Financial statement analysis is the study of relationships between the elements of the same statement or different financial statements and the trend of these elements. The purpose of financial statement analysis is to determine the meaning and significance of the data contained in the statements so that a forecast may be made of the prospects for future earnings, expected dividends and the ability of the business to pay interest and debt as it matures. Financial statement analysis involves rearrangement of financial information, comparison, analysis and interpretation of that information.
Financial statement analysis can be external or internal; horizontal or vertical; and intra-firm or inter-firm.
Analysis done by the management to assess the financial health of the organization and its operational efficiency is called internal analysis. Analysis carried out by parties external to the organization such as investors, credit rating agencies, government agencies etc. is called external analysis. Horizontal analysis compares financial data over a number of years to analyze the trend. Vertical analysis is based on the financial data of a particular year. Inter-firm analysis compares financial variables of two or more firms to get an idea of their relative competitive position. Intra-firm analysis compares the performance of different units of the same firm.
Techniques of Financial Analysis:
The following techniques can be used for analyzing the financial statements:
(i) Comparative Financial Statements:
Figures of two or more periods are placed side by side. Comparison of absolute as well as percentage change in the figures over the periods is made to derive meaningful conclusions.
(ii) Common–size Financial Statements:
All figures of a financial statement are expressed as a percentage of a common base which is taken as 100. This common base is the sales figure in case of Profit and Loss Account and the total of assets or of liabilities in case of Balance Sheet.
(iii) Trend Percentages:
These are useful for making a comparative study of the financial statements over a number of years. The earliest year used for comparison is treated as the base year. The base year figure for each item of the financial statements is taken as 100. The figures for the subsequent years are expressed as percentages of the base year figure.
(iv) Funds Flow Statement:
This statement shows the sources of working capital, uses of working capital and the change in the working capital position of an enterprise during the course of a year. For this purpose the Financial statements at the beginning and at the end of a year are used.
(v) Cash Flow Statement:
Cash Flow statement shows the sources of cash , the uses of cash and the change in cash position from one period to another.
(vi) Ratio Analysis:
Ratio analysis makes use of financial ratios for financial analysis. Financial ratios are relationships between two financial variables appearing in financial statements.
According to J. Batty, “ The term accounting ratios is used to describe significant relationships which exist between figures shown on a balance sheet, in a profit and loss account, in a budgetary control system or in any other part of the accounting organization.” A ratio is thus a numerical relationship between two variables which are connected with each other in one way or the other. A ratio may be expressed as a number, a fraction, a percentage or a proportion.
Ratio Analysis is a technique of establishing meaningful relationships between significant variables of financial statements and interpreting the relationships to form judgement regarding the financial affairs of the unit. Ratio analysis is usually employed to assess the profitability, efficiency and financial condition of an enterprise. Depending uponthe purpose they serve, the ratios may be classified into the...