What is Financial Analysis? What is Financial Statement Analysis? Roles and Scope of Financial Analysis and Financial Statement Analysis.
In the most basic sense, Financial Analysis pertains to
analyzing the financial data for a specific purpose. When we do it for a
company form of structure we analyze the financial data of that entity for a
specific pre-decided purpose. One thing which is important to keep in mind is
that the company form of structure works in a specific economic environment and
belongs to a categorized-strata commonly we refer to as industry. So whenever we
analyze the financial data of an entity we need undertake it in the context of
its industry and the economic environment in which it is working.
Now mostly the purpose to undertake the financial analysis
of a company relates to the provision of capital to the company. Investors
provide the capital to the company normally in two form – either in form of
debt capital or in form of equity capital. So to say investors wants to decide
whether to invest in the company’s equity securities or debt securities. And,
if after decision to invest is taken, to invest at what price per security that
is to say the fair valuation of the company’s debt or equity securities.
The investor who after due financial analysis chooses to
invest in company’s debt securities is concerned about whether the company will
be able to pay the interest on the debt as well as repayment of principal
amount. Whereas the investor who after due financial analysis chooses to invest
in company’s equity securities is concerned about whether the company will be
able to pay dividends as well as if the share price of the company will
appreciate in due course. Dividend is the return paid to shareholders as a
share from the net profits earned by a company in a financial year.
So what we can understand from the above description is
that, the central focus of the financial analysis undertaken by the investor is
evaluation of the company’s potential to earn return on the capital provided by
the them and investor see to it that at least the return should be equal to the
cost of capital. And if the company manages to successfully earn a return from
utilization of the capital which is equal to its cost of capital, it can
profitable grow and expand its operations and can also meet due obligations
towards the debt repayment as well as can provide the return to its
shareholders.
The financial analysis is conducted on the information provided
by the company in its financial reports which are published at regular
intervals which helps several stakeholders in economic decision making.
Financial Reports includes the financial statements of the company which are audited
as per regulations and other disclosures that are requisite as per the regulation.
The financial statements of the company are one of the most
important sources of information on which financial analysis is conducted. The
financial statements provide information regarding three main aspects of the
company – its financial performance over a period of time, its financial
position as on a particular date or time, and finally changes in financial
position over a period of time. This information forms the core part of
financial analysis and helps various stakeholders in economic decision making.
So in short the role of the financial statements is to provide
information about the company regarding three main aspects of the company – its
financial performance over a period of time, its financial position as on a particular
date or time, and finally changes in financial position over a period of time.
Now to use these financial information regarding the
financial performance, financial position and changes in the financial position
provided by the company with other important economic information as discussed
earlier which includes information regarding the economy as well as industry in
which the company is working in order to make economic decision is known as
Financial Statement Analysis.
There are several economic decisions which require Financial
Statement Analysis of the company which includes providing credit to the
company, providing equity capital to the company, providing a debt rating to
the company’s bonds or debentures by a rating agency, at time of merger and
acquisition for evaluation of potential target or company, for forecasting
future cash flows of the company and many more.
If we try to grasp what exactly is happening here, we see
that the decision maker which can be any stakeholder of the company, may be
investor or analyst, all of them are trying to assess the past as well as
current information on the company’s financial performance and financial
position provided by the company through its audited financial statements and other
disclosures in order to estimate or take gauge of what will be the future
performance of the company that is future net income and future cash flows so
as to understand if the company is worth investing in and can provide the
return on the capital provided which is at least equal to its cost of capital.
There are two important aspects to the analysis of financial
performance of the company that is if the company is profitable and other being
if the company is generating positive cash flows. Any company conducting
business provides either good or a service and in undertaking that economic activity
if the company is able to earn a profit, we say the company is profitable. But
in conducting that economic activity of providing that good or service, it is
important to see what is trend of company’s actual cash outflow and inflow.
That is to see if the company’s cash inflow is greater than the cash outflow,
then we can say that is the company is generating a positive cash flow which is
as important for the company as to being profitable. Generating a positive cash
flow includes if the company’s total cash receipts are greater than total cash
payments.
So here to say that the Profit and Loss of the company can
be different from the actual cash outflow and inflow of the company and answer
to why and how that we will see in further lessons.
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