Financial Analysis - Explained
What is a Financial Analysis?
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Table of ContentsWhat is a Financial Analysis?How Does Financial Analysis Work?Elements of Financial AnalysisTypes of Financial AnalysisBest Practices in Financial Analysis
What is a Financial Analysis?
Financial analysis is the process of examining, evaluating financial information in business to make suitable business decisions. The examination process involves analyzing both current and historical profits, cash flows, and risks in the business. The analysis often results in the reallocation of business resources or particular internal operations. Financial analysts can use excel spreadsheets to perform their evaluations and make decisions on how the business can better its performance in the future.
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How Does Financial Analysis Work?
Financial analysis in a specific company tends to focus on the balance sheet, income statements, and cash flow statements. The balance sheet highlights the financial resources that a company utilizes to carry out its day-to-day business operations. The income statement provides all the information on the company's performance and provides indicators on its sustainability. The cash flow statement shows the exact amounts of cash that the company is generating. The company uses the results of the analysis to establish its long-term goals, find investment projects, assess the economic trends, and set its financial policies.
Elements of Financial Analysis
A proper financial analysis includes the following key aspects, which determine whether your business has growth potential or not.
Revenues are a business's major source of cash. The timing, quality, and quantity of revenues are the determiners of a company's overall success. Calculations of revenues should never include one-time revenue-generation projects. One customer who makes a company generate a lot of revenue can alter the analysis when they stop buying the product.
A company that constantly generates quality profits has a higher chance of surviving in the future, than low-profit generating companies. A huge gross profit helps the company to offset minor losses, and also pay the daily operations expenses. The companys ability to manage the operations costs also helps to determine its ability to make profits.
- Operational efficiency
Involves measuring how the company is utilizing its available resources. Poor management of resources causes the company to make smaller profits, and this may hurt the companys overall growth. Inventory management also determines whether the sales of the company are good or bad.
Financial analysis should always include an analysis of the company's liquidity, its ability to create sufficient funds to cater to daily expenditures, and other liabilities. A company may fail to pay off its debts because of its inability to manage its liquid cash.
Types of Financial Analysis
Professional make use of the following types of financial analysis:
- Vertical Analysis
Analysts use this type of analysis to examine the income statements of a company, and express the figures as percentages by dividing them by the company's revenue. They then compare the results of the analysis with that of other companies to see their performances. Vertical analysis is the best type of analysis when analysts want to compare the financial data of companies of different sizes, and evaluating their margins against the dollar.
- Horizontal Analysis
Financial models store a company's data for many years. The horizontal analysis involves extracting previous financial data of a company and making comparisons between them to establish the growth rate of the company. It helps analysts determine whether the company is rising or falling, and identify trends that are important for its growth.
- Growth rates
The analysis of historical growth rates of a company helps analysts to estimate the future growth rates. Common growth rate analysis includes; top-down analysis, bottom-up analysis, regression analysis, and year-on-year analysis, and they help analyze growth rates.
- Efficiency analysis
Financial analysts make use of the efficiency analysis to look at how an organization manages its securities and assets, and how they use the assets to make money. Some of the ratios that analysts use to measure efficiency are the fixed asset turnover ratio, inventory turnover ratio, and cash conversion ratio.
- Cash flow analysis
Financial analysts emphasize a lot on the company's cash-generating activities, and they spend most time evaluating a company's cash flows. Analysis of the cash flow statements includes looking at the company's financial activities, operations activities, and investment activities.
- Valuation analysis
Valuation analysis is a critical aspect of financial analysis as it involves determining the financial worth of a business. Analysts combine different methods and financial models to make accurate estimations.
- Scenario and Sensitivity Analysis
The future value of a company is very uncertain, so, analysts perform this type of analysis to measure the risks of the business and maybe predict the future. Creating scenarios helps to define the best and the worst financial futures of the company. Managers and analysts usually use this method to predict the future and prepare their budgets accordingly.
Best Practices in Financial Analysis
Analysts can perform all the above types of analysis using excel spreadsheets, and they need to make use of best practices to do this. Given the large data sets that they examine, some ways to avoid errors include;
- Pass the work through different analysts to get their opinion
- Use simple formulas and calculations
- Present the data using charts, graphs, and tables
- Make comments on the data cells
- Carefully organize the large sets of data
- Frequently auditing the spreadsheets