Finance is the language of any business.
Among the expertise necessary for understanding and handling a business is proficiency in the language of finance, i.e the capacity to be able to read and comprehend financial information and also to be able to display data through financial reports.
The ability to be able to comprehend financial information is critical for any business manager. The goals and aims of all businesses are established in financial terms with their results also being gauged in financial terms.
"I will tell you how to become rich. Close the doors. Be fearful when others are greedy. Be greedy when others are fearful." — Warren Buffett
Finance also incorporates examining the data enclosed inside financial statements with the aim to facilitate valuable information to aid in management decisions.
This makes financial analysis one potent aspect of the overall role of finance. A company's accounts and statements contain a great deal of information. Exploring the full connotations enclosed inside the statements lies at the heart of financial analysis.
What is Financial Analysis?
Financial analysis is used to find financial stability, evaluate economic trends, financial policymaking for the long term, and evaluation of businesses in order to determine its profitability, sustainability, and strength of earning potential.
As the analysis of financial reports also means an understanding of the functioning of business decision-making which includes observation, assessment, forecasting, and formulation of diagnosis all the processes that took place in any organization, summarised within the financial statements.
Financial analysis is an essential part of all commercial operations as it facilitates litigable insights into the health and capacity of the organization in the future. Alongside providing imperative data to the lenders and investors that could sway the price of stocks or rate of interest, this information also enables company managers to measure their performance in terms of the expectations or growth of the industry.
From the perspective of the management, financial analysis is essential for the advancement of the company as it sheds light on the strengths as well as the weaknesses which in turn directly impact competitiveness.
There are many common ways to analyze financial data like calculating ratios from financial statements and comparing these financial ratios to historical data of organizations or other competitor companies.
Types of financial analysis
There are two types of financial analysis:
1. Fundamental analysis and
2. Technical analysis
1. Fundamental Analysis:
The fundamental analysis gives you the perspective of a company's intrinsic value by examining related economic and financial factors.
Generally, analysts used this technique to evaluate the major factors that influence security’s value, either from macroeconomic factors like state policies, environmental factors supporting particular industries to microeconomic factors like the company’s management.
- It is a technique that gives you a better conviction to identify companies for long term investment and create wealth.
- Analysts prefer this technique to find stocks that are currently trading at undervalued or overvalued, and then decide a fair market value of those stocks to help the investors in their investment decisions.
For example, if a stock is trading higher than its fair market value means the stock is overvalued in the current market then the sell recommendation is given by analysts.
Types of Fundamental Analysis
The various factors of Fundamental Analysis can be divided in two broad categories:
1. Qualitative analysis
It includes the quality of company’s executives, vision, brand-name recognition, patents and proprietary information, technology. Generally it is related to the nature of business and standard of organization rather than sticking to its quantity.
2. Quantitative analysis
Quantitative analysis of financial statements is used to understand a company's financial performance better before making an investment decision. The three most important financial statements being used for quantitative analysis are income statements, balance sheets and cash flow statements.
Types of Financial Analysis
2. Technical Analysis:
On the contrary, In technical analysis analysts evaluate the investment opportunities by analyzing past statistical trends such as volume and price. Technical analysts assume that prices of the stock are more likely to follow the past trend rather than move strangely.
In the stock market everything is related to market psychology or market emotions, technical analysts use past data charts to analyze these emotions and market fluctuations to better understand trends related to stock.
Technical analysts believe the fact that history will repeat itself and we can better understand the opportunities to invest if we understand the past patterns or trends.
However, fundamental analysis and technical analysis both needed to make an effective market strategy.
How is financial analysis used?
1. Corporate financial analysis:
This analysis is done by the company's internal financial analyst like the accounting department and then shared analysis reports to management to make better decisions. This analysis includes ratios like Net present value (NPV) and Internal Rate of Return (IRR).
2. Investment financial analysis:
In this an external analyst analyses business for investment purposes. Generally, analysts conduct two major approaches that are top-down or bottom-up.
In the top-down analysis, all the macroeconomic factors considered before investing like which sectors have the potential to grow, then they come down to the best companies in particular sectors for investment.
In the bottom-up analysis, analysts consider microeconomic approaches and start with specific companies and then conduct ratio analysis the same as corporate financial analysis.
Key elements of financial analysis are:
1. Income statement
2. Balance Sheet
3. Cash flow statement
Key elements of Financial Analysis
1. Income statement
Income statement basically shows the company’s performance in terms of financial gains or business profitability for a given period of time. Analysts used this report to predict the company's future performance and potential future cash flow of business. Income statement also refers to the P&L statement, statement of earnings, or statement of operations.
In this statement, the top line refers to revenue collection of a business for a particular period of time and the bottom line represents net profit or a net loss. But there are many business expenses also called operating expenses that are written in between the top line and bottom line.
2. Balance sheet
A balance sheet is a company's financial statement that shows company’s assets and liabilities, it also shows what a company owns and owes, the amount invested by investors or shareholders.
Assets- According to balance sheet analysis, assets are written from top to bottom in terms of their liquidity. If an asset is easy to convert in cash within a year or less then it will be written under current assets. Cash, marketable securities, accounts receivable, inventories are considered as current assets.
And if an asset can not be converted into cash within a year are considered as long-term assets. Land, machinery, equipment, intellectual property are listed in a company's long-term assets.
Liabilities- Money that company owes to outside parties. The definition of current liabilities and long-term liabilities are somewhat similar, current liabilities that need to pay within one year or less listed with their due date. Interest payable, wages payable, rent, dividends, and accounts payable are considered as current liabilities.
Long term liabilities that are due and need to pay after one year. For example - long-term debt, deferred tax liabilities, etc.
3. Cash Flow Statement
Cash flow statements of any company’s report all kinds of cash inflows and outflows which a company receives from operations, external investment earnings to spend for business events and activities, and other investments.
It is the most intuitive statement for any investor because it tells about cash made by business from various sources. Generally, there are three ways of cash inflows that are - from operations, investments, and financing. The sum of all these cash inflows is called net cash flow.
Read our blog on Key elements of Financial Analysis.
In the present scenario, financial analysis is thought to be an essential ingredient in business operations, without which, running a business would go futile. The financial analysis establishes the health and stability of a company, facilitating comprehension of how the company carries out its business.
Yet at the same time, it is crucial to keep in mind the challenges of financial statement analysis. Various varied accounting approaches employed by different firms’ alter the apparent health and profit levels of the firm for the better or the worse. Thus it’s important to keep in mind that for every company, financial analysis has to be handled diligently and it has to be ensured that all its findings are properly executed.