Why Is It Important To Do A Financial Analysis?

What Do You Understand By Financial Analysis?

Financial analysis can be defined as the process to evaluate the financial position of a business, project, individual segment, etc. The process is carried out to measure the profitability and viability of the business or the project that is being evaluated. It involves applying various financial techniques to obtain a comprehensive picture of the organization’s economic wellbeing.

Broadly speaking, there are two types of financial analysis techniques. The first can be called the Fundamental analysis and the second can be called the Technical analysis technique.

The Fundamental analysis technique uses the method of ratio analysis to obtain a holistic picture of the organization’s financial wellbeing. It focuses on computing the intrinsic value of the stock which is later compared with its market value to establish if it’s undervalued or overvalued.

The Technical analysis, on the other hand, uses market statistics to evaluate the current and past patterns and then incorporate that to predict future price movements of the security being evaluated.

Financial Analysis Objectives

Reviewing historical performance and trends

One of the main objectives of carrying out financial analysis by organizations is to measure past performance and make future predictions based on the assessment. The review is carried out by assessing the historical trend of profitability, cash flow, sales, Return on Investments and other similar metrics.

Evaluating the present position of the enterprise

To determined and assess the financial health of the organization it is imperative to examine the current profitability figures and operational efficiency. It also helps with the long term decision making which requires evaluating the assets and liabilities of the firm. It also helps with measuring the earning capacity of the firm and its overall operational efficiency.

Making predictions about growth and profitability

Profitability and growth prospects are the main concern of top-level management because the longevity of the firm is contingent on that. Financial analysis helps to evaluate different investment opportunities for the firm and find out the most profitable investment avenues that help in maximizing the revenue. In addition to this, it helps in predicting future economic trends that might affect the firm either positively or negatively.

Decision making in the credit risk process

One of the most crucial aspects of conducting financial analysis is to find out the creditworthiness of an individual or a company for providing loans. The analysis helps banks and other lending institutions to minimize credit risk by not providing loans to high-risk borrowers.

Significance Of The Financial Analysis

Now that we have an understanding of the financial analysis concept, let’s delve into why it is significant for various stakeholders to the organization. Financial analysis is an important process that is carried out while weighing various investment opportunities or the performance of a business entity.

From assessing the performance of financial instruments like bonds, stocks, etc. to guide on the financial needs of an organization, financial analysis helps in multiple ways. Some of the major applications of financial analysis are listed below.

  • Evaluating the efficiency of the operational processes of the organisation
  • Assessing and evaluating the performance of top management of an enterprise
  • Analysing and evaluating the creditworthiness of the company and measuring its financial standing in the industry
  • Predicting future economic trends and movements and how it’ll affect the organisation
  • Analysing the different assets and liabilities held by the organisation and their relevant impact
  • To evaluate whether resources are being used judiciously keeping efficiency and effectiveness in mind
  • To evaluate the system of internal control and regulations
  • To measure the firm’s ability to pay off its debts both short and long term
  • To measure the firm’s ability to generate cash and maintain cash flow

 

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