Financial statement analysis is the process of examining relationships among financial statement elements and making comparisons with relevant information. It is a tool in decision-making processes related to stocks, bonds, and other financial instruments. Analysis of financial statements provides valuable information for managerial decision. Financial analysis is commonly called analysis and interpretation offinancial statement. Analysis of financial statements means establishing relationship between the items in financial statements for determining the financial strength and weakness of business.
It is the process of scanning of the financial statements to judge profitability solvency, stability, growth of prosperity of a firm. According to Myer “Financial statement analysis is largely a study of relationship among various financial factors in a business as disclosed by a single set of statements and study of these factors shown in a series of statements”. Thus financial analysis is the use of financial statements to analyzea company’s financial position and performance, and to assess future financial performance.
In short financial analysis is the process of examining the composition of financial statements for getting valuable information about the business. It is a technique of x-raying the financial position as well as progress of a firm. Financial analysis includes analysis and interpretation of financial statements. The word analysis literally means ‘to break into parts’. In the context of financial statement, analysis is the process of breaking down a complex set of figure into simple statements in order to have a better understanding.
It is a critical examination of financial transactions effected during a definite period. The term interpretation ‘literally’ means to explain the meaning and significance of data. In the context of financial analysis, interpretation means to explain the financial position and earning capacity of the business that may be understood even by an ordinary person. In short, interpretation means explaining the financial statements on the basis of analysis. Ratios are a valuable analytical tool when used as part of a thorough financial analysis.
They can show the standing of a particular company, within a particular industry. However, ratios alone can sometimes be misleading. Ratios are just one piece of the financial jigsaw puzzle that makes up a complete analysis. (Leslie Rogers, 1997). Chidambaram Rameshkumar, Dr. N. Anbumani on February 2, 2006 in his article “An overview on financial statements and ratio analysis” argue that Ratio Analysis enables the business owner/manager to spot trends in a business and to compare its performance and condition with the average performance of similar businesses in the same industry.
To do this compare your ratios with the average of businesses similar to yours and compare your own ratios for several successive years, watching especially for any unfavorable trends that may be starting. Ratio analysis may provide the all-important early warning indications that allow you to solve your business problems before your business is destroyed by them. Financial ratios are widely used to develop insights into the financial performance of companies by both the evaluators and researchers.
The firm involves many interested parties, like the owners, management, personnel, customers, suppliers, competitors, regulatory agencies, and academics, each having their views in applying financial statement analysis in their evaluations. Evaluators use financial ratios, for instance, to forecast the future success of companies, while the researchers’ main interest has been to develop models exploiting these ratios. Many distinct areas of research involving financial ratios can be differentiated. ( Barne, 1986).
Peeler J. Patsula, on January 23, 2006in his article “successful business analysis” tries to define that, a sound business analysis tells others a lot about good sense and understanding of the difficulties that a company will face. We have to make sure that people know exactly how we arrived to the final financial positions. We have to show the calculation but we have to avoid anything that is too mathematical. A business performance analysis indicates the further growth and the expansion. It gives a physiological advantage to the employees and also a planning advantage.
In trend analysis, ratios are compared over time, typically years. Year-to-year comparisons can highlight trends and point up the need for action. Trend analysis works best with three to five years of ratios. The second type of ratio analysis, cross-sectional analysis, compares the ratios of two or more companies in similar lines of business. One of the most popular forms of cross-sectional analysis compares a company’s ratios to industry averages. These averages are developed by statistical services and trade associations and are updated annually.
Ezzamel, Mar-Molinero and Beecher, 1987). Susan Ward on May 1, 2008 in his article“ Financial Ratio Analysis for Performance Check” emphasis that financial analysis using ratios between key values help investors cope with the massive amount of numbers in company financial statements. For example, they can compute the percentage of net profit a company is generating on the funds it has deployed. All other things remaining the same, a company that earns a higher percentage of profit compared to other companies is a better investment option.
Financial ratios can also give mixed signals about a company’s financial health, and can vary significantly among companies, industries, and over time. Other factors should also be considered such as a company’s products, management, competitors, and vision for the future. (Fieldsend, Longford and McLeay, 1987). Following are the cautions while doing financial analysis. First, a single ratio does not generally provide sufficient information from which to judge the overall performance and status of the firm.
Only when a group of ratios is used can reasonable judgments be made. If an analysis is concerned only with certain specific aspects of a firm’s financial position, one or two ratios may be sufficient. Second, It is preferable to use audited financial statements for ratio analysis. If the statements have not been audited, there may be no reason to believe that the data contained in them reflect the firm’s true financial condition. Third, the financial data being compared should have been developed in the same way.
The use of differing accounting treatments, especially relative to inventory and depreciation can distort the results. (Whitis and Keith, 1993). Time-series analysis is applied when a financial analysts evaluates performance over time. Comparison of current to past performance, using ratio analysis, allows the firm to determine whether it is progressing as planned. Using multiyear comparisons can see developing trends, and knowledge of these trends should assist the firm in planning future operations.
As in cross-sectional analysis, any significant year-to-year changes can be evaluated to access whether they are symptomatic of a major problem. Time-series analysis is often helpful in checking the reasonableness of a firm’s projected financial statements. A comparison of current and past ratios to those resulting from an analysis of projected statements may reveal discrepancies. (Gitman,1997). A balance sheet summarizes the financial position of a company at a given point in time.
Most companies are required under accepted accounting practices to present a classified balance sheet. In which assets and liabilities are separated into current and non-current accounts. Currents assets are expected to be converted to cash and used in operations within one year or the operating cycle, whichever is longer. Current liabilities are obligations that the company must settle in the same time period. The difference between current assets and current liabilities is working capital. (Gitman, 1997).
There are many different ratios and models used today to analyze companies. The most common is the price earnings (P/E)ratio. It is published daily with the transactions of the New York Stock Exchange, American Stock Exchange, and NASDAQ. These quotations show not only the most recent price but also the highest and lowest price paid for the stock during the previous fifty-two weeks, the annual dividend, the dividend yield, the price/earnings ratio, the day’s trading volume, high and low prices for the day, the changes from the previous day’s closing price.
The price to earnings (P/E) ratio is calculated by dividing the current market price per share by current earnings per share. It represents a multiplier applied to current earnings to determine the value of a share of the stock in the market. The price-earnings ratio is influenced by the earnings and sales growth of the company, the risk (or volatility in performance), the debt equity structure of the company, the dividend policy, the quality of management, and a number of other factors. A company’s P/E ratio should be compared to those of other companies in the same industry. Garcia-Ayuso, 1994) Auditors use financial analysis techniques in determining areas warranting special attention during their examination of a client’s financial statements.
A company’s board of directors, in their role as appointees of shareholders, monitors management’s actions. Regulatory agencies utilize financial statements in the exercise of their supervisory functions, including the Securities and Exchange Commission, which watchfully oversees published financial statements for compliance with federal rites law. Other users include employees, intermediaries, suppliers, and customers.
Bernstein and Wild, 1990). Jonas Elmerraji on April 2005 in his article “Analyze Investments Quickly With Ratios” tries to say that ratios can be an invaluable tool for making an investment decision. Even so many new investors would rather leave their decisions to fate than try to deal with the intimidation of financial ratios. The truth is that ratios aren’t that intimidating, even if you don’t have a degree in business or finance. Using ratios to make informed decisions about an investment makes a lot of sense, once you know how use them.
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