The Essence and Significance of Financial Analysis
Would you like to stand out from your competition, cut costs, improve your cash flows, or take advantage of strategic opportunities available to your business?
Financial analysis is the key to competing successfully in today’s data-driven world. Financial analysis provides a good picture of your business’ overall financial health by evaluating key performance indicators. This helps to determine the profitability, liability, power, and future earning capacity of your business.
In carrying out financial analysis, business owners/managers aim to:
- Measure the operational efficiency and profitability of the business,
- Measure the short-term and long-term solvency of the business and its ability to pay obligations to creditors and other third parties over the long term,
- Examine the business’ ability to maintain positive cash flows while meeting short-term obligations, or
- Ensure that the business is able to remain stable in the long run without incurring significant losses.
Various stakeholders/groups will be interested in the financial analysis and performance of your business.
- Management will be interested in; ensuring that business resources are being used efficiently, ensuring that the business is in sound financial condition, evaluating the internal control systems, and determining the success of business operations.
- Trade creditors will be interested in; the profitability of the business and its ability to meet short-term obligations.
- Lenders are interested in your firm’s solvency and survival and will focus on; the capital structure, past and projected profitability, and credit risk.
- Investors are interested in; the current and expected future earnings, profitability, and stability of your business as they have put money into the business.
The common tools and techniques used in carrying out financial analysis are cash flow analysis, common-size statement analysis, comparative statement analysis, trend analysis, and ratio analysis.
Comparative Statement Analysis – also known as a horizontal analysis, it shows the profitability and financial position of a business for two or more periods. It involves comparing financial information over a period of time, with a base year being chosen for comparison.
Common-size Statement Analysis – also known as vertical analysis, it involves a proportional analysis of the financial statements. Each line item in the financial statements is considered as a percentage of the base year and compared with the results of previous years.
Ratio Analysis – ratios are used to calculate the relative size of one figure in relation to another. Ratio analysis highlights relationships between the balance sheet and profit and loss statement in a bid to measure the profitability, efficiency, liquidity, and solvency of the business
Trend Analysis – here the calculated ratios are analyzed over a period of time to study operational results, financial position, and the performance of management.
Cash Flow Analysis – a cash flow statement is prepared to show the actual movement of cash into and out of the business. It is an important analysis tool as it gives a picture of how cash has been utilized during the accounting year by evaluating operating, investing, and financing activities.
Conclusion: The strategic development of your business relies on the accurate and timely analysis of financial statements.