Question

There are different tools for analyzing the financial statements of a company, such as horizontal analysis, vertical analysis, ratios for measuring financial health and profitability, and so forth. But before we begin using these tools, it is important to know the purpose of each tool. Why do we need different tools for analyzing financial statements? Don't the numbers in the financial statements speak for themselves?

Answer 1

Financial statements give the basic numbers which are required to understand the business fundamentals. But to interpret and analyse we need the various tool and techniques so that meaningful judgement can be made of the financial statements. Need for different tools for financial statements:

• It helps in a meaningful understanding of the financial statements. For example, in ratio analysis we can check ratios based on profitably, liquidity, solvency, etc. Horizontal analysis helps in understanding financial statements over a period of time.
• Meaningful measure for analysis – For example, Current Assets and Liabilities listed in Balance sheet does not help in understanding how they are correlated. But when ratio is drawn up say Current ratio is becomes a meaningful measure for analysis
• It helps in bench marking with internal standards set and also with the external world. Ratios help in understanding the numbers by comparing them with benchmarks set. For example,Firms can set internal ratios for Cost, Profitability, etc
• It helps in performance evaluation of the organisation as to how did it perform with peers and industry standards. For example- Gross profit margin, Net profit margin etc
• It helps various stakeholders like bankers, investors, analysts, lenders, creditors, etc also in framing an opinion about organization performance.
• It helps in understanding and evaluation of risk involved. For example, solvency ratio indicates the risk profile of the organisation
• It helps in Operational performance improvement and efficiency. For example Vertical analysis of profit and loss account helps in understanding the cost structure and Horizontal analysis helps in understanding movement of cost over a period of time