Financial Analysis – Its Utility

Financial Analysis

Introduction

Financial analysis is the process of evaluating the business, projects, budgets and other different finance related entities for determining the suitability for the investment. It can be considered as the performance measure of the effectiveness of the funds where the investments and the debts are employed in the firm.

Basic Concept

Financial Analysis is the assessment of the efficiency and the profitability of the financial operations. It can be defined as the value, the debtors can claim against the assets of the firms. Techniques like the ratio analysis and the fund flow analysis are employed which clearly understand the opportunities and the problems of the financing decisions.

How to Financial Analysis Benefits Your Business?

Financial analysis can provide you with the status of your business in the right method. With the help of the reports and the analytics, you can get a clear view of the present financial condition of your business.

Trend Analysis

The trend analysis, also known as the time series analysis helps to determine the performance of the business over a period of time. This analysis is based on the historical data from the financial statements and the forecasted data from the pro forma of the business or the financial statements which are forward looking. The financial ratio analysis can be used in the trend analysis. If you want to calculate the financial ratios of a company, you are required to calculate minimum two year’s ratios for coming to a proper result. Ratios can only be meaningful if you have previous year’s data in handy. If the previous year’s data are not available, the financial ratios will be of no use. For example, the current ratio can be calculated by analyzing the ratios of the short term assets to the current liabilities. If the ratio results in 1.0, then it will mean that with every dollar of the short term assets, you have one dollar of current liabilities. The short term assets will include inventory, accounts receivable and other liquid accounts.

Percentage Change Financial Statement Analysis

This financial statement analysis can be calculated with the growth rates of the items from the income statement and the balance sheets related to the base year. As this is a very strong form of analysis, you can easily calculate the overall growth rates and can observe the changes in the balance sheet and the financial statement. You can easily notice the changes in the sales and the total assets whether it has risen or declined. Here is an example of the percentage change analysis. Say, ABC is a company which has $800 as inventory in 2013 balance sheet and $1000 in the 2014 balance sheet. Therefore, you can observe that the inventory has grown $200 in 1 year. The formula for calculating the percentage is Change in the inventory / Beginning balance = $200/$800 =0.25 = 25%. Therefore the change in the inventory of ABC Company is 25%.

Common Size Financial Statement Analysis

This type of analysis takes place by analyzing the percentages of the balance sheet and the financial statements. The line items of the income statements can be considered as the percentages of the sales. The balance sheet items can be measured as the percentages of the total assets. For example, the line items are divided by the sales in the financial statement. In case of the balance sheet, the line items are divided by the percentages of the total assets. Therefore, you can create a common sized financial statement analysis by applying this formula. If you can calculate the net income of the total sales, you can apply that specific formula for every line of items and can develop your common sized financial interest. If you can combine the financial ratios with this analysis, you can easily find out the data for year after year and can easily understand the performance of the firm. By using the percentages, you can easily compare instead of using the absolute numbers.

Benchmarking

The benchmarking process or the industry analysis can involve the comparison of different companies with one another. All the companies are within the same industry and their performance is measured with comparison to other companies in the same industry. The financial manager may feel any requirement of financial changes in his company after this analysis.

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Efficiency

The efficiency ratios are those which help in showing the performance measurement of the company where it turns the inventory into the revenue. The outstanding sales per day can focus on the total time required for converting the inventory into the cash. The inventory turnover ratios can show the speed at which the company is moving its merchandises. The ratio of accounts payable to sales can clearly show the percentage of the sales which is contributed with the supplier’s money.

Liquidity

The liquidity ratios can show the worth of the company by measuring its liquid assets in the balance sheet. The current ratio can exhibit the working capital relationship of the current assets and the current liabilities. Similarly, the quick ratios can also calculate the assets that can be easily converted to cash. The debt to equity ratios signify whether the creditors or the shareholders owning the company more and by how much share.

Profitability

The company’s success by generating profits can be measured with the help of the profitability ratios. The profit margin of the company can be determined through the hindrances and the adverse conditions. The return on assets can disclose the profits earned for each dollar of assets. The net worth can focus on the financial returns from the invested capital.

Key Points from the Article

From the above article we can easily understand the

  • The definition of the financial analysis
  • The basic concept of the financial analysis
  • The advantages of the financial analysis in the business

Though there are various advantages of the financial analysis, there are also some limitations. If the numbers are manipulated a little bit, the whole state of the company can show wrong through the analysis.

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