Define ‘Financial Statement Analysis’. Explain the important methods of Financial Analysis.
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Answer:
Financial statement analysis is the process of reviewing and analyzing a company's financial statements to make better economic decisions. These statements include the income statement, balance sheet, statement of cash flows, and a statement of changes in equity. Financial statement analysis is a method or process involving specific techniques for evaluating risks, performance, financial health, and future prospects of an organization.[1]
It is used by a variety of stakeholders, such as credit and equity investors, the government, the public, and decision-makers within the organization. These stakeholders have different interests and apply a variety of different techniques to meet their needs. For example, equity investors are interested in the long-term earnings power of the organization and perhaps the sustainability and growth of dividend payments. Creditors want to ensure the interest and principal is paid on the organizations debt securities when due.
*important methods of Financial Analysis.
1. Horizontal and vertical analysis
When using the horizontal analysis method, financial information is compared over a sequence of reporting periods. The vertical analysis method allows analyzing financial information in a proportional manner, where every line item on a financial statement is recorded as a proportion of another item. Naturally, this implies that each line item detailed on the income statement is quantified as a proportion of gross sales, whereas each line item detailed on a balance sheet is quantified as a proportion of total assets.
2. Ratio analysis
Ratios are used to calculate the comparative size of a number in relation to another number. After a ratio is calculated, it can be used to compare a similar ratio calculated for a previous period, or a ratio founded on an average of a particular industry in order to establish whether the company’s performance is in harmony with set expectations. In a typical financial analysis exercise, the majority of ratios will be within set expectations while a few will highlight potential issues, thereby attracting the reviewer’s attention. Ratios have been generalized into four categories namely: liquidity ratios, activity ratios, leverage ratios, and profitability ratios.
3. Trend analysis
This entails reviewing financial statements of three or more periods, an extension of horizontal analysis. The earliest year in the set data represents the base year. In trend analysis, users assess statements for incremental change patterns. A change in financial statements can indicate that there are either increased income or decreased expenses.