Financial Analysis: Objectives, Methods, and Process - GeeksforGeeks (2024)

Financial analysis is a systematic process of evaluating the financial information provided by thefinancial statements tounderstand and make judgments about the operations of the firm. It can be further explained as:

• A study of the relationships among thefinancial facts and figures providedby thefinancial statements.
• The goal is to get an understanding of the firm’s profitability and operational efficiency in order to analyse its financial health and future prospects.

The concept of “Financial Analysis” involves both ‘Analysis’, i.e., simplification of financial data and ‘Interpretation’, i.e., explanation of meaning and relevance of facts. These two concepts are complementary to each otherthat is, analysis is useless without interpretation, and interpretation without analysis becomesdifficult or sometimes evenimpossible.

In the words of John N. Myres, “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 the trends of these factors as shown in a series of statements”.

Objectives or Purpose of Financial Analysis

The financial analysis serves the following purposes and is required in the enterprisefor the following reasons:

1. Assesses the Earning Capacity:

The primary objectiveof any enterpriseis to earn a reasonablereturn on the capital employed. The goal of financial analysis is to find out if the enterprise is earningadequate profits or not. Profitability Ratios (like Gross Profit Ratio, Operating Profit Ratio, etc.)are used to evaluate theearning capacity of an enterprise.

2. Assesses the Solvency:

Financial analysis attempts to determine the business’s short-term and long-term solvency. Creditors are keen to determine theliquidity position of the term, i.e., the short-term solvency of the business, whereas long-term lenders (such as debenture-holders) are keen to know thelong-term solvency of the business. Ratio analysis is helpfulin determining the completesolvency of the business.

3. Forecasts and Prepares Budget:

Analysis of previous financial accounts is helpful inforecasting future events. It allows the businessto make predictions and develop budgets depending on theprevious performance review.

4. Provides Useful and Valuable Information:

Financial analysis attempts to provide useful and valuable information to a wide range of interestedstakeholders, including owners, investors, creditors, employees, banks, financial institutions, government departments, and so on.

5. Measures Financial Strength:

Financial analysis is used to determine thefinancial position and future of the enterprise.

6. Inter-firm and Intra-firm Comparison:

Financial analysis attempts to make inter-firm and intra-firm comparisons. This type of comparison is helpfulin identifying problems and implementing corrective steps in time.

7. Measures Management’s Efficiency:

Financial analysis attempts to assess theoperational efficiency of the management. Such analysis is helpfulin determining whether thefinancial policies decided by the managementare appropriate or not.

Methods of Financial Analysis:

Following are the various methods of financial statement analysis:

1. Internal Analysis:

Internal Analysis is the analysis performed on the basis of the company’s accounting records and other relevant information.

• It is carried out by management in order to analyse the enterprise’s financial performance and situation.
• Internal analysis is deeper and more credible becausemanagement has access to allinformation and facts of the enterprise.

2. External Analysis:

External Analysis refers to analysis performed using publishedstatements, reports, and information.

• External Analysis is carried out by individuals who do not have access to the enterprise’s completerecords.
• External parties, which include creditors, investors, banks, financial experts, and so on, usuallyconduct the externalanalysis.
• External analysis is consideredless accurate than internal analysis because of limited and inadequate information.

3. Horizontal Analysis (or Dynamic Analysis):

Horizontal Analysis refers to the analysis and review of financial statements across a period of time. This analysisis often performed using Comparative Financial Statements.

• In this analysis, the amount of two or more years is placed side by side along with absolute change and percentage change in amounts in order to perform a comparison.
• It is excellent for long-term trend analysis and planning.
• Horizontal Analysis is also referred ‘Dynamic Analysis’ because it is based on data from two or more years rather than just one.
• Horizontal Analysis is useful for time-series analysis.

4. Vertical Analysis (or Static Analysis):

Vertical Analysis refers to the analysis and review of financial statements for a single fiscal year. Ratio Analysis is an example ofverticalanalysis.

• Vertical analysis is beneficial for inter-firm comparison, i.e.,comparing the performance of multiple enterprises at the same time or different departments of an enterprise.
• Vertical Analysis is alsoknown as ‘Static Analysis’ because it is based on data onlyfrom a single year.
• Vertical Analysis is useful for cross-sectional analysis.

5. Intra-firm Analysis:

Intra-firm Comparison refers to a comparison of an enterprise’s financial variables over two or more accounting periods. It is also referred to as Time Series Analysis or Trend Analysis.

6. Inter-firm Analysis:

Inter-firm comparison refers toa comparison of financial data from two or more enterprisesover the same accounting period. It is also referred to as cross-sectional analysis.

Process of Financial Analysis

The process of Financial Analysis are:

1. Determine the Objective of Analysis:

Before analysing the financial statement of an enterprise, the reason to do it should be clear. The nature and quantum of analysis are affected by its objective.

2. Reformulating Reported Financial Statements:

Reformulating reported financial statements is the process of restating financial statements so that they better serve the goal of analysis and allow for a more efficient and accurate interpretation of the company’s performance.

3. Adjustments ofMeasurement Errors:

Adjustments ofmeasurement errors are performed to reduce errorsindatain order to improve the quality of the financial statements. For example, shifting R&D expenses fromthe income statement and putting them on the balance sheet.

4. Comparison:

After adjustment, figures are compared to derive the proper results. Comparisons between different parameters and figures from different years help a firm to know about various prevailing trends. These trends are then further studied.

5. Draw Conclusion:

Various data are then explained and conclusions are drawn out of it regarding financial soundness, liquidity, loan, repaying capacity, and earning capacity of an enterprise.

7. Reporting:

After interpretation, conclusions are reported to the management, and with the help of all the information, decisions are taken by the management in the required field.