As we already know, financial analysis is conducted by examining a business's financial statements and other necessary components. Preparing a financial statement is not enough; its interpretation and evaluation make it helpful for a business.
A concrete report made after a financial analysis is useful to several people like creditors, investors, regulatory authorities, and management. Financial Analysis is thus a powerful practice for a variety of people depending on their interests and objectives in gaining knowledge about the financial situation of a business.
Information Sources
The primary data for financial analysis is the firm's financial statement, which provides the know-how about the company’s financial condition and performance. Apart from a firm’s annual report, its quarterly reports and financial press releases also play a vital role in catering a good amount of information. When a company publishes annual reports, it contains financial statements, auditor’s report, director’s report, and notes to financial statements.
These are authentic sources of information for anyone as it comes from the business itself. Other than this, the Stock Exchanges also maintain the consolidated annual reports of the company’s performance, which they also publish for the shareholders to gather their share of information. Last but not least, the Business Periodicals are there to enrich the common public about the financial situation of the companies.
Data Preparation
The initial collection of financial data is quite messy and must be transformed and prepared professionally, after which it can be analysed properly. The collected data is modified and presented in three different components of the financial statement: Cash Flow Statement, Profit & Loss Statement, and Balance Sheet. Then these financial statements are analysed to produce ratios and concrete information about the happenings of business on which one can rely.
Data preparation not only means the collection of data but the whole process of collecting the data, cleansing, structuring, and organising the data so that professionals can analyse it.
Financial Statement Analysis
Financial statement analysis is the evaluation of the company's balance sheet while comparing it to the profit & loss statement to understand the strength and weaknesses of the business. By analysing the financial statement properly, one can comprehend the working structure of the business. Different users do financial statement analysis for their separate purposes; a stockholder determines whether the company is profitable to invest in and does they make optimum utilisation of the resources.
The government uses the financial statement to check the legitimacy of the company’s fiscal decisions and accounting procedures. The interpretation of financial statements is essential to measure the efficiency, profitability, financial soundness, and prospects of the business units.
Ratio Analysis
This quantitative analysis method gives insightful information about a company’s liquidity, efficiency, and profitability by studying its balance sheet and income statement.
Ratio Analysis is a tool that external analysts mainly use to obtain data that reflects the company's financial performance.
There are various uses of Ratio Analysis, such as;
- Comparing similar firms of the same industry to understand the firm’s position in the business market.
- Degree of efficiency in managing resources.
- To search and identify a trend in the financial performance of the company.
There are various types of ratios that are considered while carrying out the ratio analysis, such as;
- Liquidity ratios measure the company’s ability to manage its debts.
- Market prospect ratios guide the investors to predict the return on their investments.
- Coverage ratios can help one draw a trend to forecast the company’s financial position in the market. This also helps to check if the commitments are being met.
- Profitability Ratios measure the profit earnings ability of a company considering the expenses.
- Solvency Ratios help to measure a company’s long-term financial feasibility in the market.
Dupont Analysis
Dupont Analysis is a model prepared for the detailed assessment of a company’s profitability. One of the significant features comprised by this tool is it avoids misleading conclusions and gives the most accurate results on which the company can rely. In Dupont Analysis, the different components of Return on Equity(ROE) are broken down and analysed to get concrete results. The three components in which ROE is separated are:
- Operating Efficiency- It is measured by net profit margin and reflects the net income generated by the company per unit of sales.
- Asset Efficiency- It shows the total asset turnover and also speaks about the sales per unit of asset used.
- Leverage- The equity multiplier determines it.
You would learn about the business's operations by analysing the first two components. In simple terms, the more significant these components reflect, the more productive the business is. On the other hand, the last component, i.e., financial leverage, depicts the business's financial activities. The more leverage the company takes, the higher the risk of default.
As the Dupont analysis determines the change in ROE, it also allows the investor to examine the various financial components contributing to creating ROE changes.
An investor can use this analysis to compare the operational efficiency of two firms.
Performance Evaluation by Peer Group Comparison
Peer Group comparison is one of the widely used analysis and performance evaluation methods. Here, a peer group refers to a group of companies that share the same characteristics. These groups are widely known for their influential nature on one another.
Another most important aspect of peer groups is the comparison and competition that goes on between them. It forces them to enhance their performance and give tough competition to other companies. These comparisons help them to identify the trends & performance of the other as well as give them a chance to find opportunities that can help them in scaling up.
Regular cash flow statements
In simple terms, regular cash flow statements reflect the movement of cash and cash equivalents in a company. One can determine the company’s cash and debt obligations management by analysing the cash flow statement. The cash flow statement is a crucial statement presented by the company, which complements the balance sheet and income statement. Thus, one gets the whole financial statement for analysis. The cash flow statement breaks down the exchange of each penny, and everything is reflected on the statement, which analysts examine further.
This statement helps the creditors know the company's liquidity and if there’s any cash available to the company to pay out its debts. Apart from creditors, it is insightful for the investors as it reflects the management of cash by the company and its financial supremacy in the market.
There are various components present in a cash flow statement, such as
- Cash flow from operating activities
- Cash flow from financing activities
- Cash flow from investing activities and some non-cash activities as well.
Hence, regular cash flow statements reflect the financial health of the company. By studying this, an investor can get clarity on the cash generation ability of the company and its financial well-being in the market.
Checks and balances between financial statements
In simple terms, Checks and Balances refer to the process that enables the company to reduce its mistakes and decrease the use of centralisation of power. It is essential to prevent an individual from making all the decisions of a company; thus, checks and balances are important in any business.
In financial statements, checks and balances are important to prevent fraud, and there should not be an individual who controls all parts of financial transactions. This process ensures separate handling of receipt and deposit functions.
Key Ratios of a company
As we already know, data is required to conduct a financial analysis. But the initial stage of the assessment is to convert the data into ratios to get more clarity while analysing. Financial ratios are taken from the values presented in the financial statements to gather helpful information regarding the company.
Several ratios play a key role in the process of analysing the financial statement;
- Working Capital Ratio
- Earning-per-share
- Debt-to-equity ratio
- Quick Ratio
- Return on Equity
There are plenty of such ratios, but it depends on the analysts which ratio seems more favourable to them for carrying out the analysis and gaining a greater understanding of a company’s future potential.
Profit & Loss Statement
The profit & loss statement or a company's income statement reflects the profit/losses, revenues, and expenses over a specific period. It says a lot about the company’s sales, its management of expenses, and the balance of profit while incurring expenses.
The profit & loss statement is made by taking several things under consideration. Among these, some important categories are mentioned below;
- Revenues/Sales
- Marketing and Advertising Expense
- Cost of Goods Sold
- Taxes
- Administrative Expenses
- Interest Expense
- Net Income
After preparing the Profit & Loss statement, the main job is to analyse them properly to understand the business's financial health. Some ways of assessing the P&L Statement are;
- Comparison with previous year's numbers
- Trend Analysis
- Assessing the margins like gross profit margin, operating margin, etc.
- Rates of Return
Balance Sheet
Among the three financial statements (Profit & Loss Statement, Balance Sheet, Cash Flow Statement), a balance sheet is considered to be the most prominent one. In simple terms, a balance sheet reflects the total number of assets acquired by the company besides its liabilities. It also reflects whether the assets are financed through debt or equity.
The balance sheet works on the basic equation of Assets=Liabilities+Equity.
There is a particular structure to making a balance sheet, while it is also true that it can differ from organisation to organisation. Some of the components of it are;
- Current Assets
- Non-Current Assets
- Current Liabilities
- Non-Current Liabilities
- Shareholder’s Equity
The balance sheet plays an important part in evaluating the financial health & position of a company in the market. It depicts the company’s performance and efficiency over the period.
Liquidity Analysis
The purpose of liquidity ratio analysis is to measure the short-term solvency of a business. It reflects the ability of the company to meet its short-term goals. Thus, it suggests the pace at which the assets of a business can convert into cash. Moreover, it also ensures smooth cash flow to meet the liabilities and day-to-day business operations. All in all, it maintains the everyday working of a business.
The common liquidity ratios are;
- Current Ratio- Working Capital Ratio- It measures a company’s current assets concerning its current liabilities to determine the business's short-term solvency.
- Cash Ratio- This ratio measures the company’s total cash and cash equivalents relative to its current liabilities. It checks the company’s ability to meet its short-term debt obligation with liquid assets.
- Quick Ratio- (Current Assets – Inventory – Prepaid Expenses)/(Current Liabilities)
SWOT Analysis
The SWOT (strengths, weaknesses, opportunities, and threats) analysis is done to assess the company’s strengths & opportunities and then to develop strategic planning to overcome all the weaknesses & threats. This analysis examines internal and external factors associated with the company and then evaluates the collected data based on the current scenario and future potential.
SWOT Analysis gets prominence because of its practical take on the process. Its identification of strengths, weaknesses, opportunities, and threats leads to factual analysis and logical ideas incorporating analysis techniques that guide the business to make fruitful decisions instead of making strategies that might have loopholes.
Let us briefly understand the elements of SWOT Analysis;
Strengths- The company's aspects, constituting the parts in which the company excels.
Weaknesses- The areas of a business that are weaker in comparison to other parts and where the business needs to work and improve itself.
Opportuities- Favourable external factors that can help an organisation in excelling up.
Threats- Factors that have the potential to provide harm to a business.
The analysts present the SWOT analysis as a matrix of all the elements of SWOT to combine them and make strategies that deal with the weaknesses & threats of the business by appropriately using its strengths & opportunities.
Cash Flow Analysis
We have already understood the concept of the Cash Flow Statement, but the main part is to analyse and extract the relevant pieces of information from it. To do that, we must analyse each component of the cash flow statement.
Clash flows show us the different sectors through which cash inflow and outflow from the company in a given accounting period. It is essential to know the sources of your income and expenses to regulate and manage them as per your choice. This analysis shows the basics of a business, whether cash is available or not to run the business operation and complete the transactions.
By continuously analysing the business's cash flow statement, the users can see the potential and position of the business in the market and predict the future. It can even reflect the working system of business; for instance, if a company’s investing cash flow is positive, but the operating cash flow is negative, it might be understood that the business is selling off its assets to pay the operating expenses.
The analysis keeps the company on the ground and always provides the reality check of their actual worth and available money to run the business. While examining the cash flow statement, you will know the free cash flow (money left after clearing operating expenses and capital expenses) that the business has and can reflect its ability to purchase further assets or pay the interests.
Margin Analysis
In the world of microeconomics, Margin analysis is a widely used technique. It examines the worth of the expenses that are made to gain benefit. It compares the cost, financial decision, or any business activity with its outcome to know if it has the potential.
For example, if a company adds to the production by a small margin, its impact will be projected on the production quality and the number of resources used. Then the company can use margin analysis to understand the impact of the changes on its outcome. However, the margin analysis is also criticised for its idea of a “perfect market,” which is not present in the real world.
Asset Turnover Ratio
It simply calculates the ratio between the values of a company’s sales and revenue and the worth of its assets. It depicts the efficiency with which the company is using its assets to generate revenue. Hence, it can be considered a determinant in analysing the company's performance. The higher the ratio comes in the calculation, the better the company’s performance, as the higher ratio depicts the conscious use of assets in generating higher revenue. Interestingly, the asset turnover ratio is also an integral component of Dupont analysis.
This ratio can be calculated by dividing the net sales into the average of total assets. As the two key components of this ratio are net sales and total assets, an increase in asset sales or purchases can impact the ratio. The ratio varies from sector to sector, and it is mostly observed that retail businesses have higher sales turnover and less number of assets, thus creating a higher asset turnover ratio.
Investors consider this ratio when comparing companies coming from similar sectors or industries.
However, this ratio can also misguide one between a company’s plan and its actual performance. For example, a company might purchase more assets to expand its business. Still, the ratio will reflect the company's poor performance as it will decrease because of the increase in assets.
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