Financial statements are the way management communicates with the outside world on the financial performance and financial position of a business. They paint a picture to the outside world of how a business has performed over time or the state of the businesses assets and liabilities at a particular position in time. Financial statements, of course, have various user groups all with different needs. These vary from assessing management’s stewardship of resources, gauging operational efficiency, forecasting, assessing information for decision making, making dividend decisions and assessing solvency of a business. Let us define financial statement analysis to understand financial statement analysis objectives.
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What Is Financial Statement Analysis?
Financial statement analysis is the processing of numerical information contained within financial statements to gain a qualitative appreciation of the meaning of the quantitative data. Sometimes referred to as ratio analysis it provides us with a way to understand the meaning of the results presented in financial statements. A company that reports $100 million in profit seems to be doing well on the surface but if you heard the company had $10 billion of assets at their disposal this amounts to a 1% return on assets which is not good. In short, we can say the objective of financial statement analysis is to make sense of financial statement information.
Types Of Financial Statement Analysis Ratios
In the aid of understanding financial statement analysis objectives, we can also look at the type of financial statement analysis ratios that are used in the process. There are five main types of financial statement analysis ratios namely Price, Profitability, Liquidity, Debt and Efficiency ratios.
These are used to compare the value of company shares or business valuation to its assets and income. Useful in buying or investing scenarios.
Profitability ratios look at how well investing in a company or business rewards those who have done so.
Liquidity ratios are concerned with the ability of a business to meet it’s short term obligations such as interest and tax.
Debt ratios look into how reliant a business is on debt for financing as debt has implications on solvency, tax and rate of return to owners.
Efficiency ratios are all about divining how well management has used the resources available to them.
Now that we know the types of ratios and what sort of information they intend to divine from financial statement analysis we can comfortably state eight objectives of financial statement analysis.
To Assess The Earning Capacity Or Profitability Of The Firm
Owners of a business, employees and prospective investors are all concerned with the profitability of a business. For owners, it represents investment performance as it does for potential investors. Employees find profitability an important measure as it represents long term employment viability and there may be performance-related pay arrangements. Assessing business profitability is an important objective of financial statement analysis.
To assess the operational efficiency and managerial effectiveness.
Efficiency ratios paint a picture of how well management has done with resources availed to them by business owners. Because owners may not be involved in the day to day running. They need to measure management performance in this regard. Assessing management efficiency is a very important objective of financial statement analysis. If performance is poor a decision must be made to change management. Conversely, good performance should be rewarded.
To Assess The Short Term As Well As Long Term Solvency Position Of The Firm
In the short term, it is often referred to as liquidity, this is the ability to meet payments. Liquidity and solvency are important concerns to owners, lenders and trade creditors. In a precarious situation, they are of concern to employees too. The objective of financial statement analysis on liquidity and solvency is to assess the viability and going concern status particularly for those who have lent to or plan to lend to a business. The ability to meet Interest payments is also of concern here.
To Identify The Reasons For The Change In Profitability And Financial Position Of The Firm.
Seeing a change in profit or performance is not enough. A responsible investor or director needs to dig deeper and understand the reasons behind such changes. Take the example of a mining business that has increased profit only to find the increase was not due to management efficiency but an increase in mineral prices. It may not be right to award bonuses to management alone under such circumstances.
To Make The Inter-Firm Comparison.
Investors and business owners alike tend to have their eye on more than one business at a time. Whether it is an alternative investment option or a competitor in the same market, there are many cases in which the objective of financial statement analysis is to compare businesses. In cases like this financial analysis ratios give a similar scale upon which to measure businesses. Return on equity, for example, is expressed as a percentage.
To Make Forecasts About The Prospects Of The Firm
This financial statement analysis objective is common with potential investors, owners, lenders, creditors and employees. Ratios such as the internal growth rate and sustainable growth rate look to estimate how much a business will grow in the future. This can inform whether to invest or divest, increase or decrease lending and other decisions.
To Assess The Progress Of The Firm Over Time.
Potential investors and owners do not only compare to other businesses but also want to compare the businesses performance over time. Seeing an increase in profit doesn’t tell the whole story as management may have more resources available than in previous periods. The financial statement analysis objective of comparing performance with previous periods is assisted by providing standardized measures of performance, profitability and Efficiency.
To Guide Or Determine The Dividend Action
Dividends are profits paid out to shareholders. This is a very important measure of return on investment. Potential investors and current investors have a financial statement analysis objective of gaining an understanding of dividend direction through measures such as dividend yield which compares the dividend paid out to the price of buying the shares.
In conclusion, the objectives of financial statement analysis vary with the particular users of the financial statements. Users may seek an understanding of the price, profitability, solvency, efficiency and financing of a business. Financial statement analysis objectives differ from user to user but ultimately the goal is to provide information for decision making