Objectives of Financial Statement Analysis

The main objective of the financial statement analysis for any company is to provide the necessary information required by the financial statement users for informative decision-making, assessing the current and past performance of the company, predicting the success or failure of the business, etc.

Financial statement analysis techniques are crucial for assessing a company's health and making investment decisions. It gives insights into profitability, liquidity, and solvency. However, its limitations include dependence on historical data, potential manipulation, and varying accounting practices. While it helps in decision-making, caution is necessary to interpret results accurately.

Financial statements analysis ratios are important for all stakeholders. Investors need to analyze the financial statements before making any investment in the company. Same way, banks will be more comfortable granting loans to those companies whose financial books are well maintained and show a clear picture of their profits. This makes them more confident that the company will be able to pay future debt obligations.

Government agencies have their self-interest in the financials of the company. The collection of taxes from the companies is done on the basis of information provided by the accounting department of the company. Companies have to submit tax returns on a quarterly basis, which are analyzed by government authorities.

Overall the financial statement analysis makes a difference in the performance of companies. Companies with regular analysis of financials can intercept their problems within time and can opt for a strategy that can help them attain their future targets.

Also, companies with a better understanding of their financials can cope with the worst business scenarios in a better way as they know the financial strength of their balance sheet.

Each type of financial statement analysis techniques serves a specific purpose, collectively giving stakeholders and shareholders a comprehensive understanding of a company's financial position, performance, and potential future trajectory.

• Horizontal Analysis: This analysis compares financial data across different periods to identify trends, changes, or fluctuations. It calculates the percentage change in individual line items over time to assess the direction and magnitude of variations.
• Vertical Analysis: Under this analysis, an evaluation of each line item as a percentage of a base figure is done, often taking total revenue or total assets as the reference point. This provides insights into the composition and structure of financial statements, enhancing the understanding of the relative significance of different components.
• Ratio Analysis: It examines the relationships between various financial statement items, such as liquidity, profitability, and leverage ratios. By utilizing quantitative metrics to assess a company's performance, financial health, and efficiency, this analysis derives its answers.
• Trend Analysis: It assesses financial data over an extended period, identifying patterns and tendencies that may indicate the company's direction and stability. It is an attempt to make predictions about future financial performance based on historical trends.

Let us understand the top 4 objectives of financial statement analysis ratios through the detailed explanation below.

#1 - To know the Current Position

Promoters/owners want to know whether the company is heading in the right direction or lagging in their targets, which they have planned in the past. Regular recording of financial transactions helps them understand their financial position and helps them analyze prospects better.

Example: Suppose the company had previously planned to double its revenues over the next five years. We have revenue data for the company for the last four years.

As you can see in the above example, the company is performing well in the first two years. Therefore, it looks like it will reach the desired target or perform better than its desired target. But in the FY 2018-19, the company's revenue growth declined to single-digit levels, i.e., around 6% on a YoY basis.

The decline in revenue will cause concern for the management, but they will be able to gear up their team in time to work more efficiently to reach their target.

#2 - Eliminating Discrepancies if any

Recording of day-to-day transactions, i.e., sales and purchases, expenses or incomes, or other statements, helps them understand where they need to improve and make quick decisions in case of any discrepancies.

Example 1: Suppose a company named A has targeted sales of 1500 crores in this financial year. The quarterly sales report shows just 300 crores in the first quarter.

The above example shows the revenue earned by ABC Ltd. each month. During the first three months, the revenue numbers increased, but there was a consistent decline in the revenue after that. Therefore, maintaining each month's revenue will help the management get engaged with the sales team and find out the reasons for the fall in revenue numbers, eliminate discrepancies, and act accordingly to stop the dip in revenue numbers and try to reach the target as planned.

Example 2:

The above example shows that the firm's profit increases, but due to excess expenses, the ratio of the increase in net profits to increased gross profit is less.

Gross profit increased by approximately 25%, whereas net profit increased by just 13-14%. Therefore, recording and analyzing will help them eradicate the errors in the future due to which there is a decrease in net profits from the actual expected.

#3 - Future Decision Making

Quarterly statements like sales book, purchase, trading a/c or manufacturing a/c help them execute their plans better. This provides them the opportunity to make future decisions with reliable information. There is a new practice of preparing provisional final accounts even by small companies. Analyzing financial statements on a short-term basis helps the organization to make efficient decisions.

Example:  Suppose the company's operating margin is around 12-13% for the last 7-8 quarters. But in the previous quarter, the operating margin dropped significantly to 7-8 %.

The company is performing well on the revenue front but, more precisely, maintaining the operating margin at consistent levels with an increase in sales numbers. But in the quarter ending June-19, the operating margin dips to 7%, which is way below the average of 12-13%, which the company has been managing over the last 5-6 quarters.

There may be many reasons for the fall in the operating margin like an increase in raw material, a decrease in sales price due to demand, or an increase indirect expenses like wages or electricity and the company after reviewing it will need to change the future strategy and make some decisions depending upon the reason for the fall in operating margin in the last quarter.

Financial statements help understand the reason and make future decisions depending on the situation. For example, let's assume the reason is the decreasing Sales Price. Then, management can take the necessary steps to understand future market sentiments, identify the reasons for the decrease in sales prices, and opt for a strategy based on them.

#4 - Minimize the Chances of Fraud

This is not the main objective of analyzing transactions but the one which cannot be neglected. Often we come across the news that the employee cheated his boss, which led to huge losses for the company. Analyzing the statements will make sure that the employee will be aware that the management is aware of everything happening in the company. Also, if any suspicion arises on any financial entry, management can have a look into the matter and will be able to solve it without incurring extra losses.

Example: Excess commission given by the accounts department to the company's agents, or there is a difference in the purchase of raw material. Since the company records or maintains an individual account of each supplier, they can analyze each account, which will lead to a conclusion. The company will not have to suffer losses due to the fraud done by one of its employees.

In the above example, there is a surge in the firm's conveyance expenses and general expenses. More than a three-fold increase in the expenses is a case of suspicion, and management would want to look at the voucher and verify who has to pay it, received it, and for what purpose.

Let us understand the importance of this concept through the points below.

• Financial statement analysis techniques are crucial for assessing a company's overall performance, revealing its profitability, efficiency, and effectiveness in utilizing resources.
• Investors heavily rely on this analysis to make investment decisions based on actual numbers. It helps them gauge a company's financial health, potential risks, and growth prospects.
• Lenders and creditors use them to evaluate the creditworthiness of a business. It helps in determining the likelihood of timely repayment and managing credit risk.
• Companies utilize this analysis for strategic planning. It identifies areas of strength and weakness, enabling effective decision-making to enhance financial stability and growth.
• Comparative analysis against industry standards and competitors allows companies to benchmark their performance. This insight helps in identifying areas for improvement and maintaining competitiveness in the market.
• Clear and accurate financial information enhances transparency with stakeholders, building trust with shareholders, employees, and the broader financial community.

Let us understand the limitations of financial statement analysis ratios through the discussion below.

• This analysis relies on historical financial data, limiting its ability to predict future market changes or external factors that may impact a company.
• Different companies may use diverse accounting methods, making it challenging to compare financial statements accurately. This diversity can distort the analysis and hinder meaningful comparisons.
• Companies may manipulate financial statements to present a more favorable picture. Creative accounting practices can obscure actual financial health and mislead stakeholders.
• Financial statement analysis focuses solely on monetary aspects, neglecting crucial non-financial factors such as market trends, technological advancements, or changes in leadership that may significantly impact a company.
• Financial statements primarily reflect past performance and may not capture a company's future growth potential or innovative strategies that could alter its financial landscape.
• Financial statements lack qualitative information, providing limited insights into the quality of management, employee morale, or customer satisfaction, which are essential aspects of overall business health.

This has been a guide to the Objectives of Financial Statement Analysis. Here we discuss its examples, types, importance, and limitations in detail. You can learn more about accounting from the following articles –

• Annual Financial Statements
• Limitations of Financial Statements
• Who are the Users of Financial Statements?
• Components of Financial Statements