Question

What is use and purpose of financial analysis?

Answer 1

Use and purposes of financial analysis :

• To know strengths and weaknesses - Financial statements i.e. profit and loss account and balance sheet shows the financial performance and financial position respectively. But they don't convey financial strengthS and weaknesses, so financial analysis helps to analyse deeply and to know the strengths and weaknesses of a business /project.
• Caters different financial users - There are different financial statement users who need to know different aspects of a business. Financial statements analysis helps different financial statement users by providing financial information in different dimensions. For example : for creditors- liquidity ratios, for shareholders - payout ratios, for government officials - revenue trends etc.
• Helps to select right alternative - Financial analysis helps to select most suitable and profitable alternative when there are multiple alternatives. For example : if a company wants to raise funds, then it has many alternatives to do so, such as equity, debt or retained earnings. In this case company selects that alternative which has less cost of capital.
• Helps for investment decisions - Financial analysis mainly used to take capital budgeting decisions. When a company wants to start a new product line then it analyses whether the new product line gives positive returns ,whether the new product has scope in future etc. That means financial analysis helps to know about viability of a new business idea.
• Helps to run business - Financial analysis helps to run business successfully. It helps to take decisions that ensures long term survival of business. For example : after making sufficient profits, the financial manager decides how much share of profits to be retained in the business and how much to distribute as dividends. This decision is taken after analysing dividend policy and expectations of shareholders.
• Helps to face future - Financial analysis helps to analyse the future trends and circumstances that affects business. This helps to get ready for the future i.e. it helps business organisations to accumulate necessary resources and helps to face the future effectively and efficiently. Because of this, business can avoid significant losses due to changes in the environment.