Financial Accounting

What is Financial Statement Analysis

Introduction

The term ‘financial statement analysis ‘refers to determining the firm’s financial position by reviewing and analyzing the items of the balance sheet, profits and loss account, cash flow statement, funds flow statements, etc.

The purpose of the financial analysis is to understand the company’s financial health to judge the profitability of the firm. Several groups of stakeholders are interested in the analysis of financial statements.

Owners are interested in knowing how their business is performing, and trends help them determine whether to expand the business or discontinue a particular product or service. Investors are interested in knowing whether it is worth investing in the shares of a particular company.

Similarly, bankers, lenders and financial institutions want to gauge the financial performance and position before offering their financial assistance in loans and advances.

Just like a doctor examines his patient by recording his body temperature, blood pressure, etc., before making the conclusion regarding the illness and giving his treatment, a financial analyst uses various tools to judge the soundness of the firm.

Tools/ Methods or Devices of Financial Analysis

  • Comparative statements – In this method, either the financial statements of two or more years are presented in a comparative form or they are presented for two or more firms for the same years. It helps to understand which year performed better or which firm performed better.
  • Trend analysis – In this method, the trend of particular income or expense is observed for several years and compared with income or profitability to ensure whether the movement is justified or it is abnormal.
  • Common size statements – A common-size income statement is one in which each line item is stated as a percentage of a base number, as opposed to a split-size income statement. This is sometimes referred to as total revenues or total sales. In a similar way to financial ratio analysis, a common-size income statement serves a similar goal. In addition, it allows for comparable comparisons across time periods, companies, and industry sectors.
  • Fund flow analysis – It helps to analyse sources and applications of funds.
  • Cash flow analysis – Cash flow analysis helps to analyse cash and non-cash activities to ascertain net actual cash movement happened during the year.
  • Ratio analysis – This is the most popular and powerful tool which can be used to analyse several performance-related indicators such as sales, profitability, return on investment, share price etc.
  • Cost-volume- profits analysis – Profitability (CVP) analysis, also known as break-even analysis, is a financial planning technique that company executives use to determine short-term goals for their organisations. Profitability is conveyed to company decision-makers through the use of changes in selling prices, costs, and volume of sales (in the short term).
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