Financial analysis: Introduction, Meaning, Definition, Objectives Nature and Scope, Advantages and Limitation

The term ‘financial analysis’, also known as analysis and interpretation of financial statements’, refers to the process of determining financial strengths and weaknesses of the firm by establishing strategic relationship between the items of the balance sheet, profit and loss account and other operative data.

“Analyzing financial statements,” according to Metcalf and Titard, “is a process of evaluating the relationship between component parts of a financial statement to obtain a better understanding of a firm’s position and performance.”

The term ‘financial statement analysis’ includes both ‘analysis’, and ‘interpretation’. A distinction should, therefore, be made between the two terms. While the term ‘analysis’ is used to mean the simplification of financial data by methodical classification of the data given in the financial statements, ‘interpretation’ means, ‘explaining the meaning and significance of the data so simplified.’

Objectives

• 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.
• 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.
• 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, and maturity date etc.

Nature:

(i) To assess the earning capacity or profitability of the firm.

(ii) To assess the operational efficiency and managerial effectiveness.

(iii) To assess the short term as well as long term solvency position of the firm.

(iv) To identify the reasons for change in profitability and financial position of the firm.

(v) To make inter-firm comparison.

(vi) To make forecasts about future prospects of the firm.

(vii) To assess the progress of the firm over a period of time.

(viii) To help in decision making and control.

(ix) To guide or determine the dividend action.

(x) To provide important information for granting credit.

Scope

• Analyze financial ratios to assess profitability, solvency, working capital management, liquidity, and operating effectiveness.
• Compare current performance with historical conditions using trend analysis.
• Compare with peer companies or industry averages to find out how well companies are performing.

Advantages

The Ability to Detect Patterns

Financial statements reveal how much a company earns per year in sales. The sales may fluctuate, but financial planners should be able to identify a pattern over years of sales figures. For example, the company may have a pattern of increased sales when a new product is released. The sales may drop after a year or so of being on the market. This is beneficial, as it shows potential and sales patterns so executives know to expect a drop in sales.

A Chance to Budget Outline

Another advantage of using financial statements for future planning and decision making is that they show the company’s budgets. The budgets reveal how much wiggle room the company has to spend on launching products, developing marketing campaigns or expanding the current office size. Knowing how much money is available for planning and decision making ensures that the company does not spend more than expected.

Limitation

Financial analysis is a powerful mechanism of determining financial strengths and weaknesses of a firm. But, the analysis is based on the information available in the financial statements. Thus, the financial analysis suffers from serious inherent limitations of financial statements.

The financial analyst has also to be careful about the impact of price level changes, window-dressing of financial statements, changes in accounting policies of a firm, accounting concepts and conventions, and personal judgment, etc.

Some of the important limitations of financial analysis are, however, summed up as below:

(i) It is only a study of interim reports

(ii) Financial analysis is based upon only monetary information and non-monetary factors are ignored.

(iii) It does not consider changes in price levels.

(iv) As the financial statements are prepared on the basis of a going concern, it does not give exact position. Thus accounting concepts and conventions cause a serious limitation to financial analysis.

(v) Changes in accounting procedure by a firm may often make financial analysis misleading.

(vi) Analysis is only a means and not an end in itself. The analyst has to make interpretation and draw his own conclusions. Different people may interpret the same analysis in different ways.

Stages of financial statement analysis

Determine the purpose of the analysis. You need to determine what questions you want to answer through the study. The objective identifies the approach, tools, data sources, and format that you use to present the results.

• Collecting data. You then gather the necessary information. For example, to analyze a company’s historical performance, you might only need to use financial statements. When you want to examine more comprehensively, for example, valuing the company’s stock price, you need data such as economic and industry reports.
• Processing data. You need to convert financial data into useful statistics such as financial ratios or growth percentages. The more in-depth analysis may require not only descriptive statistics but also inferential statistics such as regression.
• Interpret statistics. To conclude, you might not only analyze historically but also compare with peer companies or industry averages.