Definition: Financial Statement Analysis is an analysis that assesses the financial wellbeing of the firm, its strengths and areas of concern. It determines relations among various items in the statements.
Financial Statement Analysis is used to determine the future course of actions for various decision-making aspects like:
- Financial Position
- Investing Decisions
- Strengths and Weakness
These are used by internal and external parties such as lenders, investors, security analysts, managers, etc.
Content: Financial Statement Analysis
Tools of Financial Statement Analysis
Tools to perform financial statement analysis are listed below:
Comparative Statement Analysis
It is prepared to assess the financial position of the firm or one or more firms over the years. The balance sheet and income statement of the current year are compared with previous years to ascertain the percentage increase or decrease over a period of time.
For Example– Suppose an investor wants to compare the percentage increase or decrease in net profit in the past three years between XYZ ltd and ABC ltd.
Common Size Statement
This type of analysis is done vertically, converting complex data into a concise form. It shows the relationship of individual items in terms of percentage with a common base. It can also be used horizontally while comparing data of different years of the same firm or more than one firms.
The common base is taken Net Sales in case of Income Statement, and Total Assets/Liabilities in case of Balance Sheet. Calculation of percentage can be done by using formulas given below:
Percentage in relation to Common size Income statement=
Percentage in relation to Common size Balance Sheet=
Ratio Analysis is an essential tool for financial statement analysis. It represents a meaningful quantitative relationship between individual or more interdependent components of financial statements in the form of ratios, percentages and rate or time.
These ratios are used for determining financial position, profitability, further evaluation and decision making at the end of the financial year.
It is classified into different heads according to the purpose of the evaluation, which are as follows:
- Profitability Ratios (Gross profit, Net Profit, Operating Profit, etc.)
- Liquidity Ratios (Current Ratio, Quick Ratio, etc.)
- Activity/ Turnover Ratios (Stock, Debtors, Creditors Turnover Ratios, etc.)
It is performed to evaluate the relative change in the behaviour of data in a series of years through Trend Ratio or Index Numbers. It is usually done for comparison in the long run, as well as forecasting and budgeting for the upcoming fiscal year.
Indexing is done by comparing each item with the base year. Generally, the first year is taken as a base in the series of years. It is represented through percentage, ratio and graph showing upward/downward trends of the data.
Trend Ratio/ Index Number =
It depicts the movement of cash and cash equivalents in the firm in an accounting year. The analysis is performed by evaluating net increase or decrease in cash from inflow and outflow by
- Operating Activity
- Financing Activity
- Investing Activity
Fund Flow Statements
Fund Flow Statement is a tool of Financial Statement Analysis that shows how the enterprise has been financed. This statement shows the summary of sources and utilization of funds.
Types of Financial Statement Analysis
Following are the types of financial statement analysis:
It is done by internal management to assess the overall performance and financial soundness of the business. They have access to all the records and detailed information about the company for the analysis. Internal management consists of:
- Top Level Management, etc.
This type of analysis is done by outsiders, generally Investors, Financial Institutions, Statutory bodies, etc. They check the company’s performance for different purposes. They use data published by the company through financial statements in different years.
When we are comparing financial statements or individual items performance in the past years to check their trend and patterns, in the long run, horizontal analysis is used. Tools used to perform this type of analysis are the comparative financial statement, cash flow statement, fund flow statement, trend analysis, etc.
When we analyze different items of the same year, taking a common base, then the vertical analysis is used. It is quantitative in nature and indicates the relationship between different items for forecasting and decision making.
Parties Involved in Financial Statement Analysis
The different parties involved in carrying out financial statement analysis are depicted below:
Guidelines for Financial Statement Analysis
- Choice of tools should be appropriate at the time of selection. Use ratios for better interpretations.
- Always refer to the notes provided at the end of the statements. They show the right information and detailed calculation which, helps to check the truthfulness of the facts provided by the firm.
- Financial Statement Analysis is a complex process; it requires expertise, logic and a correct approach to perform the analysis. It does not have any mechanical substitute.
- Comparison of ratios should always be made with the average of the industry benchmarks and benchmarks of the industry leaders or their own historical ratios.
- Try to choose those ratios which can provide you with maximum information for the analysis.
Importance of Financial Statement Analysis
- Management: For analyzing market trends, preparation of managerial reports, forecasting and decision making.
- Government: For taxation purposes.
- Investors: For investment and comparison with other institutions.
- Creditors: For short term and long term solvency.
- Financial institutions: For checking the creditworthiness of the firm.
- Employees: To know about the profitability and growth of the firm.
Limitations of Financial Statement Analysis:
- The difference in Accounting policies, methods, standards between both local and global firms.
- Continuous change in Technology, Trends, Techniques and Tools of evaluation due to dynamic environment.
- Manipulation by the analyst or firm through unethical practices and misleading representation of facts.
- Less reliability and truthfulness due to wrong interpretation or personal bias of the analyst.
- Selection of the wrong tool of analysis while comparisons are being made.
- Difficulty in the analysis of the firms with the large or diversified product range.
- The analysis is done on a quantitative basis; non-monetary aspects are completely ignored.
- Many firms do not consider changes in price levels resulting in the wrong interpretation at the time of analysis.
- The analysis is done only on the basis of historical data, many other factors necessary for forecasting may not be taken into consideration.
Internal and external beneficiaries carry out financial statement analysis for multiple purposes using different tools like comparative statements, common-size statements, ratio analysis, trend analysis, cash flow statements and fund flow statements using the horizontal and vertical approach.