What is the Importance of Financial Analysis in Your Business?

Out of the many factors that make a business successful, financial analysis is a crucial one.

Financial analysis is the process of evaluating businesses, budgets, projects and other major finance-related transactions to estimate their performance and suitability. Usually, financial analysis is used for analyzing whether an entity is a solvent, stable, liquid, or profitable enough to make a monetary investment in it.

An Introduction to Financial Analysis

Financial analysis lets you evaluate economic trends, develop a financial policy, create long-term plans for business activity, and identify projects and businesses for investment. Financial analysis is done by studying financial numbers and data. A financial analyst thoroughly examines a company’s financial statements, including the balance sheet, income statement and cash flow statement. You can conduct financial analysis in corporate finance settings and investment finance settings.

One of the most useful ways to analyze financial data is to calculate ratios from the data in the financial statements to compare against the same of other companies or the company’s past performances.

Types of Financial Analysis

There are two major types of financial analysis. They are:

1. Fundamental Analysis:

Fundamental analysis uses ratios extracted from the company's financial data to determine the value of the particular business. With the help of ratio analysis along with a thorough review of financial situations surrounding the company, a financial analyst can determine the intrinsic value for the security. The ultimate goal is to find the number that an investor can compare with the current price for securities to see whether it is overvalued or undervalued.

2. Technical Analysis:

This type of financial analysis uses statistical trends gathered from trading activity. It assumes that the price of securities already reflects the data available in public, and focuses on price movement's statistical analysis. Technical analysis tries to figure out the market sentiment behind price trends by searching for patterns instead of analyzing the fundamental attributes of securities.

Knowing these two types of financial analysis is not going to be enough. To understand the significance of financial analysis, you need to learn how it is used in different scenarios.

How is Financial Analysis used?

As mentioned, financial analysis can be conducted in corporate finance settings and investment finance settings. So, let's discuss how it is used in both scenarios:

1. In a corporate finance setting:

In corporate finance, the accounting department performs the analysis internally and then shares it with management to improve business decision-making. In this type of internal analysis, one uses ratios such as internal rate of return (IRR) and net present value (NPV) to find projects worth putting efforts in.

There are a lot of companies which extend credit to their customers. Quite naturally, the cash receipt from sales is likely to get delayed for a certain period. The companies with large receivable balances can track the ‘days of sales outstanding’ or DSO to determine the time it will take to turn a credit sale into cash. In a company’s overall cash conversion cycle, the ‘average collection period’ plays a crucial role.

In corporate financial analysis, it is important to extrapolate a company’s past performance into an estimate of its future performance. This helps identify seasonal trends.

1. In an investment finance setting:

In investment finance, an analyst outside of the company conducts either a top-down approach or a bottom-up approach for investment purposes. The top-down approach looks for macroeconomic opportunities before searching for the best companies within the sector. From this point, the analyst further evaluates the stocks of certain companies to identify and choose potentially successful ones for investments after learning about the companies' fundamentals.

In the bottom-up approach, the analyst should look at a specific company and perform a similar ratio analysis to the ones used in corporate financial analysis. Here, the analyst uses the companies' past performance and their expected future performance as investment indicators.  This approach compels investors to consider microeconomic factors as a priority.

This is how financial analysis is used in different scenarios.

Why Is Financial Analysis Essential to Your Business?

You have already learned how the usage of financial statements in different settings. But how does such an analysis add value to your business? Well, there are some explanations –

1. Ratio analysis offers crucial insights:

Ratio analysis explores the relationships between key numbers on a company’s financial statements. Once the ratios are calculated, they are compared to industry standards as well as to the company’s past results, projections and goals. It highlights the trends and determines the strengths and weaknesses. In simpler words, ratio analysis gives you valuable feedback to yield profitable results for your business.

2. Focus on accounts receivable:

As mentioned previously, companies extend credit to their customers. If your business does the same, you need to keep a close watch on outstanding accounts to intimate account holders about past due amounts. Financial analysis assignment help Canada you learn the company’s average collection period. The faster your company can collect money from the customers, the better its cash flow will be.

3. Better inventory management:

With inventory turnover, you can learn about the speed at which inventories of the company are sold. A slow turnover rate in comparison with the industry standards indicates that the stock levels are more than what is required. The excess money invested in inventories could be used for other purposes. There is also another possibility that inventories aren't moving, leading to cash flow issues. If your company has a high turnover ratio, it is generally a good sign. However, you need to make sure that there are sufficient inventories to fulfill customer orders on time.

In conclusion

Financial analysis may sound a bit complex initially, but as you learn about financial analysis ratios, you will start understanding how they can be valuable to your business. If you are still not 100% clear about financial analysis and related issues, it is recommended to consult with an expert with proper knowledge of such matters.