Financial analysis helps businesses assess their projects, budgets, and financial statements and make better future predictions. In other words, businesses use this analysis to determine whether the company is performing adequately and how it can improve in future.
Accounting professionals perform this analysis using ratios derived from financial statements and other reports.
What is Financial Analysis?
Financial analysis is the process of evaluating the financial statements of businesses and making growth recommendations. It helps assess their profitability, liquidity and overall financial position. Businesses use the findings from this analysis to make appropriate decisions about investments, project planning, and financing activities.
Importance of Financial Analysis
Accounting professionals prepare reports using ratios and other techniques. The information is taken from statements and other financial reports of a company.
- Continue its business operations or not
- Purchase new and upgraded machinery depending on the manufacturing demand
- Issue new shares to increase its working capital
- Make decisions regarding investing or lending capital
How Do Companies Carry Out Financial Analysis?
- Corporate Financial Analysis
Corporate financial analysis is a quantitative method that helps in evaluating a company’s financial position and its market value. It is based on the financial reports audited by accountants and published by companies to be transparent to their shareholders.
An important area of corporate analysis is to generalise a company’s past performance, such as earnings or margins. It will help to estimate the company’s future performance. This type of historical trend analysis is beneficial for identifying seasonal trends.
- Investment Financial Analysis
This is another method of financial analysis in which analysts evaluate the profitability, risk, and return of an investment opportunity. Investment analysis includes selecting the type of investment based on an investor’s needs. Analysts study past returns and evaluate individual securities to predict future performance, risks, yield potential, and price movements.
What are the Types of Financial Analysis?
Fundamental Analysis is the analysis of a business’s financial statements to determine the intrinsic value of a business’s stock. It helps in identifying the key attributes of a business and analysing its actual worth. There are mainly three sets of reports used in financial analysis- historical data, publicly known information, and information that is not public.
Technical analysis is a financial analysis methodology that uses statistical trends from trading activity to evaluate investment opportunities. Technical analysis examines past market data, price and volume of stocks to understand the viability of the business.
There are many methods of technical analysis but technical analysts mostly use bar charts, candlestick charts, line charts, and point and figure charts. These types of charts and graphs help analysts to denote patterns and trade signals.
Financial Analysis Techniques
Analysts primarily use vertical and horizontal methods while conducting financial analysis. These analyses are performed by comparing the data against a baseline benchmark.
Other essential financial analysis techniques include regression analysis and year-over-year growth analysis. Apart from these analyses, there is top-down analysis like the market share percentage and bottom-up analysis like the revenue driver analysis.
Horizontal Analysis vs Vertical Analysis
It is a type of financial analysis in which analysts look at financial trends over a period. In this analysis, financial data for one year is selected as the baseline against which all the accounts of companies are compared for each year. Subsequently, it shows a percentage that denotes which accounts are growing and which are shrinking.
In vertical analysis, a specific line item is chosen as a benchmark. Then every other component of a financial statement is compared to that benchmark. Most analysts use net sales as the benchmark and compare it to the cost of goods sold, gross profit, operating profit, and net income.
Analysts use percentages for vertical analysis, as it makes the data easier to visualise. Companies then track these percentage changes over time and take business decisions accordingly.
Examples of Financial Analysis
- Current Ratio Analysis Example
There are two companies from which an investor wants to invest. Company A has current assets worth ₹2 Cr. and current liabilities worth ₹1 Cr. Whereas Company B which is a much bigger company has current assets of ₹5 Cr. and current liabilities of ₹3.5 Cr.
Analysts use the current ratio formula to determine which is a better company to invest in.
The formula of the current ratio is:
Current ratio = current assets / current liabilities
The current ratio of Company A = 2 Cr. / 1 Cr. = 2
The current ratio of Company B = 5 Cr. / 3.5 Cr. = 1.43
According to the analysis, Company A has a current ratio of 2 and Company B has a current ratio of 1.43. This means Company A is in a much better financial position than Company B and it can repay any current debts or obligations much faster.
- Profitability Ratio Analysis Example:
Company A has an operating profit of ₹50,000 and net sales of ₹2,00,000. In contrast, Company B has an operating profit of ₹1,00,000 and net sales of ₹4,00,000. To determine which company to invest in, analysts calculate the profitability ratio.
Profitability ratio = operating profit / net sales x 100
The Profitability ratio of Company A = 50,000 / 2,00,000 x 100 = 25%
The Profitability ratio of Company B = 1,00,000 / 4,00,000 x 100 = 25%
Based on the profitability ratio analysis, both of these companies have the same profitability ratio of 25%.
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What are the key elements of financial analysis?
5 Key elements of the financial analysis are revenues, profits, liquidity, operational efficiency and capital efficiency and solvency.
What are the most important financial statements?
The most important financial statements of a business are the income statement, balance sheet and cash flow statement.
What are the advantages of financial analysis?
Results from a financial analysis help the higher authorities and stakeholders to make the correct and informed decisions about the business.
What is a balance sheet ratio analysis?
Balance sheet ratio analysis denotes the relationship between items of the balance sheet to interpret a company's quantitative results. Some of the balance sheet ratios are a debt-to-equity ratio, liquidity ratio, cash ratio, current ratio, quick ratio and efficiency ratio.
Why is financial analysis useful?
Financial analysis of a company helps to analyse the stability, liquidity, solvency, and profitability of that particular company. With the help of this analysis, investors make viable and informed business decisions. It is also a crucial element for businesses when they make plans and decisions to manage their finances.