Financial Analysis is a process used by financial managers to assess various aspects of a business, organization, or individual. It enables decision-making by examining and interpreting financial data, helping to identify historical trends, enabling comparison between past and present behaviors, and forecasting future trends and outcomes.
Types of Financial Analysis
Financial analysis comprises different types of activities which are carried out to critically assess a business’s financial position in order to help inform strategic decision-making. These types of analyses can include:
•Ratio analysis: A method of using specific numerical values to analyze financial performance. This can be done either on a historical basis or by forecasting (or ‘trending’) future performance.
•Cash flow analysis: Assessing the value and flow of money in and out of a company. This type of analysis highlights a company’s liquidity and helps to identify its short- and long-term ability to meet its debt obligations.
•Cost/benefit analysis: Weighing up the costs and benefits of a specific activity or decision. This type of analysis is usually done in order to weigh the risk of a project or activity versus its potential gain.
•Budgeting & forecasting: Drawing up a budget which is then used as a basis for forecasting future performance. A budget helps to identify potential problems areas and is a great tool for highlighting areas where cost reduction may be possible.
•DuPont analysis: Assessing a company’s return on equity (ROE) through an evaluation of its various business components. It is a helpful tool for highlighting areas of the business that are performing well or need improvement.
•Fundamental analysis: Examining various aspects of a company such as its financial history, products, services, management, and competitors. This type of analysis is typically used in evaluating a company’s potential for investing.
Overview of Financial Analysis Process
Financial analysis is a process which enables a financial manager to gain an overview of a company or entity’s past and present performance in order to inform strategic decision-making. It is a critical component of an organization’s financial management system and is used to judge whether investments or decisions are beneficial.
The financial analysis process can be summarized as follows:
• Collect and review financial data – A financial manager will collect data from various sources, such as financial statements, tax returns, and other documents.
• Analyze data and draw conclusions – The data is then analyzed in-depth using various methods such as ratio, fundamental, and cash flow analysis to gain an overall picture of the organization’s current and potential future performance.
• Report findings – A report is then written which incorporates statements, graphs, charts, financial projections and other forms of data which illustrate the manager’s conclusions.
• Take action – Finally, the manager makes a decision or recommendation informed by the data and the report. This could involve making a financial investment, cutting costs, restructuring, or making other changes.
Example
A great example of how a financial analysis process can help an organization to make a strategic decision is the case of the Amazon Corporation. One of its most famous decisions revolved around its decision in 2014 to purchase the streaming service Twitch for $970 million. To help inform this decision, a financial analysis process was conducted which looked at the cost, risk, potential gain, and other factors associated with the acquisition. By taking into consideration the data gathered during the analysis process, Amazon was able to accurately evaluate the potential impacts of the acquisition. This in-depth understanding enabled them to move forward with the deal in the knowledge that the acquisition was likely to prove advantageous to the company’s growth.
Conclusion
Financial analysis is an essential process for financial managers in both the public and private sectors, as it provides an effective and efficient way to gain an understanding of a company’s financial health. Through the use of various methods, techniques, and tools it enables decision making and forecasting based on historical trends, helping companies to better plan for the future and identify areas of improvement.
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