An Introduction to Financial Analysis
Proficiency in the language of finance, or the ability to read and analyse financial information and exhibit data through financial reports, is one of the skills required for understanding and managing a corporation. For each business manager, the capacity to understand financial data is essential. All firms have set financial objectives, and their success is also measured in financial terms.
What is Financial Analysis?
As analysing financial reports entails, it also entails comprehending how business decisions are made, which entails observing, evaluating, anticipating, and formulating diagnoses for all of the activities that occur in any organisation and are summarised in the financial accounts.
All commercial activities must include financial analysis since it enables insights into the organization’s capacity and health that can be used in court. This information not only gives lenders and investors crucial information that could affect the value of stocks or interest rates, but it also enables business managers to assess their performance with expectations or industry growth.
Types of Financial Analysis
1. Fundamental Analysis
The fundamental analysis examines relevant economic and financial elements to give you a perspective on a company’s inherent value.
Analysts generally utilise this technique to assess the key variables that affect a security’s value, ranging from macroeconomic variables like government regulations to microeconomic variables like corporate management.
- It is a method that increases your conviction in choosing businesses for long-term investment and wealth creation.
- To assist investors in their investing selections, analysts use this technique to identify stocks currently trading at discounted or overvalued levels.
For instance, if a stock is trading above its fair market value, it is overvalued in the current market, and analysts advise selling the shares.
2. Technical Analysis
On the other hand, In technical analysis, analysts examine historical statistical trends like volume and price to assess the investment potential. Technical experts believe that rather than moving erratically, stock prices will likely continue to follow the historical pattern. Market psychology or emotions influence everything that happens on the stock market. Technical analysts utilise historical data charts to examine these emotions and market swings to comprehend stock market patterns better.
Technical analysts hold that history will repeat itself and that by understanding historical patterns or trends, we may better comprehend investment opportunities.
How is Financial Analysis Used?
1. Corporate Financial Analysis
The accounting department or another internal financial analyst of the business performs this study, which is subsequently shared with management to help them make better decisions. Ratios like Net Present Value (NPV) and Internal Rate of Return are part of this analysis (IRR).
2. Investment Financial Analysis
In this, a third-party analyst examines the company for potential investment. Analysts typically use one of two major approaches: top-down or bottom-up. In the top-down approach, all macroeconomic aspects are taken into account before investing, such as which industries have the potential to expand. Then, it is determined which firms in which sectors are the best to invest in. In a bottom-up study, analysts start with specific companies, take into account microeconomic techniques, and perform ratio analysis like the corporate financial analysis.
Key Elements of Financial Analysis
1. Income Statement
The company’s performance in terms of financial gains or business profitability for a specific period is essentially displayed in the income statement. Analysts utilised this report to forecast the company’s performance and anticipated future cash flow. The P&L statement, statement of earnings, or statement of operations are also referred to as income statements. The top line in this statement relates to a company’s revenue collection over a specific time, and the bottom line denotes net profit or loss. However, numerous business costs are recorded between the top and bottom lines and are also referred to as running costs.
2. Balance Sheet
A balance sheet is a financial statement that lists a firm’s assets and liabilities. It also lists the assets and debts a company has, and the number of money owners or investors have invested.
Assets: According to the balance sheet analysis, assets are listed in order of liquidity from top to bottom. An asset will be listed under current assets if it can be quickly converted into cash in a year or less. Current assets include cash, marketable securities, accounts receivable, and inventories.
Liabilities: Liabilities are sums of money owed to third parties by the company. Current obligations must be paid within a year or less and are stated with their due dates. Current liabilities and long-term liabilities are defined similarly.
3. Cash Flow Statement
Any company’s cash flow statements describe all of its cash inflows and outflows, including those from operations, earnings from outside investments used for expenses, and other investments. Because it describes the money businesses make from diverse sources, it is the statement that any investor can understand easily. Cash inflows typically come from three sources: operations, investments, and financing. Net cash flow is the total of all of these cash inflows.
Financial analysis is currently seen as a crucial component of corporate operations, without which operating a corporation would be pointless. The financial analysis determines a firm’s health and stability, making it easier to understand how the organisation does business. However, it’s equally important to remember the difficulties of financial statement analysis. The company’s apparent health and profit levels are changed, either for the better or for the worse, by various accounting techniques used by various firms. Therefore, it’s crucial to remember that financial analysis for every organisation requires careful handling and that all recommendations are implemented correctly.