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What is Financial Analysis? Purpose, Importance, and Types

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# What is Financial Analysis?

Financial analysis is the process of evaluating a business. It is data to review past financial performance, compare actual outcome budgets, and run financial forecasts that they need to make informed decisions. So that the profitability, liability, power, and future earning capacity of the business can be determined. Various techniques can be used to assess the financial viability of an organization, including the most common method of financial analysis, such as; Horizontal analysis, vertical analysis, and ratio analysis. This practice helps a company understand where it stands financially, as it is a short-term and long-term plan for the future.

# Purpose of Financial Analysis

These are the main Purpose of financial analysis include:

  1. Profitability:- The purpose of financial analysis is to measure the operational efficiency and profitability of your business. The degree of profitability of a business is usually based on the income statement, which reports on the results of your company’s operations.
  2. Solvency:- It is meant to measure the short-term and long-term solvency of your business and at the same time it examines the firm’s ability to pay its obligations to creditors and other third parties over the long term.
  3. Liquidity:- Financial analysis examines a firm’s ability to maintain positive cash flow while meeting its immediate obligations to the business.
  4. Stability:- It has the ability to remain in the firm’s business for long periods of time, without sustaining significant losses in its business operations. This requires the use of both an income statement and a balance sheet to assess a company’s stability, as well as other financial and non-financial indicators.

# Role of Financial Analysts

Financial analysts who are in business rarely expect to predict organizations’ performance beyond a few years in the future. Unlike the current circumstances, reports provided by financial analysts allow investors and company managers to remain in the smallest business ahead of time. While these estimates are in fact subject to external or unforeseen events, in most cases it gives enough information to form a good business strategy. Which optimizes imminent opportunities for your business and limits risks. 

The role of the financial analyst is to provide reliable information that managers can use to forecast imminent events. In companies, analysts can evaluate only a portion of the organization’s performance, and then pass this information on to the appropriate managers. If their analysis predicts huge disturbances in the immediate future, they will have to reassure management to take precautionary measures.

# What is the Importance of Financial Analysis?

Financial Analysis at the present time when every business has gone digital, this decision-making process needs to capture up-to-date information. It provides in-depth information about an organization’s financial condition and enhances profitability, business value, and cash flow. Also, it helps to improve the ultimate objectives of a business which also fixes the decision-making approach. The following are necessary elements for financial analysis.

1. Financial Statements

Balance sheets and your business income statement reflect profit, loss, and earning potential over a period of time. For this, liabilities, assets, capital and debt position, and such financial figures are important to ensure budget, planning, and profitability.

2. Working Capital Statement

The financial analysis finds all your expenses and working capital changes and can be tracked using current assets, liabilities, and previous/ current year working capital statements. It is a contributing factor in budgeting, evaluation, and strategy planning.

3. Comparative Statements

This analysis helps you understand and compare the current situation in the industry with the size-disclosure statements of many companies.

4. Analysis of Ratios

It is a great tool for your business, useful in law asset management, liquidity, debt management, market value, the financial performance of various departments, and profitability of business parts.

# Types of Financial Analysis?

The financial analysis has been mainly divided into 4 types. 

  1. On the basis of material used,
  2. On the basis of the time period of the study, 
  3. On the basis of Entities involved 
  4. On the basis of the time horizon.
  • On the basis of material used:- This analysis can be of two types:

External Analysis: External analysis is always performed by outsiders who do not have access to the detailed internal accounting records of the business firm. These outsiders include investors, potential investors, creditors, potential creditors, government agencies, credit agencies, and generals, etc. External analysis is a great tool for your business, which method is useful in asset management, liquidity, debt management. , Market value, the financial performance of various departments, and profitability of business parts.

Internal Analysis: Internal analysis is performed by individuals who have access to the internal accounting records of a trading business. This can be done by employees of the organization as well as government agencies Implied with statutory powers.

  • On the basis of the time period of the study:- The method of operation followed is also of two types:

Horizontal Analysis: Through this analysis, you compare the financial data of any business for many years, we also call it dynamic analysis. The data for different years are compared with the base year. The data from this analysis are presented horizontally on several columns. This makes it possible to focus on objects that have changed considerably.

Vertical Analysis: It refers to the study of the relationship of various items in the financial statements of your business accounting period. Which we also call static analysis. Because it only takes the current year’s data, this can be done using horizontal analysis.

  • On the basis of Entities involved:-  On the basis of entities it is again divided into 2 types:

Cross-Sectional Analysis: This analysis involves comparing a firm’s financial data with competitors or industry averages of other firms for the same time period. It is also called inter-firm analysis.

Time Series Analysis: Time series analysis involves studying the performance of the same firm over a period of time. It is also called intra-firm analysis

  • On the basis of time horizon:- On the basis of time horizon, financial analysis can be classified under 2 heads: 

Short Term Analysis: Short-term analysis measures a firm’s liquidity i.e. the short-term paying capacity of a firm or the firm’s ability to meet its current obligations.

Long Term Analysis: Long-term analysis includes interest costs and the firm’s ability to meet the repayment schedule for its long-term obligations. Under this analysis, solutions, stability, and profitability are measured.

Frequently Asked Questions(FAQs)

# What is Needed to Conduct a Financial Analysis for a Business?

To conduct financial analysis, a business needs all its historical data. Because you have to track all the information such as your business revenue, payments, deposits, invoices, and business expense records to make a financial statement. Most importantly, the financial statements also include your business income statement, balance sheet, and cash flow statement, plus accounts receivable report, accounts payable, and inventory report.

# Why Do Businesses Need to Do Financial Analysis?

The Federal Reserve study states that four things are the same for small businesses to stay financially healthy- they have strong knowledge and experience with different types of credit, keep a high level of unused credit balance, and a budget. Including more regularly and saving cash specifically for payroll obligations. 

We found from that study that “there is a direct relationship between financial management and small business financial health.” Being able to understand a financial statement and make decisions based on numbers can make a difference in a business that is capable of surviving and growing. Factors and metrics to track in the analysis include profitability, cash flow cycle, working capital requirements, available liquid / near liquid assets, credit/expansion for fund operations, and individual credit scores.

# How to Use Financial Analysis Findings?

The Federal Reserve’s analysis of financial health indicators of small businesses states that investors should not place too much weight on revenue growth as an indicator of financial health. Because you also find from this study that better financial planning and management of higher financials contribute to your occupational health score. 

Digging into numbers and analyzing metrics that indicate profit, efficiency, and liquidity will give small businesses the information they need to make sound business decisions. Automating all accounting processes gives the financial team easy access to data for financial analysis. Why businesses of all sizes have increased their accounting automation over the years with accounting software that you can easily automate including invoicing, financial reports, data collection, and document storage and compliance.

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