Financial Statement: Meaning,

Objectives and Limitations

by : | category : Financial Statement

Let us make in-depth study of the meaning, objectives and

limitations of financial statement.
Meaning:
Financial Statements are the collective name given to Income
Statement and Positional Statement of an enterprise which show the
financial position of business concern in an organized manner. We
know that all business transactions are first recorded in the books of
original entries and thereafter posted to relevant ledger accounts. For
checking the arithmetical accuracy of books of accounts, a Trial
Balance is prepared.

Trial balance is a statement prepared as a first step before preparing

financial statements of an enterprise which record all debit balances in
the debit column and all credit balances in credit column. To find out
the profit earned or loss sustained by the firm during a given period of
time and its financial position at a given point of time is one of the
purposes of accounting. For achieving this objective, financial
statements are prepared by the business enterprise, which include
income statement and positional statement.

These two basic financial statements viz:

(i) Income Statement, i.e., Trading and Profit & Loss Account and

(ii) Positional Statement, i.e., Balance Sheet portrays the operational

efficiency and solvency of any business enterprise.

The income statement shows the net result of the business operations
during an accounting period and positional statement, a statement of
assets and liabilities, shows the final position of the business
enterprise on a particular date and time. So, we can also say that the
last step of the accounting cycle is the preparation of financial
statements.

Income statement is another term used for Trading and Profit & Loss
Account. It determines the profit earned or loss sustained by the
business enterprise during a period of time. In large business
organization, usually one account i.e., Trading and Profit & Loss
Account is prepared for knowing gross profit, operating profit and net
profit.

On the other hand, in small size organizations, this account is divided

into two parts i.e. Trading Account and Profit and Loss Account. To
know the gross profit, Trading Account is prepared and to find out the
operating profit and net profit, Profit and Loss Account is prepared.
Positional statement is another term used for Balance Sheet. The
position of assets and liabilities of the business at a particular time is
determined by Balance Sheet.

Objective and Importance:

(i) Knowing Profitability of Business:
Financial statements are required to ascertain whether the enterprise
is earning adequate profit and to know whether the profits have
increased or decreased as compared to the previous year(s), so that
corrective steps can be taken well in advance.

(ii) Knowing the Solvency of the Business:

Financial statements help to analyse the position of the business as
regards to the capacity of the entity to repay its short as well as long
term liabilities.

(iii) Judging the Growth of the Business:

Through comparison of data of two or more years of business entity,
we can draw a meaningful conclusion as regard to growth of the
business. For example, increase in sales with simultaneous increase in
the profits of the business, indicates a healthy sign for the growth of
the business.
(iv) Judging Financial Strength of Business:
Financial statements help the entity in determining solvency of the
business and help to answer various aspects viz., whether it is capable
to purchase assets from its own resources and/or whether the entity
can repay its outside liabilities as and when they become due.

(v) Making Comparison and Selection of Appropriate Policy:

To make a comparative study of the profitability of the entity with
other entities engaged in the same trade, financial statements help the
management to adopt sound business policy by making intra firm
comparison.

(vi) Forecasting and Preparing Budgets:

Financial statement provides information regarding the weak-spots of
the business so that the management can take corrective measures to
remove these short comings. Financial statements help the
management to make forecast and prepare budgets.

(vii) Communicating with Different Parties:

Financial statements are prepared by the entities to communicate with
different parties about their financial position. Hence, it can be
concluded that understanding the basic financial statements is a
necessary step towards the successful management of a commercial
enterprise.

Limitations of Financial Statements:

(i) Manipulation or Window Dressing:
Some business enterprises resort to manipulate the information
contained in the financial statements so as to cover up their bad or
weak financial position. Thus, the analysis based on such financial
statements may be misleading due to window dressing.

(ii) Use of Diverse Procedures:

There may be more than one way of treating a particular item and
when two different business enterprises adopt different accounting
policies, it becomes very difficult to make a comparison between such
enterprises. For example, depreciation can be charged under straight
line method or written down value method. However, results provided
by comparing the financial statements of such business enterprises
would be misleading.

(iii) Qualitative Aspect Ignored:

The financial statements incorporate the information which can be
expressed in monetary terms. Thus, they fail to assimilate the
transactions which cannot be converted into monetary terms. For
example, a conflict between the marketing manager and sales manager
cannot be recorded in the books of accounts due to its non-monetary
nature, but it will certainly affect the functioning of the activities
adversely and consequently, the profits may suffer.

(iv) Historical:
Financial statements are historical in nature as they record past events
and facts. Due to continuous changes in the demand of the product,
policies of the firm or government etc, analysis based on past
information does not serve any useful purpose and gives only post-
mortem report.

(v) Price Level Changes:

Figures contained in financial statements do not show the effects of
changes in the price level, i.e. price index in one year may differ from
price index in other years. As a result, misleading picture may be
obtained by making a comparison of figures of past year with current
year figures.

(vi) Subjectivity & Personal Bias:

Conclusions drawn from the analysis of figures given in financial
statements depend upon the personal ability and knowledge of an
analyst. For example, the term Net profit may be interpreted by an
analyst as net profit before tax, while another analyst may take it as
net profit after tax.

(vii) Lack of Regular Data/Information:

Analysis of financial statements of a single year has limited uses. The
analysis assumes importance only when compared with financial
statements, relating to different years or different firm.
 FINANCIAL STATEMENT ANALYSIS - DEFINITION, OBJECTIVE,
IMPORTANCE, LIMITATIONS
Meaning
The analysis of financial statement is a process of evaluating the relationship between
component parts of financial statement to obtain a better understanding of firm financial
position.
Analysis is a process of critically examining the accounting information given in financial
statements. For the purpose of analysis, individual items are studied; their
interrelationship with other related figures is established.
Thus analysis of financial statement refer to treatment of information contain in financial
statement in a way so as to afford a full diagnosis of the profitably and financial position
of the firm concern.
Definitions
According to Myser Financial study analysis is largely a study of relationship among
the various financial factor in the business as disclosed by the single set of statement
and a study of trend of these factor shown in the financial statement.

OBJECTIVE OF FINANCIAL STATEMENT ANALYSIS

Financial statement is helpful in assessing the financial position and profitability of the
concern. Keeping in the view of accounting ratio the accountant should calculate the
ratio in appropriate form as early as possible for presentation for management for
managerial decisions.
Following are the main objectives of analysis of financial statements: -
1. To evaluate the business in terms of profit in present and future.
2. To evaluate the efficiency of various parts or department of the business.
3. To evaluate the short term and long term solvency of business for distributing profit to
the trade creditor and debenture holders.
4. To evaluate the chances of growth of business in the future by preparing budgets and
forecasting.
5. To evaluate the operational efficiency of one firm with another firm by study the
comparative statements.
6. To evaluate the financial and economical stability of the business.
7. To evaluate the actual meaning and consequence of financial data.
8. To evaluate the long-term liquidity of the fund of the business.

IMPORTANCE OF ANALYSIS OF FINANCIAL STATEMENT

Financial statement is prepared at a certain point of time according to established
convention. These statements are prepared to suit the requirement of the proprietor. For
measuring the financial soundness, efficiency, profitability and future prospects of the
concern, it is necessary to analyze the financial statement. Following purposes are
served by the Financial analysis: -
1. Help in Evaluating the operational efficiency of the Concern:- It is necessary
to analyze the financial statement for matching the total expenses incurred in
manufacturing, Advertising, selling and distribution of the finished goods and total
financial expanses of the current year comparing with the total expanses of the previous
year and evaluate the managerial efficiency of concern.
2. Help in Evaluating the short and long term financial position:- It is necessary
to analyze the financial statement for comparing the current assets and current liabilities
to evaluate the short term and long term financial soundness.
3. Help in calculating the profitability:- It is necessary to analyze the financial
statement to know the gross profit and net profit.
4. Help in indicating the trend of achievements:- Analysis of financial
statement helps in comparing the Financial position of previous year and also compare
various expenses, purchases and sales growth, gross and net profit. Cost of goods
sold, total value of assets and liabilities can be compare easily with the help of Analysis
of financial statement.
5. Forecasting, budgeting and deciding future line of action:-The potential
growth of the business can be predicts by the analysis of financial statement which
helps in deciding future line of action. Comparisons of actual performance with target
show all the shortcomings.
LIMITATIONS OF FINANCIAL ANALYSIS

1. It is Suffering from the limitations of financial statements

2. There is Absence of standard universally accepted terminology in financial
analysis
3. price level changes is ignored in financial analysis
4. quantity aspect is ignored in financial analysis
5. Financial analysis provides misleading result in absence of absolute data

Objectives and Importance of Financial Statement Analysis:

The primary objective of financial statement analysis is to understand and
diagnose the information contained in financial statement with a view to judge
the profitability and financial soundness of the firm, and to make forecast
about future prospects of the firm. The purpose of analysis depends upon the
person interested in such analysis and his object.
However, the following purposes or objectives of financial statements
analysis may be stated to bring out the significance of such analysis:
(i) To assess the earning capacity or profitability of the firm.

(ii) To assess the operational efficiency and managerial effectiveness.

(iii) To assess the short term as well as long term solvency position of the firm.

(iv) To identify the reasons for change in profitability and financial position of
the firm.

(v) To make inter-firm comparison.

(vi) To make forecasts about future prospects of the firm.

(vii) To assess the progress of the firm over a period of time.

(viii) To help in decision making and control.

(ix) To guide or determine the dividend action.

(x) To provide important information for granting credit.

Parties Interested in Financial Analysis:

The following parties are interested in the analysis of financial
statements:
(1) Investors or potential investors.

(2) Management.

(3) Creditors or suppliers.

(4) Bankers and financial institutions.

(5) Employees.

(6) Government.

(7) Trade associations.

(8) Stock exchanges.

(9) Economists and researchers.

(10) Taxation authorities

Limitations of Financial Statement Analysis:

Financial analysis is a powerful mechanism of determining financial strengths
and weaknesses of a firm. But, the analysis is based on the information
available in the financial statements. Thus, the financial analysis suffers from
serious inherent limitations of financial statements.

The financial analyst has also to be careful about the impact of price level
changes, window-dressing of financial statements, changes in accounting
policies of a firm, accounting concepts and conventions, and personal
judgment , etc.
Some of the important limitations of financial analysis are, however,
summed up as below:
(i) It is only a study of interim reports

(ii) Financial analysis is based upon only monetary information and non-
monetary factors are ignored.
(iii) It does not consider changes in price levels.

(iv) As the financial statements are prepared on the basis of a going concern,
it does not give exact position. Thus accounting concepts and conventions
cause a serious limitation to financial analysis.

(v) Changes in accounting procedure by a firm may often make financial

analysis misleading.

(vi) Analysis is only a means and not an end in itself. The analyst has to make
interpretation and draw his own conclusions. Different people may interpret
the same analysis in different ways.