What Is the Importance Of Financial Analysis? – Learning Guide
Last updated on 15th Jul 2020, Blog, General
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There are many ways to measure financial performance, but all measures should be taken in aggregate. Line items, such as revenue from operations, operating income, or cash flow from operations can be used, as well as total unit sales. Furthermore, the analyst or investor may wish to look deeper into financial statements and seek out margin growth rates or any declining debt. Six Sigma methods focus on this aspect.
There are many stakeholders in a company, including trade creditors, bondholders, investors, employees, and management. Each group has its own interest in tracking the financial performance of a company. Analysts learn about financial performance from data published by the company in Form 10K, also known as the annual report. Public companies must publish the SEC required 10K form. The purpose of the report is to provide stakeholders with accurate and reliable financial statements that provide an overview of the company’s financial performance.
Types of Financial Analysis
There are two types of financial analysis: fundamental analysis and technical analysis.
- Fundamental Analysis
Fundamental analysis uses ratios gathered from data within the financial statements, such as a company’s earnings per share (EPS), in order to determine the business’s value. Using ratio analysis in addition to a thorough review of economic and financial situations surrounding the company, the analyst is able to arrive at an intrinsic value for the security. The end goal is to arrive at a number that an investor can compare with a security’s current price in order to see whether the security is undervalued or overvalued.
- Technical Analysis
Technical analysis uses statistical trends gathered from trading activity, such as moving averages (MA). Essentially, technical analysis assumes that a security’s price already reflects all publicly-available information and instead focuses on the statistical analysis of price movements. Technical analysis attempts to understand the market sentiment behind price trends by looking for patterns and trends rather than analyzing a security’s fundamental attributes.
In addition, company leaders audit and sign these statements and other disclosure documents. In this way, the 10K represents the most comprehensive source of information on financial performance made available to investors annually. Included in the 10K are three financial statements: the balance sheet, the income statement, and the cash flow statement.
1. Operating Cash Flow
Monitoring and analyzing your Operating Cash Flow is an essential for understanding your ability to pay for deliveries and routine operating expenses. This KPI is also used in comparison with total capital you have in use—an analysis that reveals whether or not your operations are generating sufficient cash for support of capital investments you are making to advance your business.
The analysis of your ratio of operating cash flow compared to your total capital employed gives you deeper insight into your business’s financial health, allowing you to look beyond just profits, when making capital investment decisions.
2. Working Capital
Cash that is immediately available is “working capital”. Calculate your Working Capital by subtracting your business’s existing liabilities from its existing assets. Cash on hand, accounts receivable, short-term investments are all included, as well as accounts payable, accrued expenses, and loans are all part of this KPI equation.
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This especially meaningful KPI informs you of the condition of your business in terms of its available operating funds, by showing the extent to which your available assets can cover your short-term financial liabilities.
3. Current Ratio
While the Working Capital KPI discussed above subtracts liabilities from assets, the Current Ratio KPI divides total assets by liabilities to give you an understanding the solvency of your business—i.e., how well your company is positioned to meet its financial obligations consistently on time and to maintain a level of credit rating that is required to order to grow and expand your business.
4. Debt to Equity Ratio
Debt to Equity is a ratio calculated by looking at your business’s total liabilities in contrast to your shareholders’ equity (net worth). This KPI indicates how well your business is funding its growth and how well you are utilizing your shareholders’ investments. The number indicates how profitable the business is. It tells you and your shareholders how much debt the business has accrued in effort to become profitable. A high debt-to-equity ratio reveals a practice of paying for growth by accumulating debt. This critical KPI helps you focus on your financial accountability.
5. LOB Revenue Vs. Target
This KPI compares your revenue for a line of business to your projected revenue for it. Tracking and analyzing discrepancies between the actual revenues and your projections helps you understand how well a particular department is performing financially. This is one of the two primary factors in the calculation of the Budget Variance KPI—the comparison between projected and actual operating budget totals, which is necessary in order for you to budget more accurately for needs.
6. LOB Expenses Vs. Budget
Comparing actual expenses to the budgeted amount produces this KPI. The comparison helps you understand where and how some budgeted spending went off track, so that you can budget more effectively going forward. Expenses vs. Budget is the other primary factor of the Budget Variance KPI. Knowing the amount of variance between the total assumed and total actual ratio of revenues to expenses helps you become an expert on the relationship between your business’s operations and finances.
7. Accounts Payable Turnover
The Accounts Payable Turnover KPI shows the rate at which your business pays off suppliers. The ratio is the result of dividing the total costs of sales during a period (the costs your company incurred while supplying its goods or services), by your average accounts payable for that period.
This is a very informative ratio when compared over multiple periods. A declining accounts payable turnover KPI may indicate that the length of time your company is taking to pay off its suppliers is increasing and that action is required in order to keep your good standing with your vendors, and to enable your business to take advantage of significant time-driven discounts from vendors.
8. Accounts Receivable Turnover
The accounts receivable turnover KPI reflects the rate at which your business is successfully collecting payments due from your customers. This KPI is calculated by dividing your total sales for a period by your average accounts receivable for that period. This number can serve as an alert that corrections need to be made in managing receivables, in order to bring payment collections within appropriate timeframes.
9. Inventory Turnover
Inventory continuously flows in and out of your production and warehousing facilities. It can be hard to visualize the amount of turnover that is actually taking place. The inventory turnover KPI allows you to know how much of your average inventory your company has sold in a period. This KPI is calculated by dividing sales within a given period by your average inventory in the same period. The KPI gives you a picture of your company’s sales strength and production efficiency.
10. Return on Equity
The Return on Equity (ROE) KPI measures your company’s net income in contrast to each unit of shareholder equity (net worth). By comparing your company’s net income to its overall wealth, your ROE indicates whether or not your net income is appropriate for your company’s size.
Regardless of how much your company is currently worth (its net worth), your current net income will determine its probable worth in the future. Therefore, your business’s ROE ratio both informs you of the amount of your organization’s profitability and quantifies its general operational and financial management efficiency. An improving, or high ROE clearly indicates to your shareholders that their investments are being optimized to grow the business.
11. Quick Ratio
Your Quick Ratio KPI measures your organization’s ability to utilize its highly liquid assets to immediately meet your business’s short-term financial responsibilities. This is the measurement of your company’s wealth and financial flexibility. It is understood as a more conservative evaluation of a business’s fiscal health than the Current Ratio, because calculation of the Quick Ratio excludes inventories from assets.
This Quick Ratio KPI has the popular nickname of “Acid Test” (after the nitric acid test used in detecting gold). Similarly, the Quick Ratio is a quick and easy way of assessing the wealth and health of your company. If you’ are a new adopter of KPIs, the Quick Ratio KPI is a good approach to getting a quick view of your business’s overall health.
12. Customer Satisfaction
While budget-linked KPIs are important, the ultimate indicator of a company’s potential for long-term success is in its Customer Satisfaction quantification. The Net Promoter Score (NPS) is the result of calculating the various levels of positive response that customers provide on very brief customer satisfaction surveys. The NPS a simple and accurate measurement of likely rates of customer retention (future sales to current customers) across your revenue base, and of potential for generating referral business to grow that base.
Future Performance
Financial analysis can assist small businesses in their planning. Evaluation of a company’s balance sheet, income statement and cash flow statement — interpreting trends and identifying strengths and weaknesses — might yield enough information to enable management to make projections of revenues and profits for three to five years. With knowledge of trends in the general economy and in the company’s industry, they can form a reasonable estimate of how well the company might fare in the coming years. Such analyses can be helpful to businesses that need to plan equipment purchases and other initiatives.
Benefits
By employing expert financial analysis on an ongoing basis, firms are able to make investment decisions or recommendations based on sound reasoning. Companies might employ their own financial analysts who would keep watch over the company’s strengths and weaknesses and advise upper management accordingly. Alternatively, some companies might decide to engage the services of financial consultants who could conduct periodic financial analyses.