Objectives of Analysis of Financial Statements

The purpose of analysing financial statements is not merely to read the numbers, but to understand the story behind them. A set of financial statements — the Balance Sheet and the Statement of Profit and Loss — presents the end result of a year’s transactions. Analysis digs beneath that surface to answer why the result is what it is, and what it means for the future.

The core objective is to reveal important facts about managerial performance and the overall efficiency of the firm. In broad terms, analysis helps you:

• Understand the information contained in the financial statements.
• Identify the weaknesses and strengths of the firm.
• Make a forecast about future prospects.

This understanding enables analysts — whether they are managers, investors, creditors, or regulators — to take decisions regarding the firm’s operations and further investment in it.

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Specific Objectives of Analysis

The textbook lists five precise purposes for which analysis is undertaken:

1. To assess current profitability and operational efficiency. This is about judging the financial health of the firm as a whole, and also of its different departments. You want to know: Is the firm making enough profit? Are its operations running smoothly and cost-effectively?

2. To ascertain the relative importance of different components of the financial position. A Balance Sheet contains many items — fixed assets, current assets, long-term debt, current liabilities. Analysis helps you see which components are large or small relative to the whole. For example, is the firm too heavily dependent on borrowed funds? Is too much money tied up in inventory?

3. To identify the reasons for change in profitability or financial position. A firm’s profit may have fallen from last year, or its debt may have increased. Analysis helps pinpoint the cause — was it a fall in sales, a rise in cost of goods sold, or an increase in administrative expenses? This is the diagnostic purpose.

4. To judge the ability of the firm to repay its debt. This involves assessing both:

   • Short-term liquidity: Can the firm pay its current liabilities as they fall due (e.g., pay suppliers, meet payroll)?
   • Long-term solvency: Can the firm meet its long-term obligations (e.g., repay bank loans, debentures)? …