Significance of Analysis of Financial Statements

Financial analysis is the process of identifying a firm’s financial strengths and weaknesses by establishing relationships between items in the balance sheet and the statement of profit and loss. It can be done by the management or by outside parties — owners, trade creditors, lenders, investors, labour unions, analysts, and others. The nature of analysis changes depending on the purpose of the analyst. A technique useful for one analyst may not serve another because their interests differ.

The significance of financial analysis for different users is explained below.

(a) Finance Manager

Financial analysis focuses on facts and relationships related to managerial performance, corporate efficiency, financial strengths and weaknesses, and creditworthiness. A finance manager must be skilled in using different tools of analysis to make rational decisions. These tools help in studying accounting data to determine:

• Continuity of operating policies
• Investment value of the business
• Credit ratings
• Efficiency of operations

The techniques are also important for financial control. They allow the finance manager to constantly review actual financial operations, analyse causes of major deviations, and take corrective action wherever needed.

(b) Top Management

The importance of financial analysis is not limited to the finance manager. It extends to top management and other functional managers. Management is interested in every aspect of financial analysis because it is their overall responsibility to ensure that the firm’s resources are used most efficiently and that its financial condition is sound. Financial analysis helps management in:

• Measuring the success of the company’s operations
• Appraising individual performance
• Evaluating the system of internal control

(c) Trade Payables

Trade payables (creditors) use financial analysis to appraise not only the company’s ability to meet short-term obligations but also its continued ability to meet all financial obligations in the future. They are particularly interested in the firm’s ability to pay their claims over a very short period. Their analysis therefore evaluates the firm’s liquidity position.

(d) Lenders

Suppliers of long-term debt are concerned with the firm’s long-term solvency and survival. They analyse:

• Profitability over a period of time
• Ability to generate cash to pay interest and repay principal
• Relationship between various sources of funds (capital structure relationships)

Long-term lenders study historical financial statements to assess future solvency and profitability.

(e) Investors

Investors who have put money into the firm’s shares are interested in the firm’s earnings. They concentrate on analysing present and future profitability. They are also interested in the capital structure to understand its influence on earnings and risk. They evaluate the efficiency of management and decide whether a change is needed. In large companies, shareholders’ interest may be limited to deciding whether to buy, sell, or hold the shares.

(f) Labour Unions

Labour unions analyse financial statements to assess:

• Whether the firm can presently afford a wage increase …