The process of evaluation which is critical about financial information contained in the financial statements in order to understand and make decisions regarding the operations of the firm is called ‘Financial Statement Analysis’. It is basically a study of relationship among different financial facts and figures as given in a set of financial statements, and the interpretation thereof to gain an insight into the operational efficiency and profitability of the firm to assess its financial health and future prospects. The term analysis is nothing but simplification of financial data by classification methods given in the financial statements. Interpretation means explaining the significance and meaning of the data. These two are complimentary to each other.
Analysis is useless without interpretation, and interpretation without analysis is difficult or even impossible. Financial analysis is the process of identifying the financial weakness and strengths of the firm by properly establishing relationships between the different items of the profit and loss account and the balance sheet. Financial analysis can be undertaken by management of the firm, or by parties outside the firm, viz. owners, trade creditors, lenders, investors, labor unions, analysts and others. The nature of analysis will differ depending on the purpose of the analyst. A technique frequently used by an analyst need not necessarily serve the purpose of other analysts because of the difference in the interests of the analysts. Financial analysis is useful and significant to different users in the following ways:
Finance manager: Financial analysis focuses on the facts and relationships related to managerial performance, corporate efficiency, financial strengths and weaknesses and creditworthiness of the company. A finance manager must be well-equipped with various tools of analysis to make rational decisions for the firm. The tools for analysis help in studying accounting data so as to determine the continuity of the operating policies, investment value of the business, credit ratings and testing the efficiency of operations.
Top management: The importance of financial analysis is not limited to the finance manager alone. Its scope of importance is quite broad which includes top management in general and the other functional managers. Management of the firm would be interested in every aspect of the financial analysis. It is their overall responsibility to see that the resources of the firm are used most efficiently, and that the firm’s financial condition is sound. Financial analysis helps the management in measuring the success or otherwise of the company’s operations, appraising the individual’s performance and evaluating the system of internal control.
Trade creditors: A trade creditor, through an analysis of financial statements calculates not only the urgent ability of the company to meet its obligations, but also judges the probability of its continued ability to meet all its financial obligations in future. Trade creditors are interested in the firm’s ability to meet their claims over a short period of time. Their analysis will, therefore, confine to the evaluation of the firm’s liquidity position.