Financial analysis refers to an assessment of the viability, stability, and profitability of a business, sub-business or project. What is Financial Analysis? Meaning, Objectives, and Types. Also, Tools Explain – Meaning of Financial Analysis, Objectives of Financial Analysis, Types of Financial Analysis, and Tools of Financial Analysis. It is performed by professionals who prepare reports using ratios that make use of information taken from financial statements and other reports.
Explanation each of Content, What is Financial Analysis? Meaning, Objectives, Types, and Tools.
Financial analysis is the evaluation of a business in order to determine its profitability, liabilities, strengths and future earnings potential. A wide variety of techniques may be utilized to assess an organization’s financial viability including the most common methodologies of horizontal analysis, vertical analysis, and ratio analysis.
Most analytical methods involve the company’s financial statements, internal or external audits, and investigations. Financial analysis is a critical aspect of all commercial activity as it provides actionable insights into the organization’s health and future potential. Not only does this information provide investors and lenders with critical data that may affect the price of stocks or interest rates, but these reports also allow company managers to gauge their performance with regard to expectations or industry growth. From a management point of view, financial analyses are critical to the success of the company because they highlight weaknesses and strengths that directly affect competitiveness. Don’t forget to read the Cost of Capital.
Meaning of Financial analysis:
An analysis of financial statements is the process of critically examining in detail accounting information given in the financial statements. For the purpose of analysis, individual items are studied, their interrelationships with other related figures are established, the data is sometimes rearranged to have the better understanding of the information with the help of different techniques or tools for the purpose. Analyzing financial statements is a process of evaluating the relationship between component parts of financial statements to obtain a better understanding of the firm’s position and performance.
The analysis of financial statements thus refers to the treatment of the information contained in the financial statements in a way so as to afford a full diagnosis of the profitability and financial position of the firm concerned. For this purpose financial statements are classified methodically, analyzed and compared with the figures of previous years or other similar firms. The term ‘Analysis’ and ‘interpretation’ though are closely related, but the distinction can be made between the two. Analysis means evaluating the relationship between the components of financial statements to understand the firm’s performance in a better way.
Various account balances appear in the financial statements. These account balances do not represent homogeneous data so it is difficult to interpret them and draw some conclusions. This requires an analysis of the data in the financial statements so as to bring some homogeneity to the figures shown in the financial statements. Interpretation is thus drawing of inference and stating what the figures in the financial statements really mean. Interpretation is dependent on the interpreter himself. The interpreter must have experience, understanding, and intelligence to draw correct conclusions from the analyzed data.
Objectives of Financial analysis:
Analysis of financial statements is made to assess the financial position and profitability of a concern. Analysis can be made through accounting ratios, fitting trend line, common size statements, etc. Accounting ratios calculated for a number of years show the trend of the change of position, i.e., whether the trend is upward or downward or static. The ascertainment of the trend helps us in making estimates for the future. Keeping in view the importance of accounting ratios the accountant should calculate the ratios in the appropriate form, as early as possible, for presentation to management for managerial control.
The main objectives of the analysis of financial statements are :
- to assess the profitability of the concern;
- to examine the operational efficiency of the concern as a whole and of its various parts or departments;
- to measure the short-term and long-term solvency of the concern for the benefit of the debenture holders and trade creditors;
- to undertake a comparative study in regard to one firm with another firm or one department with another department; and
- to assess the financial stability of a business concern.
The different users and decision makers to achieve the following objectives:
Assessment of Past Performance and Current Position:
Past performance is often a good indicator of future performance. Therefore, an investor or creditor is interested in the trend of past sales, expenses, net income, cash flow and return on investment. These trends offer a means for judging management’s past performance and are possible indicators of future performance. Similarly, the analysis of the current position indicates where the business stands today.
For instance, the current position analysis will show the types of assets owned by a business enterprise and the different liabilities due to the enterprise. It will tell what the cash position is, how much debt the company has in relation to equity and how reasonable the inventories and receivables are.
Prediction of Net Income and Growth Prospects:
The financial statement analysis helps in predicting the earning prospects and growth rates in the earnings which are used by investors while comparing investment alternatives and other users interested in judging the earning potential of business enterprises.
Investors also consider the risk or uncertainty associated with the expected return. The decision makers are futuristic and are always concerned with the future. Financial statements which contain information on past performances are analyzed and interpreted as a basis for forecasting future rates of return and for assessing risk.
Prediction of Bankruptcy and Failure:
Financial statement analysis is a significant tool in predicting the bankruptcy and failure probability of business enterprises. After being aware of the probable failure, both managers and investors can take preventive measures to avoid/minimize losses. Corporate management can effect changes in operating policy, reorganize financial structure or even go for voluntary liquidation to shorten the length of time losses. In the accounting and finance area, empirical studies conducted have suggested a set of financial ratios which can give the early signal of corporate failure.
Such a prediction model based on financial statement analysis is useful to managers, investors, and creditors. Managers may use the ratios prediction model to assess the solvency position of their firms and thus can take appropriate corrective actions. Investors and shareholder can use the model to make the optimum portfolio selection and to bring changes in the investment strategy in accordance with their investment goals. Similarly, creditors can apply the prediction model while evaluating the creditworthiness of business enterprises.
Loan Decision by Financial Institutions and Banks:
Financial statement analysis is used by financial institutions, loaning agencies, banks and others to make the sound loan or credit decision. In this way, they can make the proper allocation of credit among the different borrowers.
Financial statement analysis helps in determining credit risk, deciding the terms and conditions of the loan if sanctioned, interest rate, maturity date etc.
Tools of Financial Analysis:
Financial Analyst can use a variety of tools for the purposes of analysis and interpretation of financial statements particularly with a view to suit the requirements of the specific enterprise. Explanations of the Tools of Financial Analysis, The principal tools are as under:
- Comparative Financial Statements
- Common-size Statements
- Trend Analysis
- Cash Flow Statement
- Ratio Analysis
- Funds Flow statements
Note: Tools of Financial Analysis – the tool of contents give the explanation later of these articles.
Types of Financial Analysis:
There is a myriad of techniques that can be used to analyze the performance of a commercial enterprise, but the most common methods use the following strategies:
- Horizontal Analysis: This method uses past performance as a baseline metric for the success of the company. There are variations in this method that may use some number of years as a standard; for example, if the company has been in existence for some time, the two years prior may be used as a comparison. If the company is relatively new, it is common to use the initial year as a baseline and plot performance in relation to it.
- Vertical Analysis: Also known as component percentages, this type of analysis compares the profits to assets, liabilities, and equities. This method is generally helpful when comparing a large number of similar companies. The limitation of this method is that it often does not weight factors that impact future viability appropriately, like long-term partnerships, and one-time losses or investments.
- Ratio Analysis: This method analyzes various aspects of the company’s financial health. For example, a current ratio is the comparison of assets to liabilities. This type of analysis is extremely popular due to the analyst’s ability to choose two key features of businesses to analyze. Many analysts utilize this type of analysis to support their evaluations of organizations even if conventional analytical methodologies may not be as positive. The weakness in this type of analysis is that if the two characteristics are poorly chosen, an unreliable estimation of financial viability may be produced.
- Stock Price Movement: This technique relies on analyzing the performance of the company’s stock rather than their financial health. In essence, this method uses the financial markets as an analytical tool. Various methods may be used to evaluate the stock’s performance including enlarging or narrowing the window of evaluation, comparison to similar companies and trend analysis. There are some serious drawbacks to this technique. If the markets are relying on inaccurate data or analytical methodologies, it may be pricing stocks higher than their actual value. Stock analyses often ignore the company’s intrinsic sustainability in order to profit from stock price fluctuations and are unreliable foundations for establishing long-term investment relationships.
Financial analysis is the examination of financial information to reach business decisions. This analysis typically results in the reallocation of resources to or from a business or a specific internal operation. This type of analysis applies particularly well to the following situations:
Investment decisions by the external investor: In this situation, a financial analyst or investor reviews the financial statements and accompanying disclosures of a company to see if it is worthwhile to invest in or lend money to the entity. This typically involves ratio analysis to see if the organization is sufficiently liquid and generates a sufficient amount of cash flow. It may also involve combining the information in the financial statements for multiple periods to derive trend lines that can be used to extrapolate financial results into the future.
Investment decisions by the internal investor: In this situation, an internal analyst reviews the projected cash flows and other information related to a prospective investment (usually for a fixed asset). The intent is to see if the expected cash outflows from the project will generate a sufficient return on investment. This examination can also focus on whether to rent, lease, or purchase an asset.