Financial Analysis: Objectives, Methods, and Process (original) (raw)
Last Updated : 16 Jun, 2026
Financial Analysis is a systematic process of evaluating the financial information presented in a company's financial statements to understand its performance and make informed judgments about its operations. It involves the study of relationships among the financial facts and figures provided in the financial statements with the objective of assessing the firm's profitability, operational efficiency, financial health, and future prospects. Financial analysis comprises two interrelated aspects: analysis and interpretation. Analysis refers to the simplification and organization of financial data to make it easier to understand, while interpretation involves explaining the meaning, significance, and implications of the analysed information. These two aspects are complementary to each other, as analysis without interpretation is of little use, and interpretation without proper analysis is difficult or sometimes impossible. Therefore, effective financial analysis requires both the examination of financial data and the meaningful interpretation of the results.
In the words of John N. Myres, “Financial statement analysis is largely a study of relationships among the various financial factors in a business, as disclosed by a single set of statements and a study of the trends of these factors as shown in a series of statements”.
Objectives or Purpose of Financial Analysis
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The financial analysis serves the following purposes and is required in the enterprise for the following reasons:
**1. Assesses the Earning Capacity: It helps determine whether the business is earning sufficient returns on its capital. Ratios like Gross Profit Ratio and Operating Profit Ratio are used to measure profitability..
**2. Assesses the Solvency: Financial analysis attempts to determine the business's short-term and long-term solvency. Creditors are keen to determine the liquidity position of the term, i.e., the short-term solvency of the business, whereas long-term lenders (such as debenture-holders) are keen to know the long-term solvency of the business. Ratio analysis is helpful in determining the complete solvency of the business.
**3. Forecasts and Prepares Budget: Analysis of previous financial accounts is helpful in forecasting future events. It allows the business to make predictions and develop budgets depending on the previous performance review.
**4. Provides Useful and Valuable Information: Financial analysis attempts to provide useful and valuable information to a wide range of interested stakeholders, including owners, investors, creditors, employees, banks, financial institutions, government departments, and so on.
**5. Measures Financial Strength: Financial analysis is used to determine the financial position and future of the enterprise.
**6. Inter-firm and Intra-firm Comparison: Financial analysis attempts to make inter-firm and intra-firm comparisons. This type of comparison is helpful in identifying problems and implementing corrective steps in time.
**7. Measures Management's Efficiency: Financial analysis attempts to assess the operational efficiency of the management. Such analysis is helpful in determining whether the financial policies decided by the management are appropriate or not.
Methods of Financial Analysis:
**1. Internal Analysis: Internal analysis is done by the management using detailed accounting records and internal information. It is more reliable because full data is available. It helps in evaluating the financial performance and position of the business.
**2. External Analysis: External analysis is done by outsiders like investors, creditors, and banks using published financial statements. They do not have access to complete records. Therefore, it is less accurate than internal analysis.
**3. Horizontal Analysis (Dynamic Analysis): Horizontal analysis compares financial statements of two or more years. It shows changes in figures in absolute and percentage terms. It helps in identifying trends and long-term performance.
**4. Vertical Analysis (Static Analysis): Vertical analysis studies financial statements of a single year. Each item is expressed as a percentage of a base figure like sales or assets. It is useful for comparison within and between firms.
**5. Intra-firm Analysis: Intra-firm analysis compares financial data of the same company over different periods. It helps in tracking performance over time. It is also called trend or time-series analysis.
**6. Inter-firm Analysis: Inter-firm analysis compares financial data of different companies in the same period. It is used for benchmarking and competition analysis. It helps in identifying relative strengths and weaknesses
Process of Financial Analysis
**1. Determine the Objective of Analysis: The first step is to clearly define the objective of financial analysis. The purpose of analysis decides the type and depth of study to be conducted, making it more focused and relevant.
**2. Reformulating Reported Financial Statements: In this step, financial statements are reformulated or restated to make them more suitable for analysis. This helps in improving clarity and ensuring better interpretation of the company’s financial performance.
**3. Adjustment of Measurement Errors: Adjustments are made to reduce errors or distortions in financial data. This improves the accuracy and reliability of financial statements, such as correcting classification errors in expenses or revenues.
**4. Comparison: After adjustments, financial data is compared across different periods or between companies. This helps in identifying trends, patterns, and changes in financial performance.
**5. Drawing Conclusions: The analysed and compared data is interpreted to draw conclusions about the financial health of the business, including profitability, liquidity, and solvency position.
**6. Reporting: Finally, the findings and conclusions are presented in a report to the management or concerned users. These reports help in decision-making and future planning