The basis of financial analysis, planning and decision making is financial information. A firm prepares final accounts viz. Balance Sheet and Profit and Loss Account providing information for decision making. Financial information is needed to predict, compare and evaluate the firm’s earning ability.
Profit and Loss account shows the concern’s operating activities and the Balance Sheet depicts the balance value of the acquired assets and of liabilities at a particular point of time. However, these statements do not disclose all of the necessary and relevant information.
For the purpose of obtaining the material and relevant information necessary for ascertaining of financial strengths and weaknesses of an enterprise, it is essential to analyse the data depicted in the financial statement.
The financial manager have certain analytical tools that help in financial analysis and planning. In addition to studying the past flow, the financial manager can evaluate future flows by means of funds statement based on forecasts.
Financial Statement Analysis is the process of identifying the financial strength and weakness of a firm from the available accounting data and financial statements.
It is done by properly establishing relationship between the items of balance sheet and profit and loss account as,
- The task of financial analysts is to determine the information relevant to the decision under consideration from total information contained in the financial statement.
- To arrange information in a way to highlight significant relationships.
- Interpretation and drawing of inferences and conclusion. Thus, financial analysis is the process of selection, relation and evaluation of the accounting data/information.
Purposes of Financial Statement Analysis :
- The Government may be interested in knowing the comparative energy consumption of some private and public sector cement companies.
- A nationalised bank may may be keen to know the possible debt coverage out of profit at the time of lending.
- Prospective investors may be desirous to know the actual and forecasted yield data.
- Customers want to know the business viability prior to entering into a long-term contract.
There are other purposes also, in general, the purpose of financial statement analysis aids decision making by users of accounts.
Steps for financial statement analysis :
- Identification of the user’s purpose,
- Identification of data source, which part of the annual report or other information is required to be analysed to suit the purpose,
- Selecting the techniques to be used for such analysis
As such analysis is purposive, it may be restricted to any particular portion of the available financial statement, taking care to ensure objectivity and unbiasedness.It covers study of relationships with a set of financial statements at a point of time and with trends, in them, over time. It covers a study of some comparable firms at a particular time or of a particular firm over a period of time or may cover both.
Types of Financial statement analysis :
The main objective of financial analysis is to determine the financial health of a business enterprise, which may be of the following types :
1) External analysis : It is performed by outside parties, such as trade creditors, investors, suppliers of long term debt, etc.
2) Internal analysis : It is performed by corporate finance and accounting department and is more detailed than external analysis.
3) Horizontal analysis : This analysis compares financial statements viz. profit and loss account and balance sheet of previous year with that of current year.
4) Vertical analysis : Vertical analysis converts each element of the information into a percentage of the total amount of statement so as to establish relationship with other components of the same statement.
5) Trend analysis : Trend analysis compares ratios of different components of financial statements related to different period with that of the base year.
6) Ratio Analysis : It establishes the numerical or quantitative relationship between 2 items/variables of financial statement so that the strengths and weaknesses of a firm as also its historical performance and current financial position may be determined.
7) Funds flow statement : This statement provides a comprehensive idea about the movement of finance in a business unit during a particular period of time.
8) Break-even analysis : This type of analysis refers to the interpretation of financial data that represent operating activities.