Financial Analysis – Meaning, Definition and Methods

Financial statements are the source of information that present the economic value of a company to the external users. Several articles and books has defined the Financial analysis as to combine financial statement, financial notes, with other information, to evaluated the past, current, and future performance and financial position of company for the purpose of making investment, credit, and other economics decision. Financial Analysis is concerned with risk factors that might affect the future performance of a certain company.

Financial analysis is concerned with different aspects of the company, in general financial analysis deals with profitability (ability to generate profit from delivering good and services), cash- flow generating ability (ability to generate cash inflows exceed cash outflows), liquidity (the ability to meet short term obligation), and solvency (the ability to meet long term obligation).

In order to conduct a full, comprehensive analysis, analyst must collect information concerning economy, industry, competitors, company itself. This external information can be found as economics statistics, industry reports, and trade publication. The company provides the internal part of the information which includes the financial statements, and press releases.

Financial analysis is not only about financial data which is the core of the financial analysis and provided in the four major financial statements, that provide the historical and current information; is it about the non-financial data which provide the future information. Regarding the financial data, can be founded in the four major statements: income statement, balance sheet, statement of cash flow, statement of changes in owners’ equity.

The income statement shows how much revenue the company generating during certain period and what its cost incurred. Income statement can be referred as “profit and loss” and it’s prepared on consolidated basis. Revenues, operating income, net income, and earning per share can be driven from the income statement.

The balance sheet or as recently knows as the “statement of financial position”, shows the current financial position of the company by showing company resource (Assets), and what it owes (liability) at a specific point in time. While the (owners equity) shows the excess of assets over the liabilities, analysts could use the information stated in the statement of financial position to answer question regarding improvements concerning liquidity, and solvency, and give the statues of the company compared to its peers in the same industry.

The cash flow statement classifies the cash flows into of three sections: operating activities which include items determines net income as well as day to day transactions. While investing activities includes the acquisition and disposals of long term assets. The last section is financing activities which contain activities related to obtaining or repaying capital. Cash flow statement provides information related to performance and financial position. While income statement provides the necessary information regarding the company ability to generate profit, cash flow statement provides information regarding the ability of the company to generate cash flow from running the business itself.

Statement of changes in owners’ equity knows as “statement of shareholders equity”, reports the changes in the owners’ investments in the business, and it helps analysts in understanding the changes in the financial position. Beside the four major statements, financial notes and supplementary schedules, management’s discussion and analysis, and auditor’s reports, provide a quite good set of extra information for further analysis.

Financial analysis should be well defined as it could be preformed for different reasons and purposes. Different categories require different financial techniques, but for any purpose data must be gathered and analyzed, and all examining the company ability of generating cash and grow earnings. But as for different focuses, different techniques are used. For example, the most tow common categories are the equity analysis and the credit analysis. Equity analysis is usually preformed by the owner, and focuses on growth while the credit analysis is preformed by the creditors (banker or bond holder) and concentrates on risks associated.

Defining the purpose of the financial analysis is the most important and first step in effective financial analysis as it defines the necessary financial techniques that should be used, and thus defines the type and amount of data to be collected. After defining the purpose of the financial analysis, a suitable technique should be chosen to deliver the purpose of the focus. To reach the best results, a mixture of calculations and interruptions is required. For example, it is not enough just to calculate the financial ratios, further investigation explaining the reasons behind each ratio, what each ratio means, comparing the ratios with other competitors, might give a comprehensive picture.

A comparison is a must in a good evaluation, compare the company with other competitors in the industry is common size analysis, while evaluate the company through time called trend analysis, and ratio analysis is to express certain number to another in which answers some important question about the true financial position. Common size analysis is to compare a total financial statement – usually income statement, balance sheet, cash flow statement in relation to base like revenues or total assets. Common size analysis for the balance sheet includes: horizontal and vertical common size analysis, where horizontal common size analysis is to compare the increase or decrease in balance sheet items to previous years. Vertical common size analysis involves dividing each item in the same period total assets to come with a percentage, in the case of analyzing the income statement, items usually are divided by revenues. Trend analysis involves comparison of the financial statement of an entity over time, trend analysis usually provide information about the historical performance and growth. Cross sectional analysis compare a specific measurement of a company with the same measurement for another company. The use of graphs and analytical tools could facilities the comparison and highlight the most important facts that the analyst wants to communicate with the management. Statistics like regression analysis are used in more complicated situation where more precise information needed.

Ratio analysis is one of the most famous techniques in the financial analysis where it provides information about the relationships and expectations between the financial accounts. Certain issues should be in mind while conducting ratio analysis; as mentioned before computing the ratio itself is not enough for providing a comprehensive picture about the financial performance, it only indicating what certain issues are but not explaining why they are happening, therefore further investigation going beyond the numbers is required, in compliance with full compression overtime, competitors, and industry. Second issue would be to choose the relevant ratios as ratios used for different purpose and providing certain financial information; for example ROA is an indicator of profitability, where current ratio provides information regards liquidity. Different accounting policies can misrepresent ratios; therefore adjustments across different financial statements for different companies are required for a meaningful analysis.

There are about five main types of financial ratios; profitability, activity, liquidity, solvency, valuation ratios. Profitability ratio is measure the company’s ability to generate profit from its resources, the most famous ratios in this category are: return on assets (ROA) and return on equity (ROE). While activity ratios measure how efficient the company in managing the day to day activities, inventory turnover is one example of the ratios used under this category. Third type is liquidity ratios where it deals with the company ability in meeting short term obligations, can be expressed in current ratio, while solvency ratios deals with long term obligation, debt to asset is one example of solvency ratios. Valuations ratios are used to asses the company equity, P/E ratio is used for this purpose. Ratios could be driven from the financial statements of the company or from specialized websites as Bloomberg, as these kinds of websites provide easy access to the historical data.

Ratio analysis drove its importance from the information that might provide, as it gives an insight to the historical, current and future performance of the company. Though ratio analysis has its own limitation when it deals with a company operates in different industries, as the comparison become more difficult then. Another limitation would be the use of different accounting methods as comparison would be difficult unless adjustments are made, for example one company might consider account for its inventories under the FIFO method while the other account for it under the LIFO method.

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