Methods of Financial Statement Analysis
Financial statement analysis can be performed by employing a number of methods or techniques. The following are the important methods or techniques of financial statement analysis:
- Ratio analysis:It is the analysis of the interrelationship between two financial figures.
- Cash flow analysis:It is the analysis of the change in the cash position during a period.
- Comparative financial statement:It is the analysis of financial statement ratios of the company over the years.
- Trend analysis: It is the analysis of the trend of the financial ratios of the company over the years.
The methods to be selected for the analysis depend on upon the circumstances and the users need. The user or the analyst should use the appropriate method to derive required information to fulfill their needs.
Importance of Financial Statement Analysis
The financial statement analysis is important for different reasons and the importance are listed below :
- Holding of share
Shareholders are the owners of the company. Time and again, they may have to take decisions whether they have to continue with the holdings of the company’s shares or sell them out. The financial statement analysis is important as it provides meaningful information to the shareholders in taking such decision.
- Decision and plans Themanagement of the company is responsible for taking decisions and formulating plans and policies for the future. They, therefore, always need to evaluate its performance and the effectiveness of their actions to realize the company’s goal in the past. For that purpose, financial statement analysis is important to the company’s management.
- Investment decisions
The prospective investors are those who have surplus capital to invest in some profitable opportunities. Therefore, they often have to decide whether to invest their capital in the company’s shares. The financial statement analysis is important to them because they can obtain useful information for their investment decision-making purpose.
- Extension of credit
The creditors are the providers of loan capital to the company. Therefore, they may have to take a decision as to whether they have to extend their loans to the company and demand for higher interest rates. The financial statement analysis provides important information to them for their purpose.
- Higher benefits
The employee of the company sometimes may have to decide whether they have to demand for higher benefits such as wages and salaries from management. The financial statement analysis is significant to them because it provides them with meaningful information to raise their voice for their cause.
- Short-term loans:
The bank provides short-term loans to the company for meeting its working capital needs. Therefore, they may have to decide whether to extend or increase short-term loans to the company. In such a situation, they may have to resort to financial statement analysis as it provides them relevant information to reach a decision.
- Anticipating future price
The stock analysts are those who anticipate the future market price per share of the company’s stock by looking into its profitability, solvency, performance, stability and future prospect. Therefore, analysis of the company’s financial statement is important to them to forecast the trends of its stock market price.
- Compliance with law
The financial statement analysis is significant to the government, as it has to ensure whether the company’s financial statement comply with the prevailing rule and laws. The analysis may also be used to access corporate taxes.
Note: Financial statement analysis is important to the management for formulating future plans. So, investors use financial statement analysis for making investment decisions, the creditor for credit extending decision, and government for assessing the corporate tax.
Limitations of Financial Statement Analysis
Although, analysis of financial statements is essential to obtain relevant information for making several decisions and formulating corporate plans and policies, it should be carefully performed as it suffers from a number of the following limitations:
- Mislead the user
The accuracy of financial information largely depends on how accurately financial statements are prepared. If their preparation is wrong, the information obtained from their analysis will also be wrong which may mislead the user in making their decisions.
- Not useful for planning
Since, financial statements are prepared by using historical financial data, therefore, the information derived from such statements, may not be effective in corporate planning if the previous situation does not prevail.
- Qualitative aspects
The financial statement analysis provides only quantitative information about the company’s financial affairs. However, it fails to provide qualitative information such as management labor relation, customer’s satisfaction, management’s skill and so on which are also equally important for decisions making.
- Comparison not possible
The financial statements are based on historical data. Therefore, comparative analysis of financial statements of different years cannot be done as inflation distort the view presented by the statements of different years.
- Wrong judgment
The skills used in the analysis without adequate knowledge of the subject matter may lead to navigate direction. Similarly, biased attitude of the analyst may also lead to wrong judgment and conclusion.
Parties Interested in financial Statement Analysis
The analysis of financial figures contained in the company’s profit and loss account and balance sheet by employing appropriate techniques is known as financial statement analysis. Financial statement analysis is used to different parties to obtain the required information about the organization. Following are the parties interested in financial statement analysis:
Shareholders are interested in financial statement analysis to know the profitability of the organization. Profitability shows the growth potential of an organization and safety of investment of shareholders.
- Investors and lenders:
Investors and lenders are interested to know the solvency position of an organization. They make analysis about the financial statement position to know about the safety of their investment and ability to pay interest and repayment of principal amount on due date.
Creditors are interested in analyzing the financial statement in order to know the short term liquidity position of an organization. Creditors analyze the financial statement to know either the organization is enabled to pay the amount of short-term liabilities on a due date.
Management is interested in analyzing the financial statement for measuring the effectiveness of its policies and decisions. It analyzes the financial statement to know short term and long term solvency position, profitability, liquidity position and return on investment from the business.
Government is interested in analyzing the financial position in determining the amount of tax liability. It also helps for formulating effective plans and policies for economic growth.
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