Analysis and Interpretation of Financial Statements
Introduction to Analysis and Interpretation of Financial Statements:
Analysis and interpretation of financial statements are
an attempt to determine the significance and meaning of the financial statement
data so that a forecast may be made of the prospects for future earnings,
ability to pay interest, debt maturities, both current as well as long term,
and profitability of sound dividend policy.
The main function of financial analysis is the
pinpointing of the strength and weaknesses of a business undertaking by
regrouping and analysis of figures contained in financial statements, by making
comparisons of various components and by examining their content. The analysis
and interpretation of financial statements represent the last of the four major
steps of accounting.
Interpretation of financial statements involves many
processes like arrangement, analysis, establishing relationship between
available facts and drawing conclusions on that basis.
Types of Financial Analysis:
The process of analysis may partake the varying types.
Normally, it is classified into different categories on the basis of
information used and on the basis of modus operandi.
(a) On the basis of Information Used:
(ii) Internal analysis.
External analysis is an analysis based on information
easily available to outsiders (externals) for the business. Outsiders include
creditors, suppliers, investors, and government agencies regulating the
business in a normal way.
These parties do not have access to the internal records
(information) of the concern and generally obtain data for analysis from the
published financial statements. Thus an analysis done by outsiders is known as
external analysis.
Internal analysis is an analysis done on the basis of
information obtained from the internal and unpublished records and books. While
conducting this analysis, the analyst is a part of the enterprise he is
analyzing. Analysis for managerial purposes is the internal type of analysis
and is conducted by executives and employees of the enterprise as well as
governmental and court agencies which may have major regulatory and other
jurisdiction over the business.
(b) On the basis of Modus Operandi:
(ii) Vertical analysis.
Horizontal analysis is also known as ‘dynamic analysis’
or ‘trend analysis’. This analysis is done by analyzing the statements over a
period of time. Under this analysis, we try to examine as to what has been the
periodical trend of various items shown in the statement. The horizontal
analysis consists of a study of the behavior of each of the entities in the
statement.
Vertical analysis is also known as ‘static analysis’ or
‘structural analysis’. It is made by analyzing a single set of financial
statement prepared at a particular date. Under such a type of analysis,
quantitative relationship is established between the different items shown in a
particular statement. Common size statements are the form of vertical analysis.
Thus vertical analysis is the study of quantitative relationship existing among
the items of a particular data.
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