Financial Analysis: Need, Types, and

Limitations
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Financial statements are prepared to know the profitability and financial position of the
business in the market. These financial statements are then analysed with the help of
different tools and methods. The relationship between various financial factors of a
business is defined through financial analysis.
Financial Analysis can be defined as evaluating the critical financial information in the
financial statements in order to understand the operations of a firm and make decisions
regarding it. It is basically the analysis of various facts and figures in a financial
statement and interprets it so as to increase business profits.
In other words, it means establishing relationships between various items of a financial
statement and gaining useful insights. Once the data is interpreted, it can be used to find
the strengths and weaknesses of a firm and work on the areas that need improvement.

Need for Financial Analysis:

Financial analysis is needed for various purposes and is very important for any
organisation. Financial Analysis is needed to:
1. Measure the profitability and earning potential of a business: It helps to check
whether the profits earned are up to the expectations or not. After analysing the financial
statements, the trend of profit can be ascertained, and earning potential of the company
can be checked.
2. Measure the financial strength of the business: It helps to understand how strong a
business is financially and judge its position in the market.
3. Comparative study: Financial Analysis is helpful to compare the position of two
firms in the market or compare the growth of a firm. The comparison can be further of 2
types:
 Intra-Firm: It is the comparison of the firm’s profits for the current year and the
previous year, and may also be known as Trend Analysis.
 Inter-Firm: It is also termed Cross-Sectional Analysis, and is the comparison of one
company to the other in the market.
4. Efficiency of management: The trend of the profits and losses of a business allows us
to judge if the business is being managed efficiently or not, which means that the
resources of a business are being utilised effectively or not.
5. Useful to the management: An insight into the business helps the management to
make very important decisions about the business.
6. Analyse the short-term and long-term solvency: It also helps to analyse whether a
business will be able to clear its short-term and long-term debts or not.
7. Reasons for deviation: To identify the reasons for any change in the
profitability/financial position of the firm.

Types of Financial Analysis:

Financial Analysis of 4 types:

1. External Analysis: This type of analysis is carried out by investors, stakeholders,
researchers, etc., who rely upon the information published in various reports, such as
Statement of Profit and Loss, Balance Sheet, etc., as they do not have access to the
internal and confidential business information.
2. Internal Analysis: As compared to external analysis, this type of analysis is
performed by the internal management who have complete access to the confidential
business information and can perform an extensive analysis to get detailed and accurate
information.
3. Horizontal Analysis: In this type of analysis, the financial statements of several years
are compared with each other in order to understand the profitability of the business and
its growth. It is also termed Dynamic analysis or Time series analysis.
4. Vertical Analysis: Analysis of the financial statement of a single year is known as
Vertical analysis or Static analysis or Cross-Sectional analysis. It involves the study of
the relationship between various items of Statement of Profit and Loss, balance sheet,
etc., in a single financial year.

Limitations of Financial Analysis:

Though financial analysis is of great importance to an organisation, it still has various

limitations, which are as follows:
1. Current changes in the prices in the economy are not taken into consideration in the
financial statement analysis.
2. Since the analysis is done by humans, it is prone to personal bias, and may lead to
conflicts between the interpretation of the data by various experts.
3. Financial analysis is quantitative in nature and can only analyse those aspects that are
related to money, and fails to analyse the non-monetary aspects.
4. Different firms may use different accounting policies, and it may not be possible to
compare the two businesses in terms of financial analysis due to this.

Difference between Horizontal and Vertical Analysis:

Horizontal Analysis Vertical Analysis

In this, financial statements of several In this, various aspects of the financial

years are compared against the financial statement of a single year or current year
statement of a base year. are analysed or compared.

Same items of different years are Different items of the same year are
compared. compared.

It is also called Time Series Analysis or It is also called Static Analysis or Cross-
Dynamic Analysis. Sectional analysis.

It compares the financial status of a

It compares a company’s financial status
company to the other in the same financial
over a period of time.
year.
Analysis of Financial Statement: Need,
Objectives and Requisites
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Let us make an in-depth study of Analysis of Financial Statement. After

reading this article you will learn about: 1. Need of Analysis of Financial
Statement 2. Objectives of Analysis of Financial Statement 3. Requisites 4.
Steps Involved 5. Parties Interested.

Need of Analysis of Financial Statement:

We know that the analysis of financial statement helps the analyst to know
the financial information from the financial data contained in the financial
statements and to assess the financial health (i.e. strength or weakness) of an
enterprise. It also helps to make a forecast for the future which helps us to
prepare budgets and estimates.

In short, analysis of financial statements helps us to take various decisions at

various places of a firm.

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However, we highlight below the purpose or need of the said analysis:

(a) It helps us to know the reasons for relative changes—either in profitability
or in the financial position as a whole.

(b) It also help to know both the short-term liquidity position vis-a-vis
working capital position; as also the long-term liquidity and solvency
position of a firm.

(c) It also highlights the operating efficiency and the present profit-earning
capacity of the firm as a whole.

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(d) High Courts, Supreme Court, Arbitrators also require financial statements
to settle various disputed matters.
(e) Various financial journal (viz. R.B.I. Bulletins), newspapers etc. also
require financial statements for analysing and scrutinizing the financial
position of a firm for the readers.

Objectives of Analysis of Financial Statement:

It has already been pointed out above that financial statements are used by
various interested parties for their various purposes.

However, the significant objectives of financial statement analysis are:

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(a) To ascertain short-term liquidity position of an enterprise by the

application of various liquidity ratios.

(b) To evaluate the long-term solvency position by the application of various

solvency ratios;

(c) To assess the risk (both financial as well as business) involved with firm.

(d) To assess the present earning capacity of the firm for the purpose of inter-
firm comparison and thereby to assess the progress or otherwise of the firm.

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(e) To evaluate the efficiency of the firm for proper utilisation of financial
resources.

(f) To assess the intra-firm comparison among of the various components of

the firm.

(g) To see the effect of various non-economic and economic factors of the
firm.

(h) To assess the working capital position of the firm.

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(i) To assess the performance of the firm by the application of various ratios.

Requisites of Analysis of Financial Statement:

We know that financial statements are analysed by the analyst or users of
financial statement for specific purpose and also for general purpose.
However, one should remember the following requisites and procedures
for the purpose of analysis of financial statements:
(a) At first, the analyst must be clear relating to the purpose/objectives of the
analysis. According to his needs, he should collect the required information.

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(b) The analyst must go through the accounting principle, conventions and
concepts before starting his work.

(c) Application of technique must be correct. The analyst may follow one
technique for one type of analysis while the other technique for other type of
analysis.

(d) The analyst must determine the extent of analysis which will help him to
make necessary plan and programmes and accordingly he should start his
work.

(e) The data so collected from financial statements must be presented in an

understandable manner for which the grouping, re-grouping, sub-grouping of
data must be made.

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(f) The analyst must highlight information in order of importance, i.e. the
more important points at the top and the least important points at the bottom.

(g) The analyst must also ascertain the financial, operational as well as
structural relationship among the various elements of financial statements.

(h) After completing the analytical work and interpretation, the analyst must
prepare a report which will be submitted to the management or users of
accounting information.

Steps Involved in Analysis of Financial Statement:

The analysis of financial statement needs:
(a) Methodical Classification (A conventional Prerequisites to Analysis of
Financial Statement)

(b) Tools of Financial Statement Analysis

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(a) Methodical Classification:

We know that financial statements are prepared usually in a traditional form
which do not exhibit the information required by an analyst. Thus, an analyst
rearranges the data and presents and prepares the same in a modified form for
making proper interpretation and analysis.

The said data are modified in a vertical form for a particular purpose. This
modified form of the financial statement is not a compulsory requirement but
only as a matter of convenience for understanding and analysis. That is why,
there is no standard form of its presentation which should be applied in all the
cases. The financial statements used may also be prepared without
modification; in that case, we cannot use them conveniently.

While in case of methodical presentation, the information may be presented

side by side for the purpose of making proper comparison and understanding.
We have already shown the methodical presentation of Income Statement and
the methodical presentation of Balance Sheet with the help of illustrations in
earlier part of the present chapter. In order to avoid repetition, the same is not
explained here.

(b) Tools of Financial Statement Analysis:

The tools of financial statements are presented:
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Before explaining the tools we must remember that application of a single

tool is not at all sufficient to assess the financial position of an enterprise. As
such, a combination of some tools should be applied in order to assess the
financial position. For example, if an analyst desires to assess the liquidity
position of a firm, he must consider the ratio analysis (i.e. liquidity ratios)
along with the Cash Flow Analysis, Funds Flow Analysis, and Working
Capital Analysis etc. This will, no doubt, help him to assess the liquidity
position of a firm.

Thus, the tools of financial statement analysis are:

(i) Comparative Statement;
(ii) Common-Size Statement;

(iii) Trend Analysis;

(iv) Working Capital Analysis;

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(v) Funds Flow Analysis;

(vi) Cash Flow Analysis;

(vii) Ratio Analysis;

(viii) Cost-Volume Profit (CVP)/Break-Even Analysis.