Question

Module 8: Financial Statement Analysis

explain the purpose of financial statement analysis, describe the primary techniques used in financial statement analysis, and finally, discuss the problems associated with financial statement analysis.

• Write a minimum of 300 and a maximum of 350 words.

Answer 1

Financial statement analysis helps to evaluate financial performance of company with respect to other companies in the same industry or historical data. Profitability, debt repaying capacity, solvency,leverage , operational efficiency,etc are checked in this analysis.

Various methods of Financial analysis are

1. Ratio analysis:
The Ratios like Profitability ratios, Liquidity ratios, activity ratios, Debt Ratios,P/E ratio etc can help in identifying the performance of nay company. However these ratios are meaningful only when compared with the industry benchmark. It also pinpoints the area of concern for a company.

2. Horizontal and Vertical Analysis: Horizontal Analysis is comparing the financial statements over a period of time and analyzing whether a company is improving or performing poorly with respect to previous years.
Vertical analysis is converting all items in balance sheet in proportion to total assets and all items in income statement to sales.This helps in identifying the assets as proportion to total assets.

3. Technical Analysis : It focuses on the trend line or historical data to forecast or predict the future performance of company without any qualitative inputs.It is based on historical trends.

Problems of financial statement analysis are
1. It focuses on historical data and is used to predict future growth or performance of a firm which may be wrong.
2. It ignores qualitative analysis it doesn't take into account the differences due to accounting practice. The inventory calculation methods are not taken into consideration. Higher current assets may not show the true picture as higher current assets may be due to higher obsolete inventory.
3.It is Indicator only of the problem: They indicate only the problem and not the cause of the problem and does not provide solution to any financial problem.
4. Financial statement analysis lone cannot be used for valuation of companies. It might provide faulty valuations.