Meaning
The words “analysis” and “interpretation” are both included in the phrase “financial statement analysis.” Therefore, a difference between the two terms is necessary. While “analysis” is used to refer to the methodical classification of the data provided in the financial statements in order to simplify it, “interpretation” is defined as “explaining the meaning and relevance of the data so simplified.” Analysis is useless without interpretation, while interpretation without analysis is challenging or even impossible. However, “analysis” and “interpretation” are related and complementary to one another. The majority of authors exclusively use the word “analysis” to refer to both analysis and interpretation. We have also referred to the meaning of both analysis and interpretation as “financial statement analysis” or simply “financial analysis.”
There are various types of financial analysis. They are briefly mentioned here in:
External analysis: The external analysis is done on the basis of published financial statements by those who do not have access to the accounting information, such as, stock holders, banks, creditors, and the general public.
Internal Analysis: This type of analysis is done by finance and accounting department. The objective of such analysis is to provide the information to the top management, while assisting in the decision making process.
Short term Analysis: It is concerned with the working capital analysis. It involves the analysis of both current assets and current liabilities, so that the cash position (liquidity) may be determined.
Horizontal Analysis: The comparative financial statements are an example of horizontal analysis, as it involves analysis of financial statements for a number of years. Horizontal analysis is also regarded as Dynamic Analysis.
Vertical Analysis: it is performed when financial ratios are to be calculated for one year only. It is also called as static analysis.
Techniques of Financial Analysis
The process of assessing a company’s financial performance and health using a variety of methods and tools is known as financial analysis. Among the most popular techniques of financial analysis are:
- Ratio analysis: This involves comparing different financial ratios, such as liquidity ratios, profitability ratios, and solvency ratios, to gain insight into a company’s financial performance and position.
- Trend analysis: This involves analyzing a company’s financial performance over time, using historical financial data to identify trends in revenue, expenses, and other key financial metrics.
- Benchmarking: This involves comparing a company’s financial performance to that of its competitors or industry peers to determine how it measures up.
- DuPont analysis: This involves breaking down a company’s return on equity (ROE) into its constituent parts, such as net profit margin, asset turnover, and equity multiplier, to gain a deeper understanding of the drivers of ROE.
- Cash flow analysis: This involves examining a company’s cash inflows and outflows, both from its operating activities and from its investment and financing activities, to get a comprehensive view of its cash position.
- Budgeting and forecasting: This involves creating a financial plan for the future, using historical financial data, industry trends, and company-specific information to estimate future revenue, expenses, and cash flows.
These are just a few of the many techniques used in financial analysis. The specific techniques used will depend on the goals of the analysis and the type of financial information being analyzed.