What is Financial statement analysis?Importance of financial statement analysis & Meaning of financial statement analysis

Financial statement analysis

What is Financial statement analysis?

Introduction

The main objective of a company is to earn profit. If performs a number a number of activities and transaction to achieve its objective. The transaction are recorded systematically and scientifically to assess the result of business operation and financial condition. A business organization prepares profit and loss account and balance sheet to know the profit or loss and financial

position respectively. Profit and loss account is prepared to ascertain profit or loss and balance sheet to reveal the financial position. Similarly, it also prepares cash flow statement to know the position of cash. These statements are collectively called financial statements. They are further analyzed in terms of profitability, liquidity, solvency, operational efficiency and growth potentiality.
Financial statement
Financial statements are the summary reports of a company's financial transactions. They report the end result of accounting activities during a given period of time. They provide the income/profit or loss and financial position of a company. Financial statements are end of the period accounts prepared to show profit or loss situation for a period to time and to assess the financial position and cash flow situation on a particulars date. Financial statements report the results of post activities. Therefore, they are also called as the historical records of a company. Financial statement includes:

1.    Income statement: the income statement, sometimes called as the trading and profit and loss account or an earnings statement, reports the profitability of a business organization for a stated period of time. In accounting, we measure profitability for a period, such as a month or year by comparing the revenues with the expenses incurred to produce these revenues.
2.    Statement of retained earnings: the statement of retained earnings is also called as profit and loss appropriation account. One purpose of this statement is to connect the income retained earning between two balance sheets. The statement of retained earnings explains the changes in retained earnings between two balance sheet dates. These changes usually consist of the addition of net income and the deduction of dividends.
3.    Balance sheet: the balance sheet, sometimes called the statement of financial position, lists the company's assets, liabilities and stockholders' equity as on a particular date. A balance sheet is like a snap shot that captures the financial position of a company of a company at a particular point in time.
4.    Statement of cash flow: management is interested in the cash flows to the company and the cash outflows from the company, because they determine the company's liquidity-its ability to pay its bills when due. The statement of cash flows the cash inflows and outflows from operating, investing and financing activities.
Features of financial statements
The following are the features of financial statements.
i.    They are always expresses in monetary terms. They ignore the qualitative aspects. In other words, the non-monetary events do not come under the scope of financial statements.
ii.    They are always prepared for a certain period of time. They generally cover the period of one year.
iii.    They are historical in nature since they always present the past performance. Hence, they do not carry the futuristic approach.
Objectives of financial statements
Financial statements of a company are the result of management's past actions and decision. They are the end products of the accounting process. They give a picture of solvency and profitability of a company. The major objectives of the financial statements can be listed as follows.
i.    To provide the financial information to the internal and external users.
ii.    To provide the information, which are useful in the decision making process.
iii.    To reveal the profitability and solvency of the company.
iv.    To facilitate the intra company and inter comparison of the financial performance.
v.    To show the financial health of the company.
vi.    To help to evaluate the financial position and efficiency of the management.
Importance of financial statement
Financial statements are the importance sources of information to all the users of accounting information like; management, owners, debtors, creditors, employees, government agencies, financial analysis, etc. the following are the points which heighght the importance of financial statement;
i.    Financial statements are the summary of information relating to profitability, and resources owned by the firm.
ii.    Financial statements provide the information which can be compared with those of other firms.
iii.    Employs can use them to demand for increment in salary and other benefits.
iv.    Bankers and other financial institutions can use them to make the lending decisions.
v.    Government bases on financial statements of the companies for the calculation of tax revenue from the firms.
vi.    Financial statements can be used as the basis for management decision-making purpose like planning, promotion, research and development decision, etc.
vii.    Existing investors can use them to assess how efficiently the firm is using their funds.
viii.    Potential investors can obtain information which can be useful to take the investment decisions.
ix.    Financial statements reveal the history of the firm.
x.    They can be used to assets the firm's liquidity and solvency position.
Limitations of financial statements
The financial statements suffer from the following limitations;
i.    They include the quantitative information which is expressed in monetary units. They do not provide any qualitative information which may have greater impact upon the decision makers.
ii.    They record and reveal only the historical date in nature. They do not include any future possible result.
iii.    Financial statements are strictly confined within the boundary of some accounting principles. They are uses as the guidelines in recording and reporting the financial transactions.
iv.    Financial statements are just the summary reports of the company’s financial transactions. All the detailed information regarding to such transaction cannot be disclosed in the financial stalemates.
v.    Financial statements show the information on cost basis i.e. the price paid on the transaction's date. The effect of price level changes (inflation) is not shown in the financial statements. In another words, the information are not given in the currents value.
Financial statement analysis
Meaning of financial statement analysis
Financial statement analysis is an analysis that highlights the important relationships in the financial statements. It focuses on evaluation of past performance of the business firms in terms of profitability, liquidity, solvency, operational efficiency and growth potentiality. Financial statement analysis includes the methods used in assessing and interpreting the result of past performance and current financial position as they relate to particular factors of interest in investment decisions. Thus, it is an important means of assessing past perfereamnce and in forecasting and planning future performance.
1.    Assessment of past performance: past performance is often a good indicator of future performance. Therefore, an investor or creditor is interested in the trend of past sales, cost of goods sold, operating expenses, net income, cash flows and return on investment. These trends offer a means for judging management's past performance and are possible indicator of future performance.
2.    Assessment of current position: the analysis of current position indicates where the business stands today. Financial statement analysis shows the current position of the firm in terms of the types of assets owned by a business firm and the different liabilities due against the enterprises.
3.    Prediction of profitability and growth prospects: the financial statement analysis help in assessing and predicting the earning prospects and growth rates  in earnings which are  used by investors while comparing investment alternatives and other users in judging the earnings potential of business entries. Investors also consider the risk or uncertainty associate with the expected return. The decision makes are futuristic are always concerned with the future. Financial statements which contain the information on past performance are analyzed interpreted and used as the basis for forecasting the future return and risk.
4.    Predication of bankruptcy and failure: financial statement analysis is a significant tool in assessing and predicting the bankruptcy and probability of business failure. Through the analysis of the solvency position, the probability of business failure can be predicated to the greater extent. After such prediction managers and investors both can take some preventive measures to avoid or minimize losses.
5.    Loan decision by banks and financial institutions: financial statement analysis is used by banks, finance companies, lending agencies, and other to make sound loan or credit decision. With the help different borrowers. Because it helps in determining credit risks, deciding terms and condition of loans, interest rates, maturity date, etc.
6.    Assessment of the operational, efficiency: financial statement analysis is the tool that helps to assess the operational efficiency of the management of a company. The actual performance of the firm which are revealed in the financial statements can be compared performance can be used as the indicator of efficiency of the management.
7.     Simplifying the information: basically, the financial statement analysis further interprets the information disclosed in the financial statements. It attempts the tools that make the information readable and understandable even the average types of users. For this purpose, the information is analyzed in rations, trend percentages, graphs, diagrams, etc.
Techniques of financial statement analysis
Various techniques are used in the analysis of financial date to emphasize the comparative and relative importance of date presented and to evaluate the position of the firm. These techniques of analysis are intended to show relationships and change. Among several techniques; the following are some of the most widely used techniques. 

1.    Horizontal analysis: the percentage analysis of increases or decreases in corresponding items in comparative financial statements is called horizontal analysis. It involves the computation of amount charges and percentage chages from the previous to the current year. The amount of each item in the most recent statement is compared with the corresponding item on the earlier statements. The increase or decrease in the amount of the item is the listen together with the percent of increase or decrease. When the comparison is made between two statements, the earlier statement is used as the base.
2.    Vertical analysis: vertical analysis uses percentage to show the relationship of the different part to the total in a signal statement. Vertical analysis sets a total figure in the statement equal to 100 percentages and computes the percentages of each component of that figure. The figure to use as 100 percent will be total assets or total liabilities and equity capital in the case of balance sheet and revenue or sales in the case of the profit and loss account.
3.    Trend analysis: using the previous year's data of a business enterprise, trend analysis can be done to observe percentage changes over time in selected data. In trend analysis, percentage changes are calculated for several successive years instead of between two years. Trend analysis is important because with its long run view, it may point to basis changes in the nature of business. By looking at a trend in a particular ratio, one may find whether that ration is falling, rising or remaining relatively constant.
4.    Ratio analysis: ratio analysis is an important measure of expressing the relationship between two numbers. A ration can be computed from any pair of numbers. To be useful a ration must represent a meaningful relationship. Rations are useful in evaluating the financial position an operation of company and in comparing them to previous years or to other companies.
Importance of financial statement analysis
Financial statement analysis is equally important to the management, shareholders creditors, debtors, potential investors, government agencies, bankers, general public, etc. the importance of financial statement
analysis can be summarized as follows:
i.    Helpful in planning and decision making.
ii.    Helps in the evaluation of performance.
iii.    Helps in the diagnosis of managerial and operating problems.
iv.    Helpful to the bankers for credit decision.
v.    Basis for tax calculations.
vi.    Helps the government to formulate polices.
vii.    Basis of controlling.
Limitations of the financial statement analysis
The following are the limitations of financial statement analysis:
i.    It ignores the qualitative aspects of the business.
ii.    The analysis is not free the business of the analysts.
iii.    Accurate comparison may not be possible if the companies have followed different accosting principles.
iv.    Financial statement analysis only identifies/ diagnoses the problems but cannot suggest the solutions.
v.    It is not possible to adjust the effect of the price level changes in the analysis of financial statements.
vi.    There is the change of wrong analysis and misleading to the users.
Parties interested in financial statement analysis
The users of accounting information can be divided into two parties' namely internal and external parties.
1.    Internal parties: the internal parties of the accounting information are concerned with the management of the concern. They need financial statement so as to perform the different organizational activities properly and smoothly and achieve the objectives. Such activities are planning, policy making, implementing, controlling etc. the internal uses of accounting information might be:
•    Directors
•    Partners
•    Managers
•    Officers Etc.
2.    External parties: the external parties are not directly involved in the management and operation of a concern and they are external to the organization. They are closely associated with the concern. They are:
a.    Present as well as potential stockholder: a present stockholder needs accounting information so that he/ she can decide whether to continue to hold the stock or sell it. On the other hand a potential stockholder needs the financial information to choose among competing alternative investments.
b.    Bondholders, bankers and other creditors: a potential bondholder wants to be ensured that the company will be able to pay back the amount owed at maturity and the periodic interest payments. Similarly, a bank needs financial information that will help it to determine the company's ability to pay the principle as well as interest. Other creditors also want the assurance of their claims on due date and make them interested on the financial information.
c.    Government agencies: the government needs financial information to decide on permitting contraction or expansion of business, import/ export etc. in many cases, it becomes mandatory for the business to submit its financial information to different government agencies as prescribed by law.
d.    Other external users: many other individuals and groups rely on financial information provides by business. They are:
e.    Public: the public needs financial information to know about the employment opportunities, discharge of responsibility towards the society etc.
f.     Employees: the employees are interested in financial information since their present as well as future is associated with the concern.
g.    Suppliers: when the suppliers sell the goods in credit, they want the payment on time.
h.    Customers: the customers want to know whether the concern is able to supply goods continually or not.