Define financial statement analysis. Explain the objectives of financial statement analysis.

Financial statement analysis is the systematic and critical examination of the relationship between the various elements of the financial statements, carried out to extract necessary and effective information from them and to give different users more meaningful information — because financial statements by themselves are merely a presentation of summarized data, and that data is neither meaningful nor useful until it has been properly analysed and arranged.

Its nature: it is basically a post mortem of financial transactions, done to judge the operational ability, profitability, solvency, managerial efficiency, growth potentiality and overall performance of a business; hence it is an important means of assessing past performance and of forecasting and planning future performance.

Its process: the analyst first lists down the purpose of the analysis, collects relevant data (the financial statements plus discussion with stakeholders), processes it into adjusted statements, common size statements and ratios in graphs, analyses and interprets the processed figures, develops conclusions and recommendations, and finally reviews and revises them.

Its techniques: four techniques are used — comparative financial statements (horizontal analysis), common size statements (vertical analysis), trend analysis, and ratio analysis, which is the major tool for interpretation and evaluation.

Objectives:

To assess past performance: past performance is often a good indicator of future performance, so investors and creditors examine the trends in sales, cost of goods sold, operating expenses, net income, cash flows and return on investment — these trends judge past management and hint at future results.

To assess the current position: it shows where the business stands today, revealing the types of assets owned by the enterprise and the different liabilities due against it.

To predict profitability and growth prospects: it helps assess and predict earning prospects and the growth rate in earnings, which investors use to compare investment alternatives alongside the risk or uncertainty attached to the expected return.

To predict bankruptcy and failure: through analysis of the solvency position, the probability of business failure can be predicted to a great extent, which lets managers and investors take preventive measures to avoid or minimize losses.

To make loan decisions: banks, finance companies and other lending agencies use it to make sound credit decisions — determining the credit risk and deciding the terms, the interest rate and the maturity date of the loan.

To assess operational efficiency: the actual performance revealed in the statements can be compared with the standards set earlier, and any deviation from those standards becomes an indicator of management's efficiency.

To simplify the information: it makes the disclosed information readable and understandable even to average users, through ratios, trend percentages, graphs and diagrams.

Hence financial statement analysis converts raw accounting data into intelligence: it tells management, investors, lenders and the government not merely what the figures are, but what they mean — though it must be remembered that it only diagnoses problems and cannot cure them, and that it ignores qualitative aspects and cannot adjust for price level changes.