Accountancy 6 Marks Question

1. Limitations of Financial Statements: Financial analysis is based on financial statements. But financial statements themselves suffer from certain limitations, hence the limitations of financial statements are also the limitations of their analysis.

For example:

1. Sometimes the informations given in financial statements are incomplete and unauthentic.
2. Financial Statements are based on accounting concepts and conventions.

As such, the utility of financial analysis is decreased due to the shortcomings of financial statements.

2. Affected by Window-dressing: Some firms resort to window-dressing their financial statements to cover up bad financial position on the eve of accounting date. For example, they may not record the purchases made at the end of the year or they may overvalue their closing stock. In such cases, the results obtained by analysis of financial statements will be misleading.

1. To Measure the Earning Capacity or Profitability: According to Robert Anthony, "The overall objective of a business is to earn a satisfactory return on the
   funds invested in it, consistent with maintaining a sound financial position." Financial analysis helps in ascertaining whether adequate profits are being earned on the capital invested in the business. It is also disclosed by analysis of financial statements whether these profits are increasing or decreasing over the years. For this purpose, the financial statements of a few years are taken into account to compute the change in profits over the years. Such analysis helps in ascertaining the future profit ability or earning capacity of the business.
2. To Measure the Solvency: It can be ascertained from financial analysis whether the business is in a position to pay its short-term and long-term liabilities in time. For example, the liquidity ratios ( current ratio and quick ratio) are calculated to ascertain whether the business enterprise has sufficient liquid funds to meet its short term liabilities and Debt Equity. Ratio is calculated ascertain wether the business enterprise has got the ability repay the long term liabillties.

Horizontal analysis: In such type of analysis, financial statements for a number of years are reviewed and analysed. Figures for two or more years are contained in such type of analysis and these figures are placed side-by-side to facilitate comparison. Such analysis indicates the increase or decrease in these itmes not in absolute figures but also in percentage form. Thus, it involves making comparisons and establishing relationship among related items of an enterprise for a number of years. When data about sales, cost of production, profits etc. are compared for two or more years ofa firm, they indicate the areas of strength and weakness of the enterprise. It also helps in knowing the trend of the business. Since such type of analysis is based on the data from year-to-year rather than only one year, it is also called, 'Dynamic Analysis'.

The financial statement analysis is important for different reasons:

1. Holding Of Share: Shareholders are the owners of the company. Time and again, they may have to take decisions whether they have to continue with the holdings of the company's share or sell them out. The financial statement analysis is important as it provides meaningful information to the shareholders in taking such decisions.
2. Decisions And Plans: The management of the company is responsible for taking decisions and formulating plans and policies for the future. They, therefore, always need to evaluate its performance and effectiveness of their action to realise the company's goal in the past. For that purpose, financial statement analysis is important to the company's management.
3. Extension Of Credit: The creditors are the providers of loan capital to the company. Therefore they may have to take decisions as to whether they have to extend their loans to the company and demand for higher interest rates. The financial statement analysis provides important information to them for their purpose.
4. Investment Decision: The prospective investors are those who have surplus capital to invest in some profitable opportunities. Therefore, they often have to decide whether to invest their capital in the company's share. The financial statement analysis is important to them because they can obtain useful information for their investment decision making purpose.

1. Management: Management of a firm is always interested in the solvency, profitability and the capital structure of the firm. They want to make sure that the business must be in a solvent position to pay the debts as and when they fall due.
2. Investors: Investors and shareholders of the business are interested in the longevity of the business enterprise and therefore, they want to know the earning capacity of the business and its prospects for future growth and prosperity.
3. Creditors: There are two types of creditors.

1. Short-term creditors: Short-term creditors want to know the liquidity of the business, i.e., to know whether the company will have sufficient current assets and cash to pay their debts or not.
2. Long-term creditors: Long-term creditors want to know two things namely:

• Whether the company will be able to pay the interest consistently, and
• Whether the company will be able to pay their debts when they fall due.

4. Government: Government can judge on the basis of analysis of financial statements, which industry is progressing on the desired lines and which industry needs the financial help.
5. Financial Institutions: All the financial institutions which provide finance to the industries such as Banks, Insurance companies, Unit Trust etc. want to know the profit earning capacity of the business and its long-term solvency.
6. Employees: Analysis of financial statements helps the employees in determining the profitability of the business enterprise.
7. Stock Exchange Authorities: They analyse the financial statements of a company to determine its price earning ratio and earning per share (E.P.S.). With the help of such analysis, the market price of a company's share is determined.
8. Researchers: Analysis of financial statements of a company is of much importance to a researcher who is conducting research in respect of the profitability, efficiency, financial soundness and future growth potential of that company.
9. Taxation Authoritie: They analyse the financial statements of a company to know whether the financial statements have been prepared in accordance with the legal provisions and whether the figures of production, sales and profits are correct for the purpose of assessment of GST and income tax etc.
10. Other Parties: Some other parties may also be interested in the analysis of financial statements of a company from their own point of view, such as, economists, trade associations, consumer organisations etc.