Financial Statement Analysis — Meaning and Objectives

A balance sheet that reports 'sundry debtors 3,00,000' or a profit and loss statement that reports 'net profit 2,50,000' states a fact, but a single fact in isolation says very little. Is 2,50,000 a good profit? That depends on the sales that produced it, the capital employed to earn it, and the profit earned in earlier years. Financial statement analysis is the process of critically examining and interpreting the figures in the financial statements so that their real meaning becomes clear.

More formally, financial statement analysis is the process of establishing meaningful relationships between the items of the financial statements, and of comparing them — over time, or against a standard — so as to arrive at conclusions about the profitability, financial position, solvency and operational efficiency of a business. It has two closely linked parts: analysis, the methodical breaking-up and re-arrangement of the figures (into comparative statements, percentages, ratios, trends), and interpretation, the drawing of reasoned conclusions from what the re-arranged figures reveal. Analysis without interpretation is a set of numbers; interpretation without analysis is guesswork — the two must go together.

Objectives of financial statement analysis

1. To assess the profitability (earning capacity) of the business — how much profit it earns in relation to its sales and to the capital invested in it.
2. To assess the financial position of the business — the composition of its assets and the sources from which they are financed.
3. To judge the short-term solvency (liquidity) — the firm's ability to meet its current obligations as they fall due.
4. To judge the long-term solvency — the firm's ability to meet its long-term debts and the safety margin available to long-term lenders.
5. To measure operational efficiency — how effectively the firm is using its assets and controlling its costs.
6. To make inter-firm and intra-firm comparisons — comparing the firm with its own past (intra-firm) and with other firms in the same industry (inter-firm). …