WHAT IS FINANCIAL ANALYSIS? DEFINITION OF FINANCIAL ANALYSIS
Financial analysis is the process of evaluating financial statements or other finance-related transactions of a reporting entity to determine their performance and suitability. It is the process of identifying the financial strengths and weaknesses of the firm by properly establishing relationships between the various items of the balance sheet and the statement of profit and loss. Financial analysis can be undertaken by the management of the firm, or by parties outside the firm, such as owners, shareholders, trade creditors, lenders, investors, labour unions, analysts etc.
Financial Analysts primarily carry out their work in Excel, using a spreadsheet to analyze historical data and make projections of how they think the company will perform in the future. A financial analyst will thoroughly examine a company’s financial statements- the income statement, balance sheet, and cash flow statement. Financial analysis can be conducted in both corporate finance and investment finance settings.
WHY IS FINANCIAL ANALYSIS REQUIRED?
Every business needs to prepare basic financial statements that summarize its operating results and financial position for a particular period. These statements primarily include income statements, balance sheets, and cash flow statements. The purpose of preparing these statements is to ascertain the profitability and financial soundness of a business. But the detailed information reflected in such statements alone is not sufficient to reach meaningful managerial conclusions. Therefore, detailed financial analysis and interpretation of these statements are required using various tools and techniques.
TOOLS OF FINANCIAL ANALYSIS
The most commonly used techniques of financial analysis are as follows:
1. Comparative Statements
A comparative statement is a financial analysis tool used to compare a particular financial statement with prior period statements. Previous financials are presented alongside the latest figures in side-by-side columns, enabling investors to identify trends, track a company’s progress and compare it with industry rivals. These are the statements showing the profitability and financial position of a firm for different periods of time in a comparative form to give an idea about the position of two or more periods. It usually applies to the two important financial statements, namely, the balance sheet and statement of profit and loss prepared in a comparative form. The financial data will be comparative only when the same accounting principles are used in preparing these statements. Comparative figures indicate the trend and direction of financial position and operating results. This analysis is also known as ‘horizontal
2. Common Size Statements
These are the statements which indicate the relationship of different items of a financial statement with a common item by expressing each item as a percentage of that common item. The percentage thus calculated can be easily compared with the results of corresponding percentages of the previous year or of some other firms, as the numbers are brought to a common base. Such statements also allow an analyst to compare the operating and financing characteristics of two companies of different sizes in the same industry. Thus, common-size statements are useful, both, in intra-firm comparisons over different years and also in making inter-firm comparisons for the same year or for several years. This analysis is also known as ‘Vertical analysis’.
3. Trend Analysis
is a financial statement analysis technique that shows changes in the amounts of corresponding financial statement items over a period of time. It is a technique of studying the operational results and financial position over a period of time, generally a series of years. Using the previous periods’ data of a business enterprise, trend analysis can be done to observe the percentage changes over time in the selected data. The trend percentage is the percentage relationship, in which each item of different years bears the same item in the base year. Trend analysis is important because, with its long-run view, it may point to basic changes in the nature of the business. By looking at a trend in a particular ratio, one may find whether the ratio is falling, rising or remaining relatively constant. From this observation, a problem is detected or the sign of good or poor management is detected.
4. Ratio Analysis
The term financial ratio can be explained by defining how it is calculated and what the objective of this calculation is:
a. Calculation Basis
- A relationship expressed in mathematical terms;
- Between two individual figures or group of figures;
- Connected with each other in some logical manner; and
- Selected from financial statements of the concern
b. The objective of financial ratios is that all stakeholders (owners, investors, lenders, employees etc.) can draw conclusions about the Performance (past, present and future); strengths & weaknesses of a firm; and can take decisions in relation to the firm.
Ratio analysis is a quantitative procedure of obtaining a look into a firm’s functional efficiency, liquidity, revenues, and profitability by analysing its financial records and statements. It describes the significant relationship which exists between various items of a balance sheet and a statement of profit and loss of a firm. As a technique of financial analysis, accounting ratios measure the comparative significance of the individual items of the income and position statements. It is possible to assess the profitability, solvency and efficiency of an enterprise through the technique of ratio analysis.
5. Cash Flow Analysis
Cash flow analysis is a financial statement that records how money flows into and out of your business during a specific predetermined period of time. It can help you better understand where your money is going and how much cash you have at any given time. The flow of cash into the business is called as cash inflow or positive cash flow and the flow of cash out of the firm is called as cash outflow or a negative cash flow. The difference between the inflow and outflow of cash is the net cash flow. Cash flow statement is prepared to project the manner in which the cash has been received and has been utilised during an accounting year as it shows the sources of cash receipts and also the purposes for which payments are made. Thus, it summarises the causes for the changes in cash position of a business enterprise between dates of two balance sheets.
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