The term ‘financial statement analysis ‘refers to the process of determining the financial position of the firm by reviewing and analyzing the items of the balance sheet, profits and loss account, cash flow statement, funds flow statements, etc.
The purpose of the financial analysis is to understanding the financial health of the company so as to judge the profitability of the firm. There are several groups or stakeholders who are interested in the analysis of financial statements.
Owners are interested to know how their business is performing and trends help them to determine if to expand the business or discontinue a particular product or service. Investors are interested in knowing whether it is worth investing in the shares of a particular company. Similarly, bankers, lenders and financial institutions want to gauge the financial performance and position before offering their financial assistance in the form of loans and advances.
Just like a doctor examines his patient by recording is body temperature, blood pressure, etc, before making the conclusion regarding the illness and giving his treatment, a financial analyst uses various types of tools to judge the soundness of the firm.
Tools/ Methods or Devices of Financial Analysis
- Comparative statements – In this method, either the financial statements of two or more years are presented in a comparative form or they are presented for two or more firms for the same years. It helps to understand which year performed better or which firm performed better.
- Trend analysis – In this method, the trend of particular income or expense is observed for several years and compared with income or profitability to ensure whether the movement is justified or it is abnormal.
- Common size statements – In this analytical tool, all expenses and revenues are compared to sales in the percentage form.
- Fund flow analysis – It helps to analyse sources and applications of funds.
- Cash flow analysis – Cash flow analysis helps to analyse cash and non-cash activities to ascertain net actual cash movement happened during the year.
- Ratio analysis – This is the most popular and powerful tool which can be used to analyse several performance-related indicators such as sales, profitability, return on investment, share price etc.
- Cost-volume- profits analysis – It is a management accounting tool to ascertain contribution margin.