What is Meaning of Analysis of Financial Statement? Its objectives and importance
What is meaning of Analysis of Financial Statement?
Table of Contents
Meaning of Analysis of Financial Statement
Financial Statement. Analysis is the process of critically examining the accounting information given in the financial statements. For the purpose of analysis, individual items are studied, their in to relationship with other related figures is established, the data is sometimes rearranged to his better understanding of the information with the help of different techniques or tools for the purpose. Analysing financial statements is a process of evaluating relationship between component parts of financial statements to obtain a better understanding of firm’s position and performance. The analysis serves the interests of shareholders, debenture holders, potential investors, creditors, bankers, legislators, journalists, politicians, researchers, stock exchange taxation authorities and economists. The analysis of financial statements makes it simile intelligible and meaningful for all concerned parties. Financial statements are split into simple statements by the process of rearranging, regrouping and the calculation of various ratios. The analysis simplifies, summarises and systematised monotonous figures.
Financial Analysis in this way is the purposeful and systematic presentation of financial statements. Various items of income and position statements are compared and their inter relationship is the established.
Financial analysis, as such, presents meaningful expression of relationship between different items, such as, relationship between gross profit and net sale. Suppose the Gross Profit of the firm is Rs. 18,000 and Net Sales are worth Rs.90,000. At the same time the gross profit of the next firm is Rs. 30,000 and net sales worth Rs. 1.20.000. If we analays the figures, we come to know that the gross profit margin of the firm first is 20%, i.e. 18,000 × 100 / 90,000 and the second firm is 25%, i.e., 30,000/1,20,000 x100. As such, analysis shows the operational efficiency of the second firm is better than the first firm.
According to Myers, “Financial statements analysis is largely a study of relationship among the various financial factors in a business as disclosed by a single set of statements and a stood of the trend of these factors as shown in a series of statements.
The analysis of financial statements thus, refers to the treatment of the information contained in the financial statements in a way so as to afford a full diagnosis of the profitability and financial position of the firm concerned. For this purpose financial statements are classified methodically, analysed and compared with the figures of previous years of other similar firm.
Objectives of Financial Analysis
Financial analysis is helpful in assessing the financial position and profitability of a concern. This is done through comparison by ratios for the same concern over a period of years. Accounting ratios calculated for a number of years show the trend of the change of position i.c., whether the trend is upward or downward or static. The ascertainment of trend helps us in making estimates for the future. For example, ratios of gross profit to sales for the last five years indicate a rising trend, we can safely estimate that ratio of gross profit to sales for the next year will also rise keeping in view the importance of accounting ratios the accountant should calculate the ratios in appropriate form, as early as possible for presentation to the management for managerial decisions.
The main objectives of analysis of financial statements are as follows:
(i) To assess the present and future earning capacity or profitability of the concern.
(ii) To assess the operational efficiency of the concern as a whole and of its various parts or departments.
(iii) To assess the short-term and long-term solvency of the concern for the benefit of the debenture holders and trade creditors.
(iv) To assess the comparative study in regard to one firm with another firm or one department with another department.
(v) To assess the possibility of developments in the future by making forecasts and preparing budgets.
(vi) To assess the financial stability of a business concern.
(vii) To assess the real meaning and significance of financial data, and
(viii) To assess the long-term liquidity of its funds.
Importance of Financial Analysis
Financial statements are prepared at a certain point of time according to established conventions. These statements are prepared to suit the requirements of the proprietor. It is therefore, necessary to analyse financial statements to measure the efficiency, profitability, financial soundness and future prospects of the business concern. Financial analysis serves the following purpose:
1. In Judging the Operational Efficiency of the Business: It is very significant that the company must know the operational efficiency of its management. We analyse the financial statements, match the amount of manufacturing, selling, distribution and financial expenses of the current year with the corresponding expenses of the previous year and assess the managerial efficiency of the business. We can judge the operational efficiency of the business by calculating profitability ratios.
2. In Measuring Short and Long-term Financial Position: The business must know is financial soundness. It should satisfy itself that its current resources are sufficient to meet as current liabilities. We can calculate current and liquid ratios or compare current assets and current liabilities to ascertain short-term financial soundness. Long-term financial position can be measured by calculating debt-equity, proprietory and fixed assets ratios. The results of the financial analysis may be studied and corrective steps can be taken, if necessary.
3. Indicating the Trend of Achievements: Financial statements of the previous years can be compared and the trend regarding various expenses, purchases, sales, gross profit and net profit can be ascertained, cost of goods sold, values of assets and liabilities can be compared and the future prospects of the business can be indicated.
4. In Assessing Growth Potential of the Business: The trend and dynamic analysis of the business provides us sufficient information indicating the growth potential of the business of the trend predicts gloomy picture, effective measures can be applied as corrective measures cost of production is rising without corresponding increase in sales price, efforts should be made to reduce cost of production.
5. In Measuring the Profitability: Financial statements show the gross profit, net profit and other expenses. The relationship of these items can be established with sales, gross profit, net profit, expenses and operating ratios may be calculated and the profitability of the business ascertained. In case of improving profitability ratios, the causes responsible for this performance should be reinforced.
6. Intra-firm and Inter firm Comparison of the Performance: Analysis of financial statements can be made with the previous year’s performance of the same firm and also with the performance of other firms. Intra-firm analysis provides an opportunity of self appraisal where as inter firm analysis presents the operational efficiency of the firm as compared to other firms. Comparison helps us in detecting our weaknesses and applying corrective treasures.
7. Forecasting, Budgeting and Deciding Future Line of Action: Analysis of financial statements predicts the growth potential of the business. Comparison of actual performances shows our shortcomings. The analysis provides sufficient information regarding the profitability, performance and financial soundness of the business. On the basis of these information, we can make effective forecasting, budgeting and planning.
8. Simplified, Systematic and Intelligible Presentation of Facts: Analysis of financial statements is an effective tool for simplifying, systematising and summarising the monotonous figures. An average person can draw conclusion from these ratios. The facts can be made more attractive by graphs and diagrams which can be easily understood.
9. Judging the Solvency of the Concern: Creditors are always interested in knowing the solvency of the business to repay their loans. We will have to look into the following facts to ascertain liquidity:
(i) Whether current assets are sufficient to meet current liabilities.
(ii) Proportion of liquid assets and current assets.
(iii) Future prospects of the business.
(iv) Whether debentures and other loans are secured or not.
(v) Managerial efficiency of the company.
It is clear from the above discussion that there are various objectives of financial analysis and it is used by the various parties for different purposes.
IMPORTANT LINK
- What is Meaning of Analysis of Financial Statement? Its objectives and importance
- IMPORTANCE AND LIMITATIONS OF FINANCIAL STATEMENTS
- Meaning and Definitions of Financial Statement | Nature of Financial Statements | Characteristics of an Ideal Financial Statement
- What is the scope of management accounting?
- Procedure of Financial Statements Analysis
- Comparative Financial statement Analysis | Advantages of Comparative Financial Statements | Limitations of Comparative Financial Statements
- IMPORTANCE AND LIMITATIONS OF TREND ANALYSIS IN HINDI
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