Financial analysis is a systematic process of evaluating the financial information provided by the financial statements to understand and make judgments about the operations of the firm. It can be further explained as:
- A study of the relationships among the financial facts and figures provided by the financial statements.
- The goal is to get an understanding of the firm’s profitability and operational efficiency in order to analyse its financial health and future prospects.
The concept of “Financial Analysis” involves both ‘Analysis’, i.e., simplification of financial data and ‘Interpretation’, i.e., explanation of meaning and relevance of facts. These two concepts are complementary to each other that is, analysis is useless without interpretation, and interpretation without analysis becomes difficult or sometimes even impossible.
In the words of John N. Myres, “Financial statement analysis is largely a study of relationships among the various financial factors in a business, as disclosed by a single set of statements and a study of the trends of these factors as shown in a series of statements”.
Objectives or Purpose of Financial Analysis
The financial analysis serves the following purposes and is required in the enterprise for the following reasons:
1. Assesses the Earning Capacity:
The primary objective of any enterprise is to earn a reasonable return on the capital employed. The goal of financial analysis is to find out if the enterprise is earning adequate profits or not. Profitability Ratios (like Gross Profit Ratio, Operating Profit Ratio, etc.) are used to evaluate the earning capacity of an enterprise.
2. Assesses the Solvency:
Financial analysis attempts to determine the business’s short-term and long-term solvency. Creditors are keen to determine the liquidity position of the term, i.e., the short-term solvency of the business, whereas long-term lenders (such as debenture-holders) are keen to know the long-term solvency of the business. Ratio analysis is helpful in determining the complete solvency of the business.
3. Forecasts and Prepares Budget:
Analysis of previous financial accounts is helpful in forecasting future events. It allows the business to make predictions and develop budgets depending on the previous performance review.
4. Provides Useful and Valuable Information:
Financial analysis attempts to provide useful and valuable information to a wide range of interested stakeholders, including owners, investors, creditors, employees, banks, financial institutions, government departments, and so on.
5. Measures Financial Strength:
Financial analysis is used to determine the financial position and future of the enterprise.
6. Inter-firm and Intra-firm Comparison:
Financial analysis attempts to make inter-firm and intra-firm comparisons. This type of comparison is helpful in identifying problems and implementing corrective steps in time.
7. Measures Management’s Efficiency:
Financial analysis attempts to assess the operational efficiency of the management. Such analysis is helpful in determining whether the financial policies decided by the management are appropriate or not.
Methods of Financial Analysis:
Following are the various methods of financial statement analysis:
1. Internal Analysis:
Internal Analysis is the analysis performed on the basis of the company’s accounting records and other relevant information.
- It is carried out by management in order to analyse the enterprise’s financial performance and situation.
- Internal analysis is deeper and more credible because management has access to all information and facts of the enterprise.
2. External Analysis:
External Analysis refers to analysis performed using published statements, reports, and information.
- External Analysis is carried out by individuals who do not have access to the enterprise’s complete records.
- External parties, which include creditors, investors, banks, financial experts, and so on, usually conduct the external analysis.
- External analysis is considered less accurate than internal analysis because of limited and inadequate information.
3. Horizontal Analysis (or Dynamic Analysis):
Horizontal Analysis refers to the analysis and review of financial statements across a period of time. This analysis is often performed using Comparative Financial Statements.
- In this analysis, the amount of two or more years is placed side by side along with absolute change and percentage change in amounts in order to perform a comparison.
- It is excellent for long-term trend analysis and planning.
- Horizontal Analysis is also referred ‘Dynamic Analysis’ because it is based on data from two or more years rather than just one.
- Horizontal Analysis is useful for time-series analysis.
4. Vertical Analysis (or Static Analysis):
Vertical Analysis refers to the analysis and review of financial statements for a single fiscal year. Ratio Analysis is an example of vertical analysis.
- Vertical analysis is beneficial for inter-firm comparison, i.e., comparing the performance of multiple enterprises at the same time or different departments of an enterprise.
- Vertical Analysis is also known as ‘Static Analysis’ because it is based on data only from a single year.
- Vertical Analysis is useful for cross-sectional analysis.
5. Intra-firm Analysis:
Intra-firm Comparison refers to a comparison of an enterprise’s financial variables over two or more accounting periods. It is also referred to as Time Series Analysis or Trend Analysis.
6. Inter-firm Analysis:
Inter-firm comparison refers to a comparison of financial data from two or more enterprises over the same accounting period. It is also referred to as cross-sectional analysis.
Process of Financial Analysis
The process of Financial Analysis are:
1. Determine the Objective of Analysis:
Before analysing the financial statement of an enterprise, the reason to do it should be clear. The nature and quantum of analysis are affected by its objective.
2. Reformulating Reported Financial Statements:
Reformulating reported financial statements is the process of restating financial statements so that they better serve the goal of analysis and allow for a more efficient and accurate interpretation of the company’s performance.
3. Adjustments of Measurement Errors:
Adjustments of measurement errors are performed to reduce errors in data in order to improve the quality of the financial statements. For example, shifting R&D expenses from the income statement and putting them on the balance sheet.
4. Comparison:
After adjustment, figures are compared to derive the proper results. Comparisons between different parameters and figures from different years help a firm to know about various prevailing trends. These trends are then further studied.
5. Draw Conclusion:
Various data are then explained and conclusions are drawn out of it regarding financial soundness, liquidity, loan, repaying capacity, and earning capacity of an enterprise.
7. Reporting:
After interpretation, conclusions are reported to the management, and with the help of all the information, decisions are taken by the management in the required field.