The financial statements of a business enterprise are intended to provide much of the basic data used for decision making, and in general, evaluation of performance by various groups such as current owners, potential investors, creditors, government agencies, and in some instance, competitors. Financial statements are the reports in which the accountant summarizes and communicates the basic financial data. The creditors are primarily interested in the liquidity of the company. Government is interested from the regulatory point of view. Besides, other stakeholders such as economists, trade associations, competitors, etc are also interested in the financial performance of the company. So, what we discussing is – Objectives, Techniques, and Types of Financial Statement Analysis.
The Cost Accounting has explained the Objectives, Techniques, and Types of Financial Statement Analysis.
In this article what discuss: Basic Objectives of Financial Statement Analysis, Main Objectives of Financial Statement Analysis, then Techniques of Financial Statement Analysis, and finally discussing the Types of Financial Statement Analysis. The following content is below: Financial statement analysis helps to highlight the financial performance of the company. It is the process of identifying the financial strength and weakness of a firm by properly establishing the relationship between the items on the Balance Sheet and those on the Profit and Loss Account.
Objectives and Importance of Financial Statement Analysis:
The primary objective of financial statement analysis is to understand and diagnose the information contained in the financial statement with a view to judge the profitability and financial soundness of the firm and to make the forecast about future prospects of the firm. The purpose of analysis depends upon the person interested in such analysis and his object.
However, the following purposes or objectives of financial statements analysis may be stated to bring out the significance of such analysis:
- To assess the earning capacity or profitability of the firm.
- To assess the operational efficiency and managerial effectiveness.
- To assess the short term as well as long-term solvency position of the firm.
- To identify the reasons for the change in profitability and financial position of the firm.
- To make the inter-firm comparison.
- To make forecasts about the future prospects of the firm.
- To assess the progress of the firm over a period of time.
- To help in decision making and control.
- To guide or determine the dividend action, and.
- To provide important information for granting credit.
Basic Objectives of Analysis and Explains:
The users of financial statements have definite objectives to analyze and interpret. Therefore, there are variations in the objectives of interpretation by various classes of people.
However, there are certain specific and common objectives which are listed below:
- To interpret the profitability and efficiency of various business activities with the help of profit and loss account.
- To measure the managerial efficiency of the firm.
- To measure short-term and long-term solvency of the business.
- To ascertain earning capacity in the future period.
- To determine the future potential of the concern.
- To measure the utilization of various assets during the period, and.
- To compare the operational efficiency of similar concerns engaged in the same industry.
Main Objectives of Financial Statement Analysis:
The major objectives of financial statement analysis are to provide decision makers with information about a business enterprise for use in decision-making. Users of financial statement information are the decision-makers concerned with evaluating the economic situation of the firm and predicting its future course.
Financial statement analysis can be used by different users and decision makers to achieve the following objectives:
Assessment of Past Performance and Current Position:
Past performance is often a good indicator of future performance. Therefore, an investor or creditor is 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 to the enterprise. It will tell what the cash position is, how much debt the company has in relation to equity and how reasonable the inventories and receivables are.
Prediction of Net Income and Growth Prospects:
The financial statement analysis helps in predicting the earning prospects and growth rates 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 are 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. After being aware of the probable failure, both managers and investors can take preventive measures to avoid/ minimize losses. Corporate management can effect changes in operating policy, reorganize financial structure or even go for voluntary liquidation to shorten the length of time losses. In the accounting and finance area, empirical studies conducted have suggested a set of financial ratios which can give an early signal of corporate failure.
Such a prediction model based on financial statement analysis is useful for managers, investors, and creditors. Managers may use the ratios prediction model to assess the solvency position of their firms and thus can take appropriate corrective actions. Investors and shareholders can use the model to make the optimum portfolio selection and to bring changes in the investment strategy in accordance with their investment goals. Similarly, creditors can apply the prediction model while evaluating the creditworthiness of business enterprises.
Loan Decision by Financial Institutions and Banks:
Financial statement analysis is used by financial institutions, loaning agencies, banks, and others to make the sound loan or credit decision. In this way, they can make the proper allocation of credit among the different borrowers. Financial statement analysis helps in determining credit risk, deciding the terms and conditions of the loan if sanctioned, interest rate, maturity date etc.
Techniques of Financial Statement Analysis:
Various techniques are used in the analysis of financial data to emphasize the comparative and relative importance of data presented and to evaluate the position of the firm.
Among the more widely used of these techniques are the following:
- Horizontal Analysis.
- Vertical Analysis.
- Trend Analysis, and.
- Ratio Analysis.
The percentage analysis of increases and decreases in corresponding items in comparative financial statements is called horizontal analysis. The horizontal analysis involves the computation of amount changes and percentage changes from the previous to the current year. The amount of each item on the most recent statement is compared with the corresponding item on one more earlier statements.
The increase or decrease in the amount of the item is then listed, together with the percent of increase or decrease. When the comparison is made between two statements, the earlier statement is used as the base. If the horizontal analysis includes three or more statements, there are two alternatives in the selection of the base. First, the earliest date or period may be used as the basis for comparing all later dates or periods or second, each statement may be compared with the immediately preceding statement.
The percent change is computed as follows:
Percentage change = Amount of change/Previous year amount x 100.
Vertical Analysis uses percentages to show the relationship of the different parts to the total in a single statement. Vertical analysis sets a total figure in the statements equal to 100 percent and computes the percentage of each component of that figure. The figure to be used as 100 percent will be total assets or total liabilities and equity capital in the case of the balance sheet and revenue or sales in the case of the profit and loss account.
Using the previous year’s data of a business enterprise, trend analysis can be done to observe percentage changes over time in selected data. In trend analysis, percentage changes are calculated for several successive years instead of between two years. Trend analysis is important because, with its long-run view, it may point to basic changes in the nature of the business. By looking at a trend in a particular ratio, one may find whether that ratio is falling, rising or remaining relatively constant. From this observation, a problem is detected or the sign of a good management is found.
Trend analysis uses an index number over a period of time. For index number, one year, the base year is equal to 100 percent. Other years are measured in relation to that amount. For example, an analyst may be interested in sales and earnings trends for the past five years. For this purpose, sales and earnings data of a company are given to prepare further the trend analysis or percentages. The above data show a fairly healthy growth pattern but the pattern of change from year to year can be determined more precisely by calculating trend percentages. To do this, a base year is selected and then the data are divided for each of the other years by the base year data.
Ratio analysis is an important means of expressing the relationship between two numbers. A ratio can be computed from any pair of numbers. To be useful, a ratio must represent a meaningful relationship, but the use of ratios cannot take the place of studying the underlying data. Ratios are guides or shortcuts that are useful in evaluating the financial position and operations of a company and in comparing them to previous years or to other companies. The primary purpose of ratios is to point out areas for further investigation.
They should be used in connection with a general understanding of the company and its environment. Comparison of income statement and balance sheet numbers, in the form of ratios, can create difficulties due to the timing of the financial statements. Specifically, the profit and loss account covers the entire fiscal period, whereas the balance sheet is for a single point in time, the end of the period. Ideally then, to compare an income statement figure such as sales to a balance sheet figure such as receivable, we usually need a reasonable measure of average receivables for the year that the sales figure cover.
However, these data are not available to the external analyst. In some cases, the analyst should take the next best approach, by using an average of beginning and ending balance sheet figures. This approach smooth’s out changes from beginning to end, but it does not eliminate the problem due to seasonal and cyclical changes. It also does not reflect changes that occur unevenly throughout the year.
Types of Financial Statement Analysis:
The process of financial statement analysis is of different types. The process of analysis is classified on the basis of information used and ‘modus operandi’ of analysis.
The classification is as under – (1) On the Basis of Information:
This analysis is based on published financial statements of a firm. Outsiders have limited access to internal records of the concern. Therefore, they depend on published financial statements. Thus, the analysis done by outsiders namely, creditors, suppliers, investors, and government agencies are known as external analysis. This analysis serves a very limited purpose.
This analysis is done on the basis of internal and unpublished records. It is done by executives or other authorized officials. It is very much useful and significant to employees and management.
(2) On the Basis of ‘Modus Operandi’ of Analysis:
This analysis is also known as ‘dynamic’ or ‘trend’ analysis. The analysis is done by analyzing the statements of a number of years. According to John N. Myer, “the horizontal analysis consists of a study of the behavior of each of the entities in the statement”. Thus, under horizontal analysis, we study the behavior of each item shown in the financial statements. We examine as to what has been the periodical trend of various items shown in the statements i.e., whether they have increased or decreased over a period of time. If the comparative statements are prepared for more than two periods, then one of the years is taken as a basis to calculate the percentage of increase or decrease. Some analysts prefer to choose the earliest year as the basis, while some others prefer to take just the preceding year as the basis.
Vertical analysis is also known as ‘static analysis’ or ‘structural analysis’. This analysis is made on the basis of a single set of financial statements prepared on a particular date. Under vertical analysis, the quantitative relationship is established between different items shown in particular statements. Common-size statements are a form of vertical analysis. Different items shown in the statement are expressed as a percentage to any one item as the base. Use of both the methods of analysis is very much required for proper analysis. Each method provides a specific type of information and in fact, both methods constitute the backbone of financial analysis. Techniques or Tools of Financial Statement Analysis: The history of financial statement analysis is traced back to the beginning of the 20th century. The analysis was started in western countries for the use of credit analysis. Till 1914, financial institutions used to rely on the facts of financial statements. But over a period of time, the need for analysis was felt and a number of techniques were invented and made use of for the purpose of analysis.
The most important techniques of analysis and interpretation, of financial statements, are listed below:
- Ratio analysis.
- Cash flow analysis.
- Funds flow analysis.
- Comparative financial statements.
- Common measurement or size statements.
- Networking capital analysis, and.
- Trend analysis.
An analysis of financial statements based on ratios is known as ratio analysis. A ratio is a mathematical relationship between two or more items taken from the financial statements. Ratio analysis is the process of computing, determining, and presenting the relationship of items. It also includes comparison and interpretation of ratios and using them as a basis for the future projections. Ratio analysis is helpful to management and outsiders to diagnose the financial health of a business concern. It helps in measuring the profitability, solvency, and activity of a firm.
Cash flow analysis depicts the inflows and outflows of cash. The cash flow statement is the device for such an analysis. It highlights causes which bring changes in cash position between two balance sheet dates.
Funds Flow Analysis:
Funds flow statement signifies the sources and applications of funds. The term ‘funds’ refers to working capital. Funds flow analysis clearly shows internal and external sources of working capital and the way funds have been used. Funds flow is derived from analysis of changes which have taken place in assets and equities between two balance sheet dates. According to Foulke “a statement of sources and application of funds is a technical device designed to analyze the changes in the financial position of a business concern between two periods”. Funds flow analysis is helpful in judging creditworthiness, financial planning, and budget preparation.
Comparative Financial Statements:
This is yet another technique used in financial statement analysis. These statements summarise and present related data for a number of years, incorporating therein changes (absolute and relative) in individual items of financial statements. These statements normally comprise comparative balance sheets, comparative profit and loss account, and comparative statements of change in total capital as well as in the working capital. These statements help in making inter-period and inter-firm comparisons and also highlight the trends in performance efficiency and financial position.
Common Size Statements:
Common size statements indicate the relationship of various items with some common items, (expressed as a percentage of the common item). In the income statements, the sales figure is taken as the basis and all other figures are expressed as a percentage of sales. Similarly, in the balance sheet, the total assets and liabilities are taken as the base and all other figures are expressed as the percentage of this total. The percentages so calculated are compared with corresponding percentages in other periods or other firms and meaningful conclusions are drawn. Generally, a common size income statement and common size balance sheet are prepared.
Networking Capital Analysis:
Networking capital statement or schedule of changes in working capital is prepared to disclose net changes in working capitals on two specific dates (generally two balance sheet dates). It is prepared from current assets and current liabilities on the specified dates to show net increase or decrease in working capital.
‘Trend’ signifies a tendency and as such the review and appraisal of the tendency in accounting variables are nothing but trend analysis. Trend analysis is carried out by calculating trend ratios (percentage) and /or by plotting the accounting data on graph paper or chart. Trend analysis is significant for forecasting and budgeting. Trend analysis discloses the changes in financial and operating data between specific periods.