Importance of Financial Analysis

Financial analysis is a process of examining the financial data of an entity to assess its performance. The financial analysis of a company is used to evaluate economic trends and establish financial policies. Financial data is used to calculate different ratios and the performance of a company is assessed by cross-matching figures with the previous year or industry’s average. The financial analysts examine the position of an entity by thoroughly analyzing financial statements ( i.e., Cash flow statement, Statement of financial position, and income statement).

Purpose of Financial Analysis

The main objective is to analyze the performance of an entity. Financial analysis is conducted to predict about stability, solvency, liquidity, and profitability of a business organization. To set financial policy and building of long-term business plans, it is necessary to understand trends of financial performance of a business organization.

Advantages of conducting financial analysis

Financial managers use analytical skills to understand the reasons behind increasing or decreasing percentages of different items in financial statements. Here are some of the aspects to answer the question that why it is so important.

Modify business policies

The financial analysis of a company can contribute towards improving business policies especially in those areas which have shown negative trends. Let’s understand this concept by an example. If the advertising expense as a percentage of the sale is too huge this year when compared with historical years, it means that the company needs to reformulate its advertising policies so that to minimize it to such an extent that it won’t affect net income figures.

Operational Efficiency

Financial statement analysis helps the managers to evaluate the operational efficiency of a company and suggests which areas need improvements.

Divert management attention towards important areas

It assists in analyzing the strengths and weaknesses of an entity and directs the attention of management to focus on key areas to improve the performance of an entity in those areas.

Cash position and Debt analysis

Financial analysis helps company management to understand what the cash position is and tells what the proportion of debts against equity is.

Valuation of Stock

Financial analysis is conducted to understand the value of stock held by the company and also makes it understandable that either debtor’s cycle is showing improvements or there are chances of more bad debts.

To raise new loans

Sometimes it is a compulsory requirement to provide your published financial statements to apply for a loan. An analysis report can help financial institutions, banks, or loan agencies to decide whether an entity should be given a loan facility or not.

Examples of Financial Analysis

1) Suppose an entity has reported its financial reports, and the Earnings per share were $2.35 for the first quarter of 2021. Later on, the following trend was seen till the end of the third quarter.

QuarterEarnings per share (EPS)
1ST$ 2.35
2nd$ 2.40
3rd$ 2.43

As it is evident from the data that the intrinsic value of a security is showing an increasing trend. A financial analyst can use these figures to project the EPS for the 4th quarter.

2) Another example of financial analysis is to use financial data for the calculation of ratios. Like if a company calculates its Return on Assets ratio(ROA), it will suggest what return a company is obtaining after utilizing its assets. The comparison of this ratio with previous years and industry average can be used to indicate how efficiently a company is generating earnings by using assets.

Also read, profitability ratio.




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