Meaning
- Financial Statement Analysis is the process of reviewing and analyzing a company’s Financial Statements to make better economic decisions to earn income in future.
- These statements include the income statement, balance sheet, statement of cash flows, notes to accounts and a statement of changes in equity(if applicable).
- Financial statement analysis is a method or process involving specific techniques for evaluating risks, performance, valuation, financial health, and future prospects of an organization.
Financial Statement Analysis Process
Objectives of Financial Statement Analysis
The primary objective of financial statement analysis is to understand and diagnose the information contained in financial statement with a view to judge the profitability and financial soundness of the firm, and to make forecast about future prospects of the firm. The purpose of analysis depends upon the person interested in such analysis and his object.
- Reviewing the performance of a company over the past periods: To predict the future prospects of the company, past performance is analyzed. Past performance is analyzed by reviewing the trend of past sales, profitability, cash flows, return on investment, debt-equity structure and operating expenses, etc.
- Assessing the current position & operational efficiency: Examining the current profitability & operational efficiency of the enterprise so that the financial health of the company can be determined. For long-term decision making, assets & liabilities of the company are reviewed. Analysis helps in finding out the earning capacity & operating performance of the company.
- Predicting growth & profitability prospects: The top management is concerned with future prospects of the company. Financial analysis helps them in reviewing the investment alternatives for judging the earning potential of the enterprise. With the help of financial statement analysis, assessment and prediction of the bankruptcy and probability of business failure can be done.
- Loan Decision by Financial Institutions and Banks: Financial analysis helps the financial institutions, loan agencies & banks to decide whether a loan can be given to the company or not. It helps them in determining the credit risk, deciding the terms and conditions of a loan if sanctioned, interest rate, maturity date etc.
Need and Importance of Financial Statement Analysis
There are various needs and importance of financial statement analysis for different users like investors, creditors, management, government, and so on, mentioned as below:
- Helps in planning and decision making.
- Helps in evaluation of performance .
- Basis for tax calculations.
- Basis of controlling.
- Helps the Government to formulate policies.
- Helps to the banker for credit decision.
Types of Financial Statement Analysis
1. Horizontal analysis
It is one the techniques used in financial statement analysis. This type involves comparing financial data across multiple periods to identify trends and changes in essential line items. As you delve into horizontal analysis, you can cover shifts in revenue, expenses, and other financial metrics over time.
2. Vertical analysis
The analysis focuses on expressing each line item on financial statements as a percentage of a base item. This approach provides insights into the relative proportion of different components within the same period, aiding in pinpointing areas of significance.
Common size balance of A company:
3. Ratio analysis
This analysis entails calculating various financial ratios by comparing specific items on financial statements. Ratios like liquidity, leverage, profitability, and debt-to-equity ratios, offer in-depth insights into a company’s financial performance.
5. Trend analysis
This kind of analysis examines the trajectory of financial data over multiple periods, helping you identify patterns and potential changes. This type of analysis assists in predicting future financial performance based on historical data.
