Financial statements give complete information about assets, liabilities, equity, reserves, expenses and profit & loss of an enterprise. They are not readily understandable to interested parties like creditors, shareholders, investors, etc. Thus, various techniques are used for analysing and interpreting the financial statements. Techniques of analysis of financial statements are mainly classified into three categories:
1. Cross-sectional Analysis
It is also known as inter-firm comparison. This analysis helps in analysing financial characteristics of an enterprise with financial characteristics of another similar enterprise in that accounting period. For example, if company A has earned 15% profit on capital invested. This does not say whether it is adequate or not. If we analyse further and find that a similar company has earned 16% during the same period, then only we can make a conclusion that company B is better than company A. Thus, it turns into a meaningful analysis.
2. Time Series Analysis
It is also called as intra-firm comparison. According to this method, the relationship between different items of financial statements is established, comparisons are made and results obtained. The basis of comparison may be:
- Comparison of the financial statements of different years of the same business unit.
- Comparison of financial statements of a particular year of different business units.
3. Cross-sectional cum Time Series Analysis
This analysis is intended to compare the financial characteristics of two or more enterprises for a defined accounting period. It is possible to extend such a comparison over the year. This approach is most effective in analysing financial statements.