Concepts of Financial Analysis
Financial analysis is the process of determining financial strengths and weakness of the company by establishing strategic relationship between the components of balance sheet and profit and loss statement and other operative data.
Financial analysis is thus an attempt to dissect the financial statements into their components on the basis of the purpose in hand and establish relationships as between these components, on the one hand and as between individual components and totals of these items, on the other.
Alongside this, a study of trends of various important factors over the past several years is also undertaken to have clear understanding of changing profitability and financial conditions of the business organisation.
The analysis of financial statements represents the three major steps:
The first step involves the reorganization and rearrangement of the entire financial data as contained in the financial statements. This calls for the breaking down of individual components of financial statements and regrouping them into few principal elements according to their resemblances and affinities.
Thus, the balance sheet and profit and loss account are completely re-casted and presented in the condensed form entirely different from their original shape. The next step is the establishment of significant relationship between the individual components of balance sheet and profit and loss account. This is done through the application of tools of financial analysis.
Finally, significance of results obtained by means of financial tools is evaluated. This requires establishment of standards against which actual are evaluated.
Types of Financial Analysis:
Two types of analysis undertaken to interpret the position of an enterprise are:
(i) Analysis of relationship as between different individual components and as between these components and their totals for a given period of time. Such an analysis is known as Vertical Analysis. Since this sort of analysis examines relationships as between different components for a given point of time and does not shed light on changing behaviour of the above relationships, it is also regarded as ‘static analysis’.
Comparison of current assets to current liabilities or comparison of debt to equity or comparison of debt to total assets for one point of time is concrete examples of vertical analysis.
(ii) Analysis of changes in different components of the financial statements over different periods with the help of series of the statements is known as ‘Horizontal Analysis’. Such an analysis makes it possible to study periodic fluctuations in different components of the financial statements.
Study of trends in debt or share capital or in their relationship over the past ten-year period or study of profitability trends for a period of five or ten years are examples of horizontal type of analysis. Horizontal analysis is also known as ‘Dynamic Analysis’ since this reflects changes in financial position of firm over a long period of time.
Methods employed to examine the vertical as well as horizontal relationships of different financial variables with a view to studying profitability and financial position of a business firm is called ‘techniques of financial analysis’. A number of techniques are used to undertake financial analysis. Important among these are: common size statement, ratio analysis, trend analysis, funds flow analysis and profit Planning.
Utility of Financial Analysis:
Financial analysis seeks to spotlight the significant facts and relationships concerning managerial performance, corporate efficiency, financial strengths and weaknesses and credit-worthiness of the company. The tools of analysis are used to study 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.
A finance manager must equip himself with the different tools of analysis in order to reach rational decisions for the firm. These tools of analysis are immensely helpful to finance manager in carrying out his planning and controlling functions.
While preparing financial plan for the firm, finance manager must know the impact of financial decisions he is taking on financial condition and profitability of the business enterprise.
The techniques of financial analysis can serve as handmaid to the management in determining the effect of his decisions. These techniques are equally useful in the sphere of financial control in as much as they enable the finance manager to make constant reviews of the actual financial operations of the firm as a whole and of various divisions of the firm against the Performa balance sheet and profit and loss statement and to analyse the cause of major deviations which result in corrective action where indicated.
Thus, with the help of tools of financial analysis finance manager can rationalize his decisions and reach the business goal easily.
The utility of tools of financial analysis is limited not only to finance manager they are equally useful to the top management, creditors, investors and labourers. By analysing and interpreting financial statements, the top management can measure the success or otherwise of a company’s operations, determine the relative efficiency of various departments, processes and products, appraise the individual’s performance and evaluate the system of internal control.
The creditor can find out the financial strength and capacity of a borrower, the value of a floating share on the assets held as security and the value of unquoted shares. A lending bank through an analysis of these statements appraises the ability of the company at a particular time to meet its obligation and also judges the probability of its continued ability to meet all its financial obligations.
The long-term lenders examine not only the safety of principal and interest on the indebtedness but also the business. The shareholders or the investors are enabled to evaluate the efficiency of the management and determine if there is a need for change. In a large company the shareholders’ interest is limited to decide whether to buy, sell or hold the shares.
The labour unions analyse the financial statement with a view to determining the business costs and benefits before and after the taxes, the financial benefits received by the various groups interested in the enterprise, the company’s financial and operating experience compared with that of the other enterprises and likely future business course.
The unions thus assess whether the company is earning a fair rate of return on invested capital, whether it can presently afford a wage increase, whether a decrease may be necessary, whether it can absorb a wage increase through increased productivity or by raising prices.
The economists analyse the financial statement with a view to studying the prevailing business and economic conditions. The government agencies analyse them for the purpose of price regulations, rate setting and similar other purposes.
It is not necessary to employ all the techniques for analytical purposes. The choice of a particular tool would depend, by and large, on the purpose in hand. A technique that is used frequently by an analyst may not prove useful to other analyst because of difference in the particular interests of the analysis.