What is Financial Analysis?
Financial Analysis is an aspect of the overall business finance function that involves examining historical data to gain information about the current and future financial health of a company. Financial analysis can be applied in a wide variety of situations to give business managers the information they need to make critical decisions. The ability to understand financial data is essential for any business manager. Finance is the language of business. Business goals and objectives are set in financial terms and their outcomes are measured in financial terms. Among the skills required to understand and manage a business is fluency in the language of finance—the ability to read and understand financial data as well as present information in the form of financial reports.
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 weigh 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 its 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.
Application of Financial Analysis
Financial 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.