Question

What is analysis of financial statement? Describe its objectives and limitations.

Hint:

Financial statement analysis is a useful tool for decision-making, but it should be combined with other factors such as industry trends and economic conditions for more accurate predictions.

Answer 1

(1) Analysis of Financial Statements:
The analysis of financial statements involves evaluating a company’s financial performance and position by studying its financial reports, including the balance sheet, income statement, and cash flow statement. The primary purpose is to assess the company’s profitability, liquidity, solvency, and operational efficiency. It helps stakeholders, such as investors, creditors, and management, make informed decisions about the company.
(2) Objectives of Financial Statement Analysis:
The key objectives of analyzing financial statements are as follows:

Evaluate Profitability: Financial analysis helps to assess whether the company is earning enough profit relative to its sales, assets, and equity. It involves calculating key ratios like profit margin, return on equity, and return on assets.
Assess Liquidity: This objective focuses on the company's ability to meet short-term obligations, such as current liabilities. Liquidity ratios like the current ratio and quick ratio help in determining the company's liquidity position.
Assess Financial Health: By analyzing the debt-to-equity ratio and other solvency ratios, financial statement analysis provides insights into the company’s long-term financial stability and its ability to repay long-term debt.
Investment Decision Making: Investors use financial statement analysis to decide whether to buy, hold, or sell shares based on the company’s financial health and performance trends.

(3) Limitations of Financial Statement Analysis:
Although financial statement analysis is important, it has its limitations, including:

Based on Historical Data: Financial statements reflect past performance, which may not accurately predict future results due to changes in market conditions, management decisions, or external factors.
Reliance on Accounting Policies: The results of financial statement analysis can be influenced by accounting methods and policies chosen by the company, which may vary between companies and affect comparability.
Lack of Non-Financial Information: Financial statements do not provide a complete picture of a company’s performance as they omit qualitative factors, such as market conditions, management quality, and operational risks.
Manipulation of Financial Data: Companies may engage in window dressing or manipulate financial statements to present a better financial position than is true, which can mislead stakeholders.

Conclusion:
While the analysis of financial statements provides valuable insights into a company’s financial performance and position, it should be supplemented with qualitative analysis and other information for a complete understanding.