It refers to the process of the critical examination of the financial information contained in the financial statements in order to understand and make decisions regarding the operations of the firm. This statement is basically a study of relationship among various financial facts and figures as given in a set of financial statements. The complex figures given in balance sheet and the income statement are broken up into simple and valuable elements and significant relationships are established between the elements of the same statement or different financial statements. This process of breaking up, establishing relationships and interpretation thereof to understand the working and financial position of a firm is called analysis of financial statements. Thus, analysis of financial statement is the process of establishing and identifying the financial weaknesses and strength of the firm.
Types of Analysis of Financial Statements
1. Internal analysis of financial statement: When the analysis is done by a person who has access to the books of the accounts and other related information of the firm, it is called internal analysis of financial statements. It is undertaken by either the employee of the same firm or the responsibility may be given to an outside agency. This type of analysis is conducted for measuring the operational and managerial efficiency at different hierarchy levels of the firm.
2. External analysis of financial statement: The analysis which is conducted by an outsider without having any access to the basic accounting record of the firm, it is called external analysis of financial statements. These outsiders may be creditors, shareholders, investors or the credit agencies. This analysis serves only limited purpose because it is dependent on the published financial data of the firm.
3. Dynamic analysis of financial statement: When an analysis covers a period of several years, it is termed as dynamic analysis of financial statements. Dynamic analysis is also called as horizontal analysis.
4. Static analysis of financial statement: Static analysis of financial statement covers a period of one year and the analysis is made on the basis of only one set of financial statements. Static analysis is also called vertical analysis. Static analysis of financial statement fails to incorporate the periodic changes, so it may not be very conductive to a proper understanding of the financial position of the firm