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Financial Analysis: Uses, Importance, Limitations

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  • Last Updated : 27 Sep, 2022
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Finance is the lifeline of a business. Without the appropriate availability of finance, a business idea remains only an idea. It comes into shape only when sufficient funds are parked into it. However, only establishing a business and recording the transactions is not enough. The proprietor has to be getting some kind of return on his investment because parking funds in a business idea that does not yield any or very low returns or profits is not beneficial to the investor.

Meaning:

An analysis is defined as scrutinising or carefully examining something and drawing results. Thus, financial analysis implies assessing the monetary or financial aspects or transactions happening in an organisation and observing the net result of such transactions, i.e., examining whether they resulted in profit or loss. In other words, the evaluation of a business project or idea for its viability, feasibility, stability, and profitability is called financial analysis. The idea of financial analysis is not restricted to a single, isolated business project or idea, rather it extends to the entire business organisation, its budgets, portfolios, and other finance-related transactions. The idea is to determine the suitability and the profitability of all such transactions. Almost every organisation requires the use of such analysis to determine whether it is stable, solvent, and liquid enough to warrant a monetary investment.

According to Finney and Miller “Financial analysis consists in separating facts according to some definite plan, arranging them in groups according to certain circumstances and then presenting them in a convenient and easily readable and understandable form.”

Uses of Financial Analysis:

1. Security analysis: Securities are defined as tradeable financial instruments used by corporations to raise funds. These include shares, debentures, bonds, derivatives, hybrids, etc. Security analysis deals with the determination of the exact value of these securities for the corporation, as well as the costs to the company in raising funds from these securities. Financial analysis helps in ascertaining all such values by way of comprehensive scrutiny of all transactions related to securities, like the floating costs, brokerage, dividend and interest percentages, etc.

2. Credit analysis: Credit analysis is used by the lenders of an organisation to determine the level of security of their lending. In other words, credit analysis is used to check whether the firm would be able to repay its debts or go bankrupt in the near future. It is done using solvency ratio analysis such as debt-equity ratio, proprietary ratio, etc. 

3. Debt analysis: Debt analysis is the calculation of the proportion of debt to the assets owned by an organisation. It is used to determine if the given assets would be sufficient in order to repay the debt taken. Ratio analysis is the most commonly used parameter for debt analysis. Matrices like solvency ratios are employed to compute the proportion of assets to debt and interpreted accordingly. 

Importance of Financial Analysis:

1. Assessing the Financial Performance and Position: Financial data does not make any meaningful contribution unless it is analysed. Financial performance over the years can be analysed with the help of comparative statements of profit and loss, wherein the revenues and expenses of the current year and previous year are recorded side-by-side to calculate the percentage shift between the two. Similarly, the financial position is analysed using comparative balance sheets.  

2. Operational Efficiency: Financial analysis consists of ratio analysis and other techniques used to study the financial statements of a business and to draw conclusions thereof. Ratio analysis, especially the activity ratios help to determine the operational efficiency of the business. Operational efficiency can be judged with the help of inventory turnover ratio, working capital turnover ratio, operating ratio, operating profit ratio, etc.

3. Indicating Growth Trends: Comparative statements of profit and loss and balance sheets are used to reflect the percentage changes in the facts and figures recorded in those statements. This helps the users of financial statements judge how the organisation has grown or faced losses over the years. Moreover, ratio analysis such as net profit ratio, return on investment, etc., also facilitates disclosing the growth pattern over the years.

4. Trend Forecasting: This method examines patterns in the operating efficiency and financial standing of the company over a long period of time. In this study, a single year is used as the base year, with the remaining years’ results given as a percentage of the base year. Along with determining the firm’s operational effectiveness and financial status, it aids in problem identification and inefficiency detection.

5. Facilitates Comparison: Another important advantage of financial analysis is that it facilitates comparison both inter and intra-firm. Inter-firm comparison means comparing two or more business units that are similar in nature in order to derive a competitive position to facilitate improvement in performance and productivity, ultimately improving profitability. Intra-firm comparison means comparison among different units or products of the same business with the purpose of competitive and meaningful analysis to improve the efficiency of all departments in the business. 

6. Provides Information to Stakeholders: Financial data does not make any meaningful contribution unless it is analysed. The figures recorded in financial statements only provide useful info when compared with other years’ figures and are analysed and interpreted thereafter to communicate the results to the users of such information. Without financial analysis techniques, numbers are just numbers. They are studied and scrutinized to make the results comprehensible and comparable. 

Limitations of Financial Analysis:

Since financial analysis relies entirely upon the data recorded in the financial statements, it suffers from the limitations inherent in financial statements. These are:

1. Financial analysis ignores price level changes since it is based on the historical cost concept of accounting.

2. Qualitative aspects, such as the quality of employees and management, etc., are overlooked since financial statements only keep records of quantitative aspects of the transactions. 

3. Financial statements often involve personal bias, judgments, and prejudices of the accountant. Hence, the results of the analysis of such biased statements are not fair. 

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