Financial Analysis: Meaning, Importance, Process and Limitations

Meaning of Financial Analysis

Financial analysis is the process by which financial weaknesses and strengths of a company are determined. It is done by establishing a relationship between the data present in the balance sheet to other data.

Basically, financial analysis is a process that is used to analyze if an entity is considered to be stable and profitable enough so that a person could invest money.

The analysis of financial statements is necessary to know and understand the mystery hidden in the figures which are present in financial statements. It is an attempt that is used to determine the importance of data from the financial statement that can be used to forecast future earnings and the ability to pay interest. It is used to determine the profitability of a policy including a sound dividend.

The term financial analysis is comprised of analysis and interpretation where analysis is the process of simplification of data which can be done by methodical classification of the data present in the financial statements and interpretation refers to the explanation of the meaning and importance of data that is simplified.  

Importance of Financial Analysis

Judging the Financial Position

The data relating to finance becomes meaningful after it is analyzed. Comparative statements of profit and loss can be analyzed to know the financial performance of the firm. Comparative balance sheets can be used to determine the financial position of the firm by analyzing them.

Operational Efficiency

Financial analysis is comprised of various techniques such as ratio analysis which is used to study the financial statements regarding the business of a firm. The operational efficiency of a business is determined with the help of activity ratios. It can also be known by operating ratio, inventory turnover ratio, etc.

Indicating Growth Trends

The percentages of change in the figures which are in the comparative statements of profit and loss are recorded in the statements. This is used by the users to judge the growth or loss the organization has faced over the period.

Trend Forecasting

It is used to know the pattern regarding the operating efficiency of a company for a period where a single year is referred to as the base year. It also helps to identify the problem and detect the inefficiency.

Facilitates Comparison

It helps to compare both intra and inter-firm. The intra-firm comparison refers to the comparison which is made among different parts of the same business to analyze and improve the efficiency of the business. The inter-firm comparison refers to the comparison that is made between two or more different business units that perform in similar departments. This is done to improve the performance of the firm which will help it to make a profit.

Beneficial to Stakeholders

The financial data becomes meaningful once it is analyzed. It provides the necessary information to the stakeholders by comparing the data present in the financial statements with the data of the previous year.

Process of Financial Analysis

Firstly, gather the information of financial statements. All the relevant data and requisite documents need to be assembled so as to avoid any mess. The relevant documents include the income statement, invoices, balance sheet, cash flow statements, government reports if any, quarterly reports, and the reports as necessary for the particular organization for its effective working.

Second, calculating the ratios which provide the snapshot of the health of the entity in financial terms include return on investments, profitability ratios, and turnover ratios which tells the status of the organization and forms the basis for comparison intra-firm and interfirm and shows the investors how profitable the business is.

The ratios which are relevant to the company must only be calculated for the financial analysis report.

The third step includes the assessment of the risk, that is the frequency of the risk associated with the business and whether the business is worthy of that risk. In order to gain the confidence of the investors, it is necessary to conduct the risk assessment test by the following process-

  • Identification of the risks
  • Documenting the risk
  • Identify the individuals to monitor the risk
  • Determining the controls to reduce the risk
  • Review of risks from time to time

Fourth, determine the worth of your business by estimating the share prices or value of the stock and how much worth value it can add to the investors.

Techniques of Financial Analysis­

Techniques of Financial Analysis

Investors before investing in a business look for various techniques for analyzing the worth of the business.

Vertical Analysis – It is a technique that is used to identify the ways the company has used its resources and the proportion in which these resources are distributed in the balance sheet.  

Horizontal Analysis – In this technique, the financial statements of the company are reviewed for several years. Thus, it is also known as long-term analysis. This technique is useful for long period planning.

Trend Analysis – This technique includes the collection of information from various resources and then plotting the same on a horizontal line. This is used to determine actionable patter from the collected information.

Liquidity Analysis – This technique is used to determine the ability of the company to fulfill its short term financial promises and also its ability to manage short term loan repayment.

Stability Ratio Analysis– This technique of stability ratio is used for long term vision. This technique is basically used to know if the company is stable or not in the long run.

Limitations of Financial Analysis

  1. As financial analysis is based on historical concepts thus it does not consider the changes in the price level.
  2. Only the quantitative aspects are considered and not the qualitative aspects. For example: dedication of employees towards work are neglected.
  3. Considering the results of the analysis based on the financial statements is not fair as they include the judgement of the accountant. This bias analysis is not correct to be considered.
  4. The financial analysis is done with the help of financial statements which are made on the basis of an ongoing situation and thus it does not tell about the exact position of the firm.

Conclusion

Analysis and interpretation of the financial statements of the company are important to know the company’s present position. It helps to know about the company’s management skills. A report is made after the analysis and interpretation which further helps the company’s employees to make decisions on the basis of the report. Also, investors study the report to think about their investment in that company.

Leave a Comment