When you hear finance, it is an indication that it revolves around the future of a company. In financial analysis, a company’s current and future health is calculated or estimated based on its past performance. The accounting data helps in financial analysis as it allows the financial analyst to make a calculated assumption about the performance of a company in the future. These estimations are vital for business managers as they can make critical decisions based on what they have. If the analysis is done wrong, it can result in wrong decisions and poor performances of a company. Therefore, this article will discuss the essentials of financial analysis and why it is critical to the future of your company.
Finance is a language of business; if a business manager cannot understand the financial data well, the company will suffer. Goals and objectives for the company are also set in terms of finance, which means that the required outcome must be explained in numbers. Financial data requires proper analysis, and also it must be presented in a way that the employees at the decision-making level can understand it. The essential requirement for managing a business is to have good proficiency in the language of finance. It gets a little tricky when the data is presented in the form of financial reports. Therefore, a sound knowledge of understanding financial information is extremely crucial.
Economic trends, financial policies, and long term goals for business activities are set for the company. Furthermore, the finance function requires inventory valuation, capital expenditure approval, and the disbursement of expenses. These internal control systems are used in preparing financial statements such as income statements, balance sheets, and cash flow statements.
Last but not least, the finance department is required to deliver a comprehensive analysis of the data within the financial statements. Financial analysis is just one part of the finance function; however, it is incredibly crucial. You can understand a lot about a company’s financial health, looking into its financial statements. A financial analyst must be able to understand all the essential details these numbers have to offer. You can figure out whether your expenses are more than usual or if a particular strategy is working well financially. All these important details are forwarded to the relevant people who are decision-makers, and they can act on it.
The sources of financial data are a company’s balance sheet, income statement, and cash flow statement. These statements are used for proper financial analysis.
The balance sheet is mainly used to observe a company’s financial position in the present. This financial statement provides no details on the future of a company. The balance sheet’s purpose is to provide details regarding the assets of a company, and the liabilities it has. Also, it lists down the equity that a company has at a fixed point in time. Let’s look into what these items on the balance sheet mean.
Assets and liabilities are the main elements of a balance sheet, and they are analyzed opposite to each other. The balance sheet shows the number of assets a company has against its liabilities. Ideally, assets should be higher than the liabilities so that the company can stay operative in the future. Equity, on the other hand, is located under the assets column.
Assets are of two types, current assets, and noncurrent assets. Current assets are those items which are converted to cash or its equivalent within a year; however, noncurrent assets are held for more than one year. The noncurrent assets contain fixed assets like machinery, plants, and land. These fixed assets are used for the operation of the business, and they are considered valuable. The noncurrent assets also include intangible assets like copyrights, patents, and goodwill. All these asset accounts are essential for a financial analyst.
Liabilities are included in the balance sheet under two categories, current liabilities and long-term liabilities. The debts which are due within one year are included under the current liabilities section. These accounts include accounts payable, short-term loans, and taxes. Long-term liabilities are those which are due after one year. The accounts under long-term liabilities may include, bonds, lease obligations or contracts, individual notes payable, etc.
Financial analysts put more emphasis on the current liabilities of the company because those debts are due within a year, and the company needs to have good cash in hand to keep the company up and running. Long term debts are not that crucial because they are not urgent business matter. However, having good long term debt means that the company is credible enough to be given loans.
Finally, equity shows how much a company’s shareholders will receive if the company’s assets are liquidated, and all the liabilities are paid. It also indicates the book value of a company which might be different from what the company shows to outsiders. The difference between Assets and Liabilities shows the equity value of a company. Retained earnings are part of equity. This amount is either invested again into the company or used to pay off its liabilities. Some percent of the retained earnings is distributed to its stakeholders.
The income statement is another important financial statement that provides insight into a company’s performance over a specific accounting period. The income statement lacks in providing solid information regarding the current financial situation; however, it does provide good future viability of the company. This statement has few accounts such as revenues, expenses, and net profit or loss.
Revenues account consists of sales. Some analysts also include accounts like interest, royalties, or any other extraordinary items. Similarly, the operating expense account consists of the cost of goods sold (COGS); however, depending on the analyst, some unusual items can also be included. Net income is the final result of the income statement (revenues minus expenses). This can either be net profit or net loss, depending on the company’s financial health.
Ideally, you need to have higher revenues than expenses in order to stay operative in the long run. Since every company in the market lives to generate bigger revenues, the income statement helps in setting the priorities straight. If the company has a net loss in a given accounting period, you can see which expenses are excess and try to remove those while trying to increase the revenue.
The cash flow statement resembles the income statement in many ways. It also records the performance of a company in a specific accounting period. The only thing that differentiates a cash flow statement from an income statement is the fact that a cash flow statement takes into account only cash related accounts. For example, in an income statement, you can find depreciation being considered. Therefore, the cash flow statement is solely based on money and how much money is being generated as opposed to the expenses. An analyst checks how the company performed in terms of managing the inflow and outflow of cash. If you really want to focus on the money aspect, the cash flow statement will definitely provide a sharper image of a company.
There are three major indicators that provide information regarding the company’s financial health. These indicators are liquidity, leverage, and profitability. The company’s management has total control over these indicators because they are internal measures. However, things can get out of control and even beyond management’s control. For example, economic ups and downs or any other external changes render management helpless in this regard.
If a company is able to pay its bills and expenses in time, it is said to be well liquidated. Therefore, a company’s ability to meet its current liabilities is called liquidity. It is simply the availability of cash and other assets that can be used to pay for any short term liability like bills, accounts payable, and other related liabilities. Usually, new businesses need a certain degree of liquidity in order to make the payments within time. For established companies, having low-level liquidity shows a problem with management or a need for more capital. Liquidity might change in different seasons depending on external forces.
Sometimes, due to bad management, a company might get into some liquidity troubles. Cash outflows are strict, and cash being generated may not be at the same rate. For example, creditors expect their money to be paid within the agreed time and hardly give any flexibility. For employees, the salaries also follow a certain schedule as the employees also expect payments within time. However, companies sometimes cannot generate money as fast as money is due, which is why there should be an excessive amount of cash ready in order to cover all short term dues.
Leverage is the contribution of investors as compared to creditors in a company’s capital. It shows how much a company depends on borrowing money to finance its operations. Ideally, the debt to equity ratio must be lower, as a high D/E ratio indicates that the company might be exposed to severe risk and downturns. There’s an old saying in the finance world, higher the risk – higher the return. This is closely monitored by both bankers and investors because everyone wants higher returns from the company. However, if you invest in a company with a very high D/E ratio, you are gambling on earning a lot of money or losing a lot.
Profitability is quite different than liquidity. Where liquidity is the amount of ready cash at any time, profitability is whether the business made any profit from its operations. Both of these are extremely crucial for a business. Profitability is calculated through the income statement, where revenue and expenses are subtracted. There are several other ratios which we will we discuss later on. These ratios also revolve around the profitability of a company.
Many of these ratios calculate how much money a company earns on its investments. As creditors and investors worry about profitability the most (due to dividends), it is the responsibility of the management to improve the profitability in order to maximize shareholder’s earnings. Measures of profitability can be affected by changes in price, volume, and expenses. Furthermore, buying an asset or lending money also affects profitability.
As the name suggests. Financial ratios are methods to gain deeper insight into the financial health of a company. Different accounts in the financial statements are divided in order to understand the relationship between those accounts. This information is very crucial, especially for businesses because it provides the company with knowledge of their current condition and also provides them with a chance to improve it further.
The ratios are also closely followed by investors and creditors in order to understand the condition of the company in which their money is invested. Of course, profit is the biggest reason which attracts creditors and investors as no one likes to lose money. Financial ratios are also used before investing money or giving loans to any company. The ratios help portray a picture that, ideally, should be clear as crystal. By looking at the financial statements and their ratios, the interested parties can make an educated investment decision.
In order to check the liquidity of a company, current ratios, quick ratios, and liquidity ratios are used. Current ratios show whether the company can pay its short term debts using its assets or not. Sometimes, companies are short on deadlines. Proper management in a company would make sure that they have enough liquid assets which can easily be converted into cash if needed. Ideally, the current ratio must be above average, which would mean that the company can meet its obligations on time.
The quick ratio is also called the acid test. This ratio is a stricter version of the current ratio because it shows whether the company has enough quick assets which are easily converted into cash within 90 days or not. For the current ratio, the assets can be sold within one year; however, the acid test requires the calculation of those quick assets which can be cash or any equivalent asset that can be converted or sold out within 90 days. Finally, the liquidity ratio strictly focuses on cash availability and ignores all other assets.
For finding out the leverage of a firm, the D/E ratio or debt to equity ratio is used. This ratio tells about the risk of a company. If the debt to equity ratio is very high, it means that the company depends heavily on loaning money. It is a bad sign because those investors who avoid risk will never be interested in investing in such stocks of a company. Ideally, the equity should be higher than the debt in a company.
In order to check the profitability of a company, ROE or return on equity is used. This ratio is considered to be the best one in terms of accurately conducting the profitability analysis. Investors are especially interested in the company’s ROE because it shows how well a company can manage its equity investments. Ideally, the ROE should be above 10% in order to grow in the future. A low ratio indicates that the management has failed in using the investment to benefit the company and its stockholders.
Efficiency measures how well a company can manage its assets and liabilities within a short period of time. There are several ratios available in order to check the efficiency of an organization. These ratios check whether the company can generate a sufficient amount of cash using its assets or liquidating inventory. Efficiency ratios include inventory turnover ratio, asset turnover ratio, and receivables turnover ratio. They all are used best when compared with competitor’s ratios within the same industry.
It is extremely important to conduct a financial analysis of a company because it benefits the company itself and those looking to invest in it. If any problems arise during the analysis process, the management can take appropriate action to fix it. With the proper tools of financial analysis such as those mentioned above, management can make sure the company performs best in the interest of its stakeholders or they can also hire a professional business consultant. It also helps companies irrespective of their size – whether big or small, as it provides useful information for a company’s success. It also provides them the perspective of bankers, investors, and other interested parties.