

3. Comparative statement

4. Analysis of Financial ratios

What is a Financial Analysis Report?

A financial research report is usually produced by someone investigating a company to recommend its shares to investors. The report is the essence of the target company so that investors can understand how it does business, what competitive advantages it has, and why it is a good investment. Investors who need the information to make investment decisions scrutinise these documents.

What is Financial Performance?

Financial performance refers to calculating the monetary value of the outcomes of a company’s policies and activities. It is used to assess a company’s overall financial health over time and compare competition in the same industry or other industries or sectors.

Conclusion

“Annual financial statements are a summary statement of accounting data that provides information about a company’s performance and financial position”. The financial statements provide a summary of accounts of a business enterprise, the balance sheet reflecting the assets, liabilities, and capital as of a certain date and an income statement showing the results and operations during a certain period.

Analysis of the financial statements is a study of relationships among various financial values as set out in the financial statements. The process of division, establishing relationships, and interpretation to understand a business’s working and financial position is known as the financial analysis statement.
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