The financial function in any organization consists of the activities covering operations, financing and investment. The objective of preparing the financial statements of the organization is to record and summarize the financial transactions and activities in the different functional areas. (Philadelphia University) The analysis of the financial statements exhibits the financial health of an organization at any given point of time. The financial statement analysis is the measure of the financial responsiveness of the organization with respect to the protection of the interests of its shareholders. According to the Financial Accounting Standards Board (FASB) the financial statements of a firm should provide sufficient information that is useful to investors and creditors in making their investment decisions in an informed way.
Rationale for Financial Analysis
The financial analysis is done to meet the information requirements of investors, suppliers, customers and others. Each of these categories of people has different objectives for undertaking financial analysis. Financial statements prepared by the organizations form the basis for the financial analysis. Apart from the financial statements the information collected from the industry, from the economy and the market also provides the basis for making the financial analysis. There are basically four financial statements prepared which normally are used for making the financial analysis. They are; (i) statement of earnings that shows the profit or loss made by the organization during a given period, (ii) balance sheet showing the assets and liabilities of the organization as on a given date. Assets represent what the organization owns and liabilities represent what the organization owes to others, (iii) statement of changes in equity representing what the business has returned to the owners by way of profit and (iv) statement of cash flows showing the several sources from which cash came into the business and the ways in which cash was spent to run the business. It is essential that an analysis of all these four statements is made to ascertain the direction of the business in respect of its financial performance. (Cameron University).
The financial statements of a business can be analyzed from different perspectives. There may be a historical comparison to assess the growth of the organization by comparing the financial status of the company for the current period with that of the previous periods. Secondly the financial performance of the organization can be compared with the standards established for the industry in which the firm is operating. The standards usually reflect the relative competitive strength of the company in terms of financial performance. Ratio analysis is the appropriate tool to compare the performance of the organization with that of the industry as well as other firms in the industry.
Purposes of Financial Analysis
It is usual for the organizations to analyze the financial position periodically on the basis of financial statements for various purposes. One of the major purposes is the financial planning for the organization’s business. Financial planning is undertaken to determine when funds are needed and also to ensure that the funds are made available when needed. The financial analysis enables the firm to identify the sources from which funds can be arranged. Moreover funds are required for the conduct of the business over long-term, short-term and medium-term. The need for the funds over various periods can be precisely estimated by the organization through a proper analysis of the financial statements prepared at the end of each month or quarter.
Financial planning usually requires forecasts and forecasts are aided by financial planning tools like cash budgets and projected financial statements. Therefore it can reasonably be stated that the financial statement analysis is at the root of financial planning of the organization both on a long-term and short-term basis.
Since the financial statements summarize and provide an overview of the events relating to the functioning of the firm, they help to identify the strengths and weaknesses of the firm. By analyzing the strengths and weaknesses of the firm the management would be able to take advantage of the firm’s strengths and take corrective actions for addressing the weaknesses of the firm. For instance financial analysis provides information on whether the inventories are adequate to support the projected level of operations or whether the firm has a too heavy investment in accounts receivable. Thus the analysis of the financial statement becomes useful to the management from the following angles:
- The management can anticipate the future working conditions of the firm.
- The analysis provides the starting point for financial and other planning activities of the firm.
- The financial analysis influences the future course of action of the firm.
- It shows whether the position of the firm has improved or deteriorated over a period of time.
Financial Statements Analysis and Ratio Analysis
Analysts usually perform horizontal and vertical analyses of the financial statements for comparison of performances of firms. Horizontal analysis focuses on the growth of the company as brought out by changes in income statement and balance sheet of the firm over the periods.
Vertical analysis examines the percentage composition of the income statement and the balance sheet. The analysts use common size financial statements for the purpose of analysis. (Chapter 11).
Ratio analysis is an integral part of the financial analysis. Ratio analysis starts with the calculation of a set of financial ratios designed to show the relative strengths and weaknesses of a firm in relation to the other firms in the industry as well as the financial performance of the company during the previous periods. Different kinds of ratios like liquidity ratios, asset management ratios, debt management ratios and profitability ratios are prepared to analyze the relative financial strengths and weaknesses of a firm. (Santa Clara University).
In order that the financial statements are made useful to those who study them they need to be interpreted in a proper and meaningful way. Such financial analysis helps various users of financial statements like investors, managers, customers, potential suppliers and creditors, government regulators, trade unions and public interest and community groups.
Cameron University ‘Financial Analysis – Rationale’. 2008. Web.
Chapter 11 ‘A Framework for Financial Statement Analysis’. 2008. Web.
Philadelphia University ‘ Financial Statement Analysis’. 2008. Web.
Santa Clara University ‘Financial Statement Analysis’. 2008. Web.