Question

Describe the different techniques of financial analysis and explain the limitations of financial analysis.

Answer 1

The most commonly used techniques of financial analysis are as follows
(I) Comparative Statements:
These are the statements showing the profitability and financial position of a firm for different periods of time in a comparative form to give an idea about the position of two or more periods. The financial data will be comparative only when same accounting principles are used in preparing these statements. Comparative figures indicate the trend and direction of financial position and operating results. This analysis is also known as 'horizontal analysis'.

(II) Common Size Statements:
These are the statements which indicate the relationship of different items of a financial statement with some common item by expressing each item as a percentage of the common item. The percentage thus calculated can be easily compared with the results corresponding percentages of the previous year or of some other firms, as the numbers are brought to common base. Such statements also allow an analyst to compare the operating and financing characteristics of two companies of different sizes in the same industry. This analysis is also known as 'Vertical analysis'.

(III) Trend Analysis:
It is a technique of studying the operational results and financial position over a series of years. Using the previous years' data of a business enterprise, trend analysis can be done to observe the percentage changes over time in the selected data. Trend analysis is important because, with its long run view, it may point to basic changes in the nature of the business. By looking at a trend in a particular ratio, one may find whether the ratio is falling rising or remaining relatively constant. From this observation, a problem is detected or the sign of good management is found.

(IV) Ratio Analysis:
It describes the significant relationship which exists between various items of a balance sheet and a profit and loss account of a firm. As a technique of financial analysis, accounting ratios measure the comparative significance of the individual items of the income and position statements.
(V) Cash Flow Analysis:
It refers to the analysis of actual movement of cash into and out of an organisation. The flow of cash into the business is called as cash inflow or positive cash flow and the flow cash out of the firm is called as cash outflow or a negative cash flow. The difference between the inflow and outflow of cash is the net cash flow.

Limitations of Financial Analysis
The following are the limitations of financial analysis:

(i) Ignorance of Price Level Changes:
Financial statement is based historical cost method and fails to capture the change in price level. The figures of different years are taken on nominal values and not in real terms (i.e., not taking price change into considerations).

(ii) Misleading and Wrong information:
The financial analysis fails to reveal the change in the accounting procedures and practices. Consequently, they may provide wrong and misleading information.

(iii) Fail to Provide Final Picture:
The financial analysis presents only the interim report and thereby provides incomplete information.

(iv) Consider Only Monetary Aspect:
This is one of the limitations of financial analysis that it reveals only the monetary aspects. Only those items are considered here which can be measured in term of money and fail to disclose managerial efficiency, growth prospects. and other non-operational efficiency of a business.

(v) Non-Reliable Conclusions:
Conclusion base on financial analysis may be non reliable because financial statement are based on certain concepts and conventions.

(vi) Involves Personal Biasness:
The financial analysis reflects the personal biasness and personal value judgments of the accountants and clerks involved. There are different techniques used by different personnel for charging depreciation (original cost or written-down value method) and also for inventory valuation. The use of different techniques by different people reduces the effectiveness of the financial analysis.

(vii) Unsuitable for Comparisons:
Due to the involvement of personal value judgment, personal biasness and use of different techniques by different accountant, various types of comparisons such as inter-firm and intra-firm comparisons may not be possible and reliable.