Financial analysis is the process of examining a company’s performance in the context of its industry and economic environment to arrive at a decision or recommendation. The goal of financial analysis is to analyze whether an entity is stable, solvent, liquid, or profitable enough to warrant a monetary investment. It is used to evaluate economic trends, set financial policies, build long-term plans for business activity, and identify projects or companies for investment.
The primary objective of accounting is to provide information useful for decision-making. To provide information that supports this objective, accountants must consider the intended users, the types of decisions users make with financial statement information and available means of analyzing the information.
The Users of financial statement information include managers, creditors, stockholders, potential investors, and regulatory agencies. These individuals and organizations use financial statements for different purposes and bring varying levels of sophistication to understanding business activities.
Financial statements can provide only highly summarized economic information and should focus primarily on isolating information useful for making a particular decision. The information required can take many forms but usually involves comparisons, such as comparing changes in the same item for the same company over several years, key relationships within the same year, or the operations of several different companies in the same industry.
METHODS OF ANALYSIS
Financial accounting calls for all companies to create a balance sheet, income statement, and cash flow statement, which form the basis for financial statement analysis. Horizontal, vertical, and ratio analysis are three techniques that analysts use when analyzing financial statements. These techniques were highlighted in the Corporate Financial Accounting course, (CFA), at Lagos Business School, (LBS)
Horizontal analysis refers to studying the behavior of individual financial statement items over several accounting periods. These periods may be several quarters within the same fiscal year, or they may be several different years. The analysis of a given item may focus on trends in the absolute dollar amount of the item or trends in percentages. Horizontal analysis allows investors and analysts to see what has been driving a company’s financial performance over several years and to spot trends and growth patterns. This type of analysis enables analysts to assess relative changes in different line items over time and project them into the future.
The vertical analysis uses percentages to compare individual components of financial statements to a key statement figure. It is the comparison of financial statements by representing each line item on the statement as a percentage of another line item. Horizontal analysis compares items over many periods; vertical analysis compares many items within the same period.
Vertical analysis of an income statement involves converting each income statement component to a percentage of sales. Although vertical analysis suggests examining only one period, it is useful to compare common-size income statements for several years.
Ratio analysis is the study of the line items present in the financial statements of the company. It can be used to check various factors of a business such as profitability, liquidity, solvency, and efficiency of the company or the business. It involves studying various relationships between different items reported in a set of financial statements. For example, net earnings reported on the income statement may be compared to total assets reported on the balance sheet. Analysts calculate many different ratios for a wide variety of purposes.
With these tools, business managers can analyze the performance of their business with a view to making good decisions as well as projections for the future. It could also help potential investors decide how and where to invest their capital and have good justifications to proceed. Knowledge of financial analysis is a key learning point of my MBA at Lagos Business School. All managers should endeavor to have a vast knowledge of financial analysis to keep them informed of their business performance at any given time.