Types of Financial Statement Analysis; The financial statement of a business enterprise is intending 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. The government interests in 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.
Cost Accounting explains 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 to judge the profitability and financial soundness of the firm and to make the forecast about the prospects of the firm. The purpose of analysis depends upon the person interested in such an analysis and his object.
However, the following purposes or objectives of financial statements analysis may state 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.
- 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.
- Make the inter-firm comparison.
- Make forecasts about the prospects of the firm.
- To assess the progress of the firm over some time.
- Help in decision making and control.
- Guide or determine the dividend action, and.
- 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 a profit and loss account.
- Measure the managerial efficiency of the firm.
- Measure the short-term and long-term solvency of the business.
- Ascertain earning capacity in the future period.
- Determine the future potential of the concern.
- Measure the utilization of various assets during the period, and.
- 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 use 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 about 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 using 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 always concerned with the future. Financial statements that contain information on past performances are analyzing and interpret 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 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 that 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 by 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 uses by financial institutions, loaning agencies, banks, and others to make a 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 using 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 widespread use of these techniques are the following:
- Horizontal Analysis.
- Vertical Analysis.
- Trend Analysis.
- Ratio Analysis.
- Cash flow analysis.
- Funds flow analysis.
- Comparative financial statements.
- Common measurement or size statements, and.
- Net Working capital analysis.
Now, explain each;
The percentage analysis of increases and decreases in corresponding items in comparative financial statements calls 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 compares with the corresponding item on one earlier statement. The increase or decrease in the amount of the item is then listed, together with the percent of increase or decrease. When the comparison makes between two statements, the earlier statement uses 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 use as the basis for comparing all later dates or periods or second, each statement may compare with the immediately preceding statement.
The percent change computes as follows:
Percentage change = Amount of change/Previous year amount x 100.
The 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 use 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 finish observing percentage changes over time in selected data. In trend analysis, percentage changes are calculating 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 like 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 detecting or the sign of good management is found. Trend analysis uses an index number over some time. For index number, one year, the base year is equal to 100 percent. Other years are measuring that amount. For example, an analyst may interest in sales and earnings trends for the past five years.
For this purpose, the 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 determine more precisely by calculating trend percentages. To do this, a base year selects 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 compute 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 other companies. The primary purpose of ratios is to point out areas for further investigation. They should use 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 covers.
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 smoothes 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.
Cash flow Analysis:
Cash flow analysis depicts the inflows and outflows of cash. The cash flow statement is the device for such an analysis. It highlights causes that 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 using. Funds flow derives from analysis of changes that 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 design to analyze the changes in the financial position of a business concern between two periods.”
Funds flow analysis helps judge creditworthiness, financial planning, and budget preparation.
Comparative Financial Statements:
This is yet another technique used in financial statement analysis. This is statements summarize and present related data for several years. Incorporating therein changes (absolute and relative) in individual items of financial statements.
The 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. Also, 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 takes as the basis and all other figures are expressing as a percentage of sales.
Similarly, in the balance sheet, the total assets and liabilities are taking. As the base and all other figures are expressing as the percentage of this total. The percentages so calculate are comparing 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 preparing.
Networking Capital Analysis:
Networking capital statement or schedule of changes in working capital prepares to disclose net changes in working capital on two specific dates (generally two balance sheet dates). It is preparing from current assets and current liabilities on the specified dates to show a net increase or decrease in working capital.
Types of Financial Statement Analysis:
The process of financial statement analysis is of different types. The process of analysis is classifying based on information use and “Modus Operandi” of analysis.
The classification is as under – (1) based on Information:
This analysis is base on published the financial statements of a firm. Outsiders have limited access to internal records of the concern. Therefore, they depend on publishing financial statements. Thus, the analysis done by outsiders namely, creditors, suppliers, investors, and government agencies knows as external analysis. This analysis serves a very limited purpose.
This analysis is done based on 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) Based on “Modus Operandi” of Analysis:
This analysis is also known as ‘dynamic’ or ‘trend’ analysis. The analysis is done by analyzing the statements for several 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 to increase or decrease over some time. If the comparative statements are preparing for more than two periods, then one of the years takes 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.
The analysis also knows as ‘static analysis’ or ‘structural analysis’. This analysis makes based on a single set of financial statements preparing on a particular date. Under vertical analysis, the quantitative relationship is establishing between different items shown in particular statements. Common-size statements are a form of vertical analysis. Different items shown in the statement are expressing as a percentage to any one item as the base. The use of both methods of analysis is very much requiring for proper analysis. Each method provides a specific type of information and in fact, both methods constitute the backbone of financial analysis.