What Is The Purpose and Importance Of Financial Analysis

What Is The Purpose and Importance Of Financial Analysis?

Last updated on 10th Oct 2020, Artciles, Blog

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The process of reviewing and analyzing a company’s financial statements to make better economic decisions is called analysis of financial statements. In other words, the process of determining financial strengths and weaknesses of the entity by establishing the strategic relationship between the items of the balance sheet, profit and loss account, and other financial statements.

The term ‘analysis’ means the simplification of financial data by methodical classification of the data given in the financial statements, ‘interpretation’ means, ‘explaining the meaning and significance of the data so simplified.’ However, both’ analysis and interpretation’ are interlinked and complementary to each other.

Significance of Financial Analysis

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Finance Manager

Analysis of financial statements helps the finance manager in:

  • Assessing the operational efficiency and managerial effectiveness of the company.
  • Analyzing the financial strengths and weaknesses and creditworthiness of the company.
  • Analyzing the current position of financial analysis,
  • Assessing the types of assets owned by a business enterprise and the liabilities which are due to the enterprise.
  • Providing information about the cash position company is holding and how much debt the company has in relation to equity.
  • Studying the reasonability of stock and debtors held by the company.
  • Browse more Topics under Analysis Of Financial Statements
  • Tools of Financial Analysis
  • Statements and Limitations of Financial Analysis

Top Management

Financial analysis helps the top management

  • 1. To assess whether the resources of the firm are used in the most efficient manner
  • 2. Whether the financial condition of the firm is sound
  • 3. To determine the success of the company’s operations
  • 4. Appraising the individual’s performance
  • 5. Evaluating the system of internal control
  • 6. To investigate the future prospects of the enterprise.
  • 7. Trade Payables
  • 8. Trade payables analyze of financial statements for:
  • 9. Appraising the ability of the company to meet its short-term obligations
  • 10. Judging the probability of the firm’s continued ability to meet all its financial obligations in the future.
  • 11. Firm’s ability to meet claims of creditors over a very short period of time.
  • 12. Evaluating the financial position and ability to pay off the concerns.

Lenders

Suppliers of long-term debt are concerned with the firm’s long-term solvency and survival. They analyze the firm’s financial statements

  • To ascertain the profitability of the company over a period of time,
  • For determining a company’s ability to generate cash, to pay interest and repay the principal amount
  • To assess the relationship between various sources of funds (i.e. capital structure relationships)
  • To assess financial statements which contain information on past performances and interpret it as a basis for forecasting future rates of return and for assessing risk.
  • For determining credit risk, deciding the terms and conditions of a loan if sanctioned, interest rate, and maturity date etc.

Investors

Investors, who have invested their money in the firm’s shares, are interested in the firm’s earnings and future profitability. Financial statement analysis helps them in predicting the bankruptcy and failure probability of business enterprises. After being aware of the probable failure, investors can take preventive measures to avoid/minimize losses.

Labour Unions

Labour unions analyze the financial statements:

  • To assess whether an enterprise can increase their pay.
  • To check whether an enterprise can increase productivity or raise the prices of products/ services to absorb a wage increase.

Objectives of Financial Analysis

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Let us look at some of the main objectives of financial analysis,

  • 1. Reviewing the performance of a company over the past periods: To predict the future prospects of the company, past performance is analyzed. Past performance is analyzed by reviewing the trend of past sales, profitability, cash flows, return on investment, debt-equity structure and operating expenses, etc. 
  • 2. Assessing the current position & operational efficiency: Examining the current profitability & operational efficiency of the enterprise so that the financial health of the company can be determined. For long-term decision making, assets & liabilities of the company are reviewed. Analysis helps in finding out the earning capacity & operating performance of the company.
  • 3. Predicting growth & profitability prospects: The top management is concerned with future prospects of the company. Financial analysis helps them in reviewing the investment alternatives for judging the earning potential of the enterprise. With the help of financial statement analysis, assessment and prediction of the bankruptcy and probability of business failure can be done.
  • 4. Loan Decision by Financial Institutions and Banks: Financial analysis helps the financial institutions, loan agencies & banks to decide whether a loan can be given to the company or not. It helps them in determining the credit risk, deciding the terms and conditions of a loan if sanctioned, interest rate, maturity date etc.

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