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Describe the Different Techniques of Financial Analysis and Explain the Limitations of Financial Analysis. - Accountancy

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Answer in Brief

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

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The various techniques used in financial analysis are as follows:

1. Comparative Statements: These statements depict the figures of two or more accounting years simultaneously that help to access the profitability and financial position of a business. The Comparative Statements help us in analysing the trend of the financial position of the business. These statements also enable us to undertake various types of comparisons like inter-firm comparisons and intra-firm comparisons. It presents the change in the financial items both in absolute as well as percentage terms. Therefore, these statements help in measuring the efficiency of the business in relative terms. The analyses based on these statements are known as Horizontal Analysis.

2. Common Size Statements: These statements depict the relationship between various items of financial statements and some common items (like Net Sales and the Total of Balance Sheet) in percentage terms. In other words, various items of Trading and Profit and Loss Account such as Cost of Goods Sold, Non-Operating Incomes and Expenses are expressed in terms of percentage of Net Sales. On the other hand, different items of Balance Sheet such as Fixed Assets, Current Assets, Share Capital, etc. are expressed in terms of percentage of Total of Balance Sheet. These percentage figures are easily comparable with that of the previous years’ (i.e. inter-firm comparison) and with that of the figures of other firms in the same industry (i.e. inter-firm comparison) as well. The analyses based on these statements are commonly known as Vertical Analysis.

3. Trend Analysis: This analysis undertakes the study of trend in the financial positions and the operating performance of a business over a series of successive years. In this technique, a particular year is assumed to be the base year and the figures of all other years are expressed in percentage terms of the base year’s figures. These trends (or the percentage figures) not only helps in assessing the operational efficiency and the financial position of the business but also helps in detecting the problems and inefficiencies.

4. Ratio Analysis: This technique depicts the relationship between various items of Balance Sheet and the Income Statements. It helps in ascertaining the profitability, operational efficiency, solvency, etc of a firm. The analysis expresses financial items in terms of percentage, fraction, proportion and as number of times. It enables budgetary controls by assessing the qualitative relationship among different financial variables. This analysis provides vital information to different accounting users regarding the financial position, viability and performance of a firm. It also facilitates decision making and policy designing process.

5. Cash Flow Analysis: This analysis is presented in the form of a statement showing inflows and outflows of cash and cash equivalents from operating, investing and financing activities of a company during a particular period of time. It helps in analysing the reasons of receipts and payments in cash and change in the cash balances during an accounting year in a company.

Limitations of Financial Analysis

The limitations of Financial Analysis are :

1. Ignores Changes in the Price level

The financial analysis 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).

2. 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.

3. Interim and Final Picture

The financial analysis presents only the interim report and thereby provides incomplete information. They fail to provide the final and holistic picture.

4. Ignores Qualitative and Non-monetary Aspects

The financial analysis reveals only the monetary aspects. In other words, these analyses consider only that information that can be expressed only in monetary terms. These analyses fail to disclose managerial efficiency, growth prospects, and other non-operational efficiency of a business.

5. Accounting Concepts and Conventions

The financial analysis are based an accounting concepts and conventions. Therefore, the analysis and conclusions based on such analyses may not be reliable. For example, the analysis considers only the book-value of various items (i.e. according to the Going Concept) and consequently ignores the present market value of those items. Hence, the analysis may not be realistic.

6. 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.

7. 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. 

Concept: Tools of Analysis of Financial Statements
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NCERT Class 12 Accountancy - Company Accounts and Analysis of Financial Statements
Chapter 4 Analysis of Financial Statements
Long Answer Questions | Q 1 | Page 184
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