Question

Why does the management of any companies analyze financial statements? Explain by using the different tools in analyzing financial statement with proper numerical example.

Answer 1

Management of a company needs to analyze Financial Statements to manage the affairs of the company by assessing its financial performance and position and taking important business decisions.

Most commonly used tools of financial statement analysis are:

1. Comparative statements: This tool is basically used to compare the performance of the company and how it compares to its previous year or years. Comparative statements are also known as Horizontal anaylsis because each and every line item is compared to previous 2 or more years. It gives a clear understanding of a company's financial performance and position over the years.

2. Common Size Statement: this analysis is basically comparing the figures of the statements to a specific parameter. So, a percentage form is used where each line item is shown as a percentage of basic financial information. for example for balance sheet items it is shown as % of total assets and for Income statement it can be shown as a % of sales or revenue.

3. Ratio Analysis: Quantitative analysis of information contained in a company’s financial statements is ratio analysis. It describes the significant relationship which exists between various items of a balance sheet and a statement of profit and loss of a firm.

4. Trend Analysis: This tool is used to see the trend of the company's performance over many years. It shows whether the company is growing, loosing or stagnant. It compares some critical ratios over the years and the company's performance is measurec against previous years and decisions are taken to improvise accordingly.