Financial Statement Analysis: Meaning, Objectives and Limitations | Firm (2024)

Let us make in-depth study of the meaning, objectives, parties interested, and limitations of financial statement analysis.

Meaning of Financial Statement Analysis:

The term ‘financial analysis’, also known as analysis and interpretation of financial statements’, refers to the process of determining financial strengths and weaknesses of the firm by establishing strategic relationship between the items of the balance sheet, profit and loss account and other operative data.

“Analyzing financial statements,” according to Metcalf and Titard, “is a process of evaluating the relationship between component parts of a financial statement to obtain a better understanding of a firm’s position and performance.”

In the words of Myers, “Financial statement analysis is largely a study of relationship among the various financial factors in a business as disclosed by a single set-of statements and a study of the trend of these factors as shown in a series of statements.”

The purpose of financial analysis is to diagnose the information contained in financial statements so as to judge the profitability and financial soundness of the firm. Just like a doctor examines his patient by recording his body temperature, blood pressure, etc. before making his conclusion regarding the illness and before giving his treatment, a financial analyst analysis the financial statements with various tools of analysis before commenting upon the financial health or weaknesses of an enterprise.

The analysis and interpretation of financial statements is essential to bring out the mystery behind the figures in financial statements. Financial statements analysis is an attempt to determine the significance and meaning of the financial statement data so that forecast may be made of the future earnings, ability to pay interest and debt maturities (both current and long-term) and profitability of a sound dividend policy.

The term ‘financial statement analysis’ includes both ‘analysis’, and ‘interpretation’. A distinction should, therefore, be made between the two terms. While the term ‘analysis’ is used to mean 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 complimentary to each other Analysis is useless without interpretation and interpretation without analysis is difficult or even impossible.

Most of the authors have used the term ‘analysis’ only to cover the meanings of both analysis and interpretation as the objective of analysis is to study the relationship between various items of financial statements by interpretation. We have also used the term ‘Financial statement Analysis or simply ‘Financial Analysis’ to cover the meaning of both analysis and interpretation.

Objectives and Importance of Financial Statement Analysis:

The primary objective of financial statement analysis is to understand and diagnose the information contained in financial statement with a view to judge the profitability and financial soundness of the firm, and to make forecast about future prospects of the firm. The purpose of analysis depends upon the person interested in such analysis and his object.

However, the following purposes or objectives of financial statements analysis may be stated to bring out the significance of such analysis:

(i) To assess the earning capacity or profitability of the firm.

(ii) To assess the operational efficiency and managerial effectiveness.

(iii) To assess the short term as well as long term solvency position of the firm.

(iv) To identify the reasons for change in profitability and financial position of the firm.

(v) To make inter-firm comparison.

(vi) To make forecasts about future prospects of the firm.

(vii) To assess the progress of the firm over a period of time.

(viii) To help in decision making and control.

(ix) To guide or determine the dividend action.

(x) To provide important information for granting credit.

Parties Interested in Financial Analysis:

The following parties are interested in the analysis of financial statements:

(1) Investors or potential investors.

(2) Management.

(3) Creditors or suppliers.

(4) Bankers and financial institutions.

(5) Employees.

(6) Government.

(7) Trade associations.

(8) Stock exchanges.

(9) Economists and researchers.

(10) Taxation authorities

Limitations of Financial Statement Analysis:

Financial analysis is a powerful mechanism of determining financial strengths and weaknesses of a firm. But, the analysis is based on the information available in the financial statements. Thus, the financial analysis suffers from serious inherent limitations of financial statements.

The financial analyst has also to be careful about the impact of price level changes, window-dressing of financial statements, changes in accounting policies of a firm, accounting concepts and conventions, and personal judgment , etc.

Some of the important limitations of financial analysis are, however, summed up as below:

(i) It is only a study of interim reports

(ii) Financial analysis is based upon only monetary information and non-monetary factors are ignored.

(iii) It does not consider changes in price levels.

(iv) As the financial statements are prepared on the basis of a going concern, it does not give exact position. Thus accounting concepts and conventions cause a serious limitation to financial analysis.

(v) Changes in accounting procedure by a firm may often make financial analysis misleading.

(vi) Analysis is only a means and not an end in itself. The analyst has to make interpretation and draw his own conclusions. Different people may interpret the same analysis in different ways.