Financial Analysis: Need, Types, and Limitations
Financial statements are prepared to know the profitability and financial position of the business in the market. These financial statements are then analysed with the help of different tools and methods. The relationship between various financial factors of a business is defined through financial analysis.
Financial Analysis can be defined as evaluating the critical financial information in the financial statements in order to understand the operations of a firm and make decisions regarding it. It is basically the analysis of various facts and figures in a financial statement and interprets it so as to increase business profits.
In other words, it means establishing relationships between various items of a financial statement and gaining useful insights. Once the data is interpreted, it can be used to find the strengths and weaknesses of a firm and work on the areas that need improvement.
Need for Financial Analysis:
Financial analysis is needed for various purposes and is very important for any organisation. Financial Analysis is needed to:
1. Measure the profitability and earning potential of a business: It helps to check whether the profits earned are up to the expectations or not. After analysing the financial statements, the trend of profit can be ascertained, and earning potential of the company can be checked.
2. Measure the financial strength of the business: It helps to understand how strong a business is financially and judge its position in the market.
3. Comparative study: Financial Analysis is helpful to compare the position of two firms in the market or compare the growth of a firm. The comparison can be further of 2 types:
- Intra-Firm: It is the comparison of the firm’s profits for the current year and the previous year, and may also be known as Trend Analysis.
- Inter-Firm: It is also termed Cross-Sectional Analysis, and is the comparison of one company to the other in the market.
4. Efficiency of management: The trend of the profits and losses of a business allows us to judge if the business is being managed efficiently or not, which means that the resources of a business are being utilised effectively or not.
5. Useful to the management: An insight into the business helps the management to make very important decisions about the business.
6. Analyse the short-term and long-term solvency: It also helps to analyse whether a business will be able to clear its short-term and long-term debts or not.
7. Reasons for deviation: To identify the reasons for any change in the profitability/financial position of the firm.
Types of Financial Analysis:
Financial Analysis of 4 types:
1. External Analysis: This type of analysis is carried out by investors, stakeholders, researchers, etc., who rely upon the information published in various reports, such as Statement of Profit and Loss, Balance Sheet, etc., as they do not have access to the internal and confidential business information.
2. Internal Analysis: As compared to external analysis, this type of analysis is performed by the internal management who have complete access to the confidential business information and can perform an extensive analysis to get detailed and accurate information.
3. Horizontal Analysis: In this type of analysis, the financial statements of several years are compared with each other in order to understand the profitability of the business and its growth. It is also termed Dynamic analysis or Time series analysis.
4. Vertical Analysis: Analysis of the financial statement of a single year is known as Vertical analysis or Static analysis or Cross-Sectional analysis. It involves the study of the relationship between various items of Statement of Profit and Loss, balance sheet, etc., in a single financial year.
Limitations of Financial Analysis:
Though financial analysis is of great importance to an organisation, it still has various limitations, which are as follows:
1. Current changes in the prices in the economy are not taken into consideration in the financial statement analysis.
2. Since the analysis is done by humans, it is prone to personal bias, and may lead to conflicts between the interpretation of the data by various experts.
3. Financial analysis is quantitative in nature and can only analyse those aspects that are related to money, and fails to analyse the non-monetary aspects.
4. Different firms may use different accounting policies, and it may not be possible to compare the two businesses in terms of financial analysis due to this.
Difference between Horizontal and Vertical Analysis:
|In this, financial statements of several years are compared against the financial statement of a base year.||In this, various aspects of the financial statement of a single year or current year are analysed or compared.|
|Same items of different years are compared.||Different items of the same year are compared.|
|It is also called Time Series Analysis or Dynamic Analysis.||It is also called Static Analysis or Cross-Sectional analysis.|
|It compares a company’s financial status over a period of time.||It compares the financial status of a company to the other in the same financial year.|
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