Financial analysis describes the evaluation of the economic trends of a business. Usually, the purpose of this exercise is to analyse the financial health of a company.
What is financial analysis?
Once a company opens for business, management must meet numerous obligations, including tax payments, dividends, and loan repayments – to name just a few. Primarily, financial analysis seeks to achieve three objectives. First, it seeks to evaluate how a company manages investment and debt. Second, it examines the operations of a business to identify profitability. Third, it provides information on the safety and value of claims that debtors have against the assets of the business.
How does financial analysis happen?
The process relies nearly entirely on financial statements from the business. The statements include balance sheets, shareholder equity statements, income statements, and cash flow statements. Usually, analysts collect statements dating back approximately five years.
After collecting the statements, the next step involves scanning them to identify large movements and any other notable changes. For instance, scanning the cash flow statements enables analysts to determine if revenues jumped or fell from one year to the next. Scanning the shareholder equity statements enables analysts to identify growth patterns, or lack thereof. During the scanning process, analysts can identify suspicious activity that warrants further research.
Usually, the financial analysis process starts with assessing the balance sheet of the company. The balance sheet depicts the financial situation of the company at a given period. Next, the process deals with the assets and liabilities of the business. Other items analysts assess include the book value of the company and the market-to-book multiple of the business.
Types of financial analysis
Various types of financial analyses go into financial analysis. They include:
- Vertical analysis – This technique identifies the manner in which a business employed its resources. The technique looks at the proportion of resource application and distributing across the balance sheet and income statement. Here, analysts represent items like liabilities, assets, and shareholder equity as a percentage of the gross assets under the company’s control. On the other hand, every income element is represented as a percentage of gross sales over the same period.
- Horizontal analysis – This kind of technique seeks to review the long-term performance of a company. Specifically, analysts determine the growth rate of the company for the current year compared to years past. The objective here is to identify problems in the business and opportunities that can be exploited.
Other techniques that are helpful to analysts include trend analysis, liquidity analysis, turnover ratio analysis, profitability analysis, business risk analysis, financial risk analysis, and stability ratios.