Financial Statement Analysis: Its Objectives, Methods, Users and Limitations.

Concept Of Financial Statement Analysis

Financial statement analysis is an analysis which highlights the essential relationship in the financial statements. Normally, financial statement analysis focuses on the evaluation of past performances of the business enterprise in terms of profitability, liquidity, operational efficiency and growth potentiality. Financial statements analysis, however, includes the methods used in assessing as well as interpreting the result of past performance and the current financial position as they relate to certain factors of interest in investment decisions. Thus, financial statement analysis is an essential means of assessing the past performance and also in forecasting, maintaining and planning future performance. 

Objectives of financial statement analysis are as follows

1.Assessment Of Past Performance: Past performance can serve as a good indicator of future performance. Creditors or Investors are very much interested in the trend of past performances like sales, operating expenses, cost of good sold, cash flows, net income and return on investment. These trends provide a means for judging the past performance of management and are possible indicators of future performance. If a company has poor past performance, creditors and investors might have bad impression about the company which would have effect on their decisions.

2. Assessment of current position: Financial statement analysis also shows the current position of the firm regarding the types of assets owned by a business entity and the different liabilities due against the concern.

3. Prediction of profitability and growth prospects: Financial statement analysis helps to assess and predict the earning prospects which are used by investors during the process of comparing investment alternatives. 

4. Prediction of bankruptcy and failure: Financial statement analysis is a very essential tool in assessing and even predicting bankruptcy and likelihood of business failure.

5. Assessment of the operational efficiency: Financial statement analysis helps in assessing a company's management's operational efficiency. The firm's actual performance which is revealed in the financial statements are comparable with some standards set earlier and the deviation of any standard and actual performance is used as the indicator of the management's efficiency.

Methods of financial statements analyses

Financial statement analysis can be done by employing many techniques or methods. The following are the essential methods of financial statement analysis:

1. Ratio Analysis
The analysis of the interrelationship between two financial figures is referred to as Ratio analysis.

2. Cash Flow Analysis
The analysis of the change in the cash position during an accounting period is known as cash flow analysis.

3. Comparative Financial Statements
Comparative financial statement is a analysis of the financial statements of a company for two years or the financial statements of two companies of similar types.

4. Trend Analysis
The analysis of the pattern of movement of the financial ratios of a company over the years is called trend analysis.

The method or technique to be selected for the analysis depends on the circumstances and the needs of the users. The analyst should use suitable methods to derive the needed information to fulfill their needs.

The analysis of financial figures present in the profit and loss account and balance sheet of an organization by adopting suitable method or technique is referred to as financial statement analysis. It is useful to several parties to obtain the needed information about the organization. The parties interested in the analysis of financial statement are as follows:

1. Shareholders
Shareholders are interested in financial statement analysis in order to know the profitability of the organization. Profitability shows the growth potentiality of a concern and safety of investment of shareholders.

2. Investors And Lenders
Investors and lenders are also interested in the analysis to know the position of solvency of an organization. The lenders examine and analyze the position of the financial statement so as to know about their investment's safety and ability to pay both interest and principle amount on due date.

3. Creditors
Creditors are interested in the analysis of the financial statements so as to know the short term liquidity position of a business entity. They analyse the financial statements to know whether the organization will be able to pay short term liabilities on due date.




4. Management
The management is very much interested in the analysis of the financial statement in order to measure the effectiveness of its decisions and policies, know the short term and long term solvency position, liquidity position, profitability and investment return from the business.

5. Government
Government is also interested in the analysis of the financial statements in order to determine the amount of tax liability. Also, it helps to formulate effective policies and plans for economic growth.

Although, the financial statement analysis is important to acquire relevant information used in making several decisions as well as formulating corporate policies and plans. It should be carefully carried out because it suffers from the following limitations;

 

1. Over-dependence on financial statements
The accuracy of financial information depends on how accurately the financial statements are prepared. If the financial statements are prepared wrongly, then the information acquired from their analysis will be wrong and this may mislead the users in making decisions.

2. Not useful for planning
Because the financial statements are prepared using historical financial data, the information obtained from such statements may not be suitable in corporate planning.

3. Qualitative aspects
Financial statement analysis gives only quantitative information about a concern's financial affairs. However, it does not give qualitative information like management-labor relation, management's skills, customer's satisfaction, etc. which are equally essential for making decisions.

The limitations stated above about the analysis of financial statement clarify it that the analysis is a means to an end and not an end to itself. The analysts and users must understand and consider the limitations before the financial statements of a firm are analyzed.