in this article, we will share the financial analysis, its uses , types and steps to an effective statement analysis, which is useful for any organization and for commerce and management students:
The process of reviewing and analyzing a company`s financial statements to make better economic decisions is called analysis of financial statements. In other words, the process of determining financial strengths and weaknesses of the entity by establishing the strategic relationship between the items of the balance sheet, profit and loss account, and other financial statements.
The term analysis means the simplification of financial data by methodical classification of the data given in the financial statements.
Interpretation means, explaining the meaning and significance of the data so simplified. However, both analysis and interpretation are interlinked and complementary to each other.
Financial analysis is the process of evaluating businesses, projects, budgets, and other finance related transactions to determine their performance and suitability.typically, financial analysis is used to analyze whether an entity is stable,solvent,liquid or profitable enough to warrant a monetary investment.
How financial analysis is used??
- CORPORATE FINANCIAL ANALYSIS: in corporate finance, the analysis is conducted internally by the accounting department and shared with management in order to improve business decision making. This type of internal analysis may include ratios such as net present value(NPV) and internal rate of return(IRR) to find projects worth executing.
Many companies extend credit to their customers. As a result, the cash receipt from sales may be delayed for a period of time. For companies with the large receivable balances, it is useful to track days sales outstanding(DSO), which helps the company identify the length of time it takes to turn a credit sale into cash. The average collection period is an important aspect in company`s overall cash conversion cycle.
A key area of corporate financial analysis involves extrapolating a company`s past performance, such as net earnings or profit margin, into an estimate of the company`s future performance. This type of historical trend analysis is beneficial to identify seasonal trends.
- INVESTMENT FINANCIAL ANALYSIS:In investment finance, an analyst external to the company conducts an analysis for investment purposes. Analysts can either conduct a top down or bottom up investment approach. A top down approachfirst looks for macroeconomic opportunities, such as high performing sectors, and then drills down to find the best companies within that sector. They further analyze the stocks of specific companies to choose potentially successful ones as investments by looking last at a particular company`s fundamentals.
A, bottom up approach, looks at a specific company and conducts similar ratio analysis to the ones used in corporate financial analysis , looking at past performance and expected future performance as investment indicators. Bottom up investing forces investors to consider microeconomic factors first and foremost. These factors include a company`s overall financial health, analysis of financial statements, the products and services offered, supply and demand, and other individual indicators of corporate performance over time.
Types of financial analysis:
There are two types of financial analysis:
- Fundamental analysis
- Technical analysis
- Fundamental Analysis: Fundamental analysis uses ratios gathered from data within the financial statements, such as a company`s earning per share, in order to determine the business value. Using ratio analysis in addition to a thorough review of economic and financial situations surrounding the company, the analyst is able to arrive at an intrinsic value for the security. The end goal is to arrive at a number that an investor can compare with a security`s current price in order to see whether the security is undervalued or overvalued.
- Technical Analysis:Technical analysis uses statistical trends gathered from trading activity, such as moving averages. Essentially, technical analysis assumes that a security`s price already reflects all publicly available information and instead focuses on the statistical analysis of price movements. Technical analysis attempts to understand the market sentiments behind price trends by looking for patterns and trends rather than analyzing a security`s fundamental attributes.
Procedure used in financial statement analysis: For any,financial professional , it is important to know how to effectively analyze the financial statements of a firm. This requires an understanding of three key areas:
- The structure of the financial statements
- The economic characteristics of the industry in which the firm operates and
- The strategies the firm pursues to differentiate itself from its competitors.
There are generally six steps to developing an effective analysis of financial statements:
- identify the industry economic characteristics..
- identify company strategies
- assess the quality of the firm`s financial statements
- analyze current profitability and risk
- prepare forecasted financial statements
- value the firm