Meaning :

— Analysis of Financial Statements is a systematic process of

analysing the financial information in the financial statements
to understand and take economic decisions.
— Analysis of Financial Statements is a study of relationships
among various financial values as set out in the financial
statements, i.e., Balance Sheet, Statement of Profit and Loss and
Cash Flow Statement. The complex data given in the financial
statements is divided or broken into simple and valuable
elements and relationships are established between the
interdependent or related elements of the same statement or
different financial statements.
— Financial statement analysis is largely a study of relationships
among the various financial factors in a business, as disclosed by
a single set of statements , and a study of trends of these factors,
as shown in a series of statements. - MYER
 TOOLS OR TECHNIQUES
— Comparative Financial Statements
— Comparative Statements mean a comparative study of individual items or
components of financial statements, i.e., Balance Sheet and Statement of Profit
and Loss of two or more years of the enterprise itself.
— Common Size Financial Statements
— Common-size Statements mean statements in which
individual items of financial statements of two or more years
are placed side by side and thereafter converted into percentages
taking a common base.
— Ratio Analysis
— Ratio is an arithmetical expression of relationship between two related or
interdependent components of financial statements of an accounting period.
— Cash Flow Statements
— Cash Flow Statement is a statement showing flow of Cash and Cash Equivalents
during the accounting period, classified under Operating Activities, Investing
Activities and Financing Activities.
Types of Financial Statement analysis
— External analysis
— External Analysis is conducted by those who do not have
access to the detailed records of an enterprise and,
therefore, have to depend on published accounts, i.e.,
Statement of Profit and Loss, Balance Sheet, Directors'
and Auditor's Reports. Such type of analysis is made by
investors, lenders, creditors, government agencies and
research scholars.
— Internal analysis
— Internal Analysis is conducted by the management to
know the financial position and operational efficiency of
the organisation.
Types of Financial Statement analysis
— Horizontal or Dynamic analysis
— This analysis is made to review and analyse financial statements for
a number of years. It is a Time Series Analysis. It shows comparison
of financial data for several years against a chosen base year. It is
useful for trend analysis and long-term planning. Comparative
Statements or Comparative Financial Statements are examples of
horizontal analysis.
— Vertical or Static analysis
— This analysis is made to review and analyse the financial statements
of one year only. It is a Cross-sectional Analysis. Ratio analysis of the
financial statement relating to a particular accounting year is an
example of this type of analysis.
Types of Financial Statement analysis
— Inter firm comparison
— A comparison of two or more enterprises or firms is known as Inter-
firm Comparison. It compares financial variables of two or more
enterprises or firms to determine their competitive position. When
single set of statements of two firms is compared, it is known as Cross-
sectional Analysis.
X ltd Y ltd Z ltd A ltd
NP Ratio 12% 14% 15% 17%

— Intra firm comparison

— A comparison of financial variables of an enterprise over a period of
time is known as Intra-firm Comparison. It is also called Time Series
Analysis or Trend Analysis.

Year 2017 2018 2019 2020

NP Ratio 12% 14% 15% 17%
Process of Financial statement Analysis
— Rearrangement of Financial Statements
— For analysis, it is necessary to reclassify the complex data contained in the
financial statements into purposive classes so that maximum desired
information from every data for analysis can be extracted or obtained.
— Comparison
— After the classification of data of financial statements into different
categories, it is necessary to obtain comparative data of the same enterprise
of the past periods if it is a time series analysis. In case of cross-sectional
analysis, it is necessary to obtain comparative data of the same accounting
period of similar or comparable enterprises.
— Analysis
— Comparative financial data are then analysed with reference to financial
characteristics like profitability, solvency and liquidity.
— Interpretation
— The concluding part of financial statement analysis is interpretation of
financial information generated in the process of financial statement
analysis.
Objectives of Financial statement Analysis
— Assessing the Earning Capacity or Profitability
— On the basis of financial analysis, the earning capacity or profitability of an
enterprise can be assessed. In addition, the earning capacity of the enterprise, in
coming years, may also be forecast. All the external users of financial statements,
especially investors and potential investors, are interested in earning capacity and
forecast.
— Assessing the Managerial Efficiency
— The financial statement analysis helps to identify the areas where the managers have
been efficient and the areas where they have been inefficient. For example, by using
accounting ratios, it is possible to analyse relative proportion of production,
administrative and marketing expenses. Any favourable or unfavourable variation
can be identified and reasons thereof can be ascertained to pinpoint managerial
efficiency or inefficiency.
— Assessing the Short-term and Long-term Solvency of the Enterprise
— Long-term and short-term solvency of an enterprise can be assessed on the basis of
financial statement analysis. Creditors or suppliers are interested to know the short-
term solvency or liquidity of the enterprise, i.e., its ability to meet short-term
liabilities. Debenture holders and lenders are interested to know the long-term and
short-term solvency of the enterprise to assess the ability of the company to repay the
principal amount and interest thereon.
Objectives of Financial statement Analysis
— Inter-firm Comparison
— Inter-firm comparison becomes easy with the help of financial analysis. It
helps an enterprise in assessing its own performance as well as that of
others, if mergers and acquisitions are to be considered.
— Forecasting and Preparing Budgets
— Past financial statement analysis helps in assessing developments in future,
especially in the next year. For example, given a certain investment, it may
be possible to forecast the next year's profit on the basis of earning capacity
shown in the past. An analysis thus helps in forecasting and preparing the
budgets.
— Explainable and Understandable
— Financial analysis helps the users of the financial statements to understand
the complicated matter in a simplified manner. Financial data can be made
more comprehensive by charts, graphs and diagrams, which can be easily
explained and understood.
Uses of Financial statement Analysis
— Securities Analysis
— It is a process by which the investor comes to know whether the firm is fulfilling his
expectations with regard to payment of dividend, capital appreciation and security of
money.
— Credit Analysis
— Such analysis is useful when a firm offers credit to a new customer or a dealer. The
manager of the firm would like to know whether to allow or extend credit to them or
not. Such analysis is also useful for a bank before granting loan.
— Debt Analysis
— Such analysis is done by the firm to know its borrowing capacity.
— Dividend Decision
— Financial analysis helps the firm in deciding about the rate of dividend. The
management would have to decide about how much portion of the earnings to
distribute and how much to retain.
— General Business Analysis
— Financial analysis can be used to identify the key profit drivers and business risks in
order to assess the profit potential of the firm. It helps in future growth scenarios for
the firm.
Parties interested in Financial statement Analysis
— Management
— Financial analysis helps the management to ascertain overall as well as segment-wise
efficiency of the business. Besides, it helps them in decision-making, controlling and
self-evaluation.
— Employees and Trade Unions
— Employees are interested in better emoluments, bonus, better working conditions
and security of their jobs. So, they are always interested in profitability, operating
sustainability and financial strength of the business. Trade Unions are also interested
in financial analysis because the degree of profitability helps them in negotiating and
entering into revised wage agreements with the employers.
— Shareholders or Owners or Investors
— Owners invest their savings in the enterprise. Therefore, they are interested in
profitability and safety of their investments. They would like to know whether the
business is profitable, has growth potential and its progress is on expected lines.
Growth potential of business helps in appreciation of their investment.
Parties interested in Financial statement Analysis
— Potential Investors
— They are interested to know the present profitability (i.e., earning) and
financial position as well as future prospects to determine whether they
should invest in a particular company or not.
— Suppliers or Creditors
— They are interested to know the short-term solvency position of a firm, i.e.,
the ability to meet its short-term liabilities. On the basis of analysis, they
decide whether they should allow or extend credit to the enterprise or not.
— Bankers and lenders
— Bankers and Lenders are interested in servicing of the loans granted to an
enterprise, i.e., regular payment of interest and repayment of principal
amount on due dates. In other words, they are interested in long-term and
short-term solvency of a firm, i.e., ability to pay interest on loans and debts
and its repayment.
Parties interested in Financial statement Analysis
— Researchers
— Researchers may like to analyse profitability, growth, financial position and
future prospects of a business or industry.
— Regulatory authorities
— Tax authorities are interested in ensuring proper assessment of tax
liabilities of the enterprise as per the laws in force from time to time.
— Customers
— Customers have an interest in information about the continuance of an
enterprise, especially when they have a long-term involvement with, or are
dependent on the enterprise.
Limitations of Financial statement Analysis
— Historical Analysis
— Financial statement analysis is a historical analysis. It analyses what has
happened till date. It does not reflect the future. Persons like shareholders,
investors, etc., are more interested in knowing the likely position in future.
— Ignores Price Level Changes
— Price level changes and purchasing power of money are inversely related. A
change in the price level makes analysis of financial statements of different
accounting years invalid because accounting records ignore change in value
of money.
— Qualitative Aspect ignored
— Since the financial statements are confined to monetary matters alone, the
qualitative aspects like quality of management, quality of staff, public
relations are ignored while carrying out the analysis of financial statements.
Limitations of Financial statement Analysis
— Suffers from the Limitations of Financial Statements
— Analysis of financial statements is based on the information given in the financial
statements. Hence, this analysis suffers from all such limitations from which the
financial statements suffer. Therefore, unless the basic data given in the financial
statements is reliable, the conclusions derived on the basis of the analysis of this data
cannot be reliable.
— Not Free from Bias
— In many situations, the accountant has to make a choice out of alternatives available,
e.g., choice in the method of inventory valuation, choice in the method of
depreciation (straight line or written down value), etc. Since the subjectivity is
inherent in personal judgment, the financial statements are, therefore, not free from
bias.
— Variations in Accounting Practices
— For inter-firm comparison, it is necessary that accounting practices followed by the
firms do not vary significantly. As there may be variations in accounting practices
followed by different firms, a meaningful comparison of their financial statements is
not possible.
Limitations of Financial statement Analysis
— Window Dressing
— Window dressing refers to the presentation of a better financial position
than what it actually is by manipulating the books of account. On account
of such a situation, financial analysis may give false information to the
users.