Understanding Financial Analysis
Financial Analysis can be understood as the process in which the financial stability and profitability of a business or a project are determined by using various analysis techniques. It is also used to find out profitable investment opportunities and longevity of the business. It helps the managers to make informed future business decisions by acting on the predictions. In addition to this, it also helps managers to understand the historical business trends and paints a holistic picture of the organisation.
From a broader perspective, the financial analysis techniques are categorised under two types - Fundamental analysis and Technical analysis. The process of fundamental analysis is centred on finding the intrinsic value of the stocks or the business. It uses various ratio analysis techniques that rely on the data provided in the financial statements to determine the financial health of the business. It also takes a comprehensive view and evaluates the overall economic stability of the organisation. The technical analysis is different from fundamental analysis. Its main emphasis is to make future predictions based on past and current statistical data. It relies on the market information about the stock of an enterprise to come to any conclusion. It is carried out using various charts and trading patterns of the securities.
Tools of Financial Analysis
Now that we have understood what financial analysis is and what it entails, let’s delve deeper into the subject and find out the tools of financial analysis.
- Common Size Statements: Common Size Statements are income statements in which each item in the statement are expressed as the percentage of a base metric. Each line item is expressed as a percentage of sales or revenue that helps to facilitate the analysis. The market is very diverse and organisations are operating at various scales, to make the comparison viable the units should be expressed in terms of percentage. This format of representing the financial data is globally accepted. Common size statements include a common size balance sheet that uses the total asset as the base value, common size income statement that uses revenue as the base figure, etc.
- Ratio Analysis: Ratio analysis is the technique deployed in the fundamental analysis process to find out the intrinsic value of the security or the enterprise. Ratio analysis uses relevant figures from the financial statements to calculate various ratios. There are various types of ratios that are calculated to establish a comprehensive financial picture of the organisation. The ratios that are generally calculated to assist in the financial analysis include Profitability ratio, Rate of return analysis, Solvency ratio, Liquidity ratio, Turnover ratios, Business risk ratios, Operating profitability ratios, etc.
- Benchmarking: In the benchmarking technique the actual financial figures and estimates are compared with the benchmark or standard figures set by the top-level management of the organisation. Benchmarking techniques can also put the best practices in the industry as the standard and organisations are required to meet the same. The process of benchmarking includes selecting the area or segment that needs to be optimized, identifying trigger points for comparison, setting up the standard or benchmark figure, evaluation of periodic performance, checking whether the performance matches the standard or not. If it doesn’t match the benchmark then the process is followed by variance analysis.
- Comparative Financial Statements: The comparative financial statements are used in carrying out the horizontal financial analysis process. It helps in measuring period changes in financial variables and establishing the pain points of the business. It can be prepared in absolute or percentage form. The advantages of comparative financial statements include easy comparability, timely evaluation of financial performance, etc.