Nature of Financial Statement Analysis
Financial Statement Analysis is the art and science of examining and drawing inferences from the financial statements. Financial analysis is also known as analysis and interpretation of financial statements. It refers to the process of determining financial strengths and weaknesses of the firm by studying the relationship between the items of the balance sheet, profit and loss account, and the other operative data. Myers says, "Financial statement analysis is largely a study of relationship among the various financial factors in a business as disclosed by a single set of statements, and a study of the trend of these factors as shown in a series of statements."
The term "financial statement analysis" contains both 'analysis' and 'interpretation'. Therefore, a distinction should be made between the two terms. The term analysis is used to mean the simplification of the financial data by methodical classification of the data given in the financial statements; on the other hand, interpretation means, "explaining the meaning and significance of the data so simplified." Analysis and interpretation are interlinked and complimentary to each other. Both are interdependent. Most writers use only the term 'analysis' to cover the meaning of both analysis and interpretation as the objective of analysis is to study the relationship between various items of financial statements by interpretation. The usage of the term "financial statement analysis" or simply "financial analysis" is to cover the meaning of both analysis and interpretation.
Financial analysis can be used as a preliminary screening tool in the selection of stocks in the secondary market. It can be used as a forecasting tool of future financial conditions and results. It may be used as a process of evaluation and diagnosis of managerial, operating or other problem areas. Above all, financial analysis reduces reliance on intuition, guesses and thus narrows the areas of uncertainty that is present in all decision-making processes. Financial analysis does not lessen the need for judgment but rather establishes a sound systematic basis for its rational application. There are several methods used in analyzing financial statement, such as comparative statements, trend analysis, common size statements, funds flow and cash flow analysis, cost-volume-profit analysis, and ratio analysis.
As a doctor examines a sick person by measuring his temperature, blood pressure, etc., before making his dignosis regarding the sickness and before giving his treatment, likewise, the financial analyst also analyzes the financial statements with various tools of analysis before drawing conclusions about the financial health or weakness of an enterprise. The purpose of the analysis and interpretation of financial statements is essential to bring out the mystery behind the figures in financial statements.
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