[Chapter Summary: financial Statement analysis] | |
Chapter Summary: Financial Statement Analysis
Key Concepts and Objective * Financial Statement Analysis: Meaning, Users and Purpose * Methods of Analysis * Measures of Debt Paying Ability. * Measures of Profitability. * * Limitations of financial statement analysis.
Financial Statement Analysis: Meaning, Users and Purpose
The primary objective of accounting is to provide information useful for decision making. To provide information that supports this objective, the types of decisions different users make with financial statement must be considered.
Presentation of financial statements is an important part in accounting process and aims to provide meaningful information to enable the owners, investors, creditors or users of financial statements in evaluating the financial standing and efficiency of a business during the particular period. In order to make the purposeful decisions about the profitability and financial soundness of the business it is essential to consider analysis and interpretation of financial statements.
Financial statement analysis and interpretation refer to the process of establishing meaningful relationship between the items of the two financial statements with the objective of identifying the financial and operational strengths and weaknesses.
The users of financial statement information include: * Managers: Interested in analyzing the performance of the business often uses financial information for forecasting, budgeting and controlling decisions. * Creditors: Interested in evaluating the solvency or the ability of business to meet its debts and its operating cycle. * Stockholders: Interested in accessing the wellbeing of the business and keen in knowing the earning capacity and its future prospect to grow. * Potential investors: Interested in profitability of the business and the assets it holds. * Regulatory agencies: Government and their agencies need financial information to regulate the activities of the enterprises/ industries and determine taxation policy. They suggest measures to formulate policies and regulations.
The analysis and interpretation of financial statements is very essential to measure the efficiency, profitability, financial soundness and future prospects of the business units. Financial analysis serves the following purposes * Measuring Profitability * Assessing the growth of business * Comparative position in relation to other firms * Assess overall financial strength * Access solvency of the firm
Method of Analysis
Financial statement analysis focuses primarily on isolating information useful for making a particular decision. The information required usually involves comparisons, such as comparing changes in the same item for the same company over a number of years, comparing key relationships within the same year, or comparing the operations of several different companies in the same industry. There are three categories of analysis methods: horizontal, vertical, and ratio.
Horizontal analysis, also called trend analysis, refers to studying the behavior of individual financial statement items over several accounting periods. These periods may be several quarters within the same fiscal year or several different years. The analysis of a given item may focus on trends in the absolute dollar amount of the item or trends in percentages.
The absolute amounts of particular financial statement items have many uses. Financial statement users with expertise in particular industries might evaluate amounts reported for research and development costs to judge whether a company is spending excessively or conservatively. Users are particularly concerned with how amounts change over time. For example, a user might compare a pharmaceutical company’s revenue before and after