Financial Analysis Techniques: Tools for Effective Decision Making

Admin 29 Dec, 20239.1k

Introduction

The term "financial analysis" refers to a review of projects and activities that are financially related, an evaluation of a company's financial statements, which include an income statement and a balance sheet, or the use of financial ratios to evaluate a company's performance and trend to make crucial decisions. Financial information is utilized to evaluate a company's development via Financial Analysis Techniques. After that, senior management of the business is notified of the findings and suggestions for further improvement.

When analyzing a company, analysts look for answers to questions like:

How well has the business done compared to its competitors and past performance?
What kind of future performance can the company anticipate?
Based on expected future performance, what are the company's or its securities' values?

According to their usage and needs, common size statements, comparative financial statements, ratio analysis, cash flow analysis, and trend analysis are some of the most popular Financial Analysis Techniques.

When an analyst or student is tackling a financial problem or wants to understand the financial consequences and economic alternatives involved in decisions about business investment, financing, or operations, many different analytical Financial Analysis Techniques and uncommon rules can be used to generate quantitative conclusions. As a result, picking the most appropriate major tools and techniques of financial statement from among the available options is an important element of the complete analytical process.

Financial Analysis Tools and Techniques

Let's assess the many analytical tools available: -

Common Size Statements

It is the first tool for Financial Analysis Techniques. There are companies with different sizes and organizational structures on the market. The absolute forms of their financial statements, including all the details, must be prepared to compare them. Bringing data in a percentage format is the only way of disclosing the financial & accounting data universally accepted for comparison. The company will create key financial documents, including a balance sheet and an income statement of a standard size, and a cash flow statement of a conventional size. All parts shall be accurately and completely disclosed to the peer group in percentage form for internal or external review.

Financial Statement Comparison

In horizontal analysis or trend analysis, comparative financial accounts are used. It helps analyze the recurring changes in different financial statement components and shows which has the most influence. Such financial statements may be created using percentages or monetary amounts. As a result, it is simple to compare the periodic data from the above in numerical or percentage terms. The comparative financial statement includes benefits like straightforward comparison, trend observation, routine performance monitoring, etc. However, it has drawbacks such as neglecting the effects of inflation, placing a large reliance on potentially manipulable financial data, requiring separate businesses to utilize different accounting methods, etc.

Trend Analysis

Among the Financial Analysis Techniques used, trend analysis plays a significant role. It is based on the assumption that previous events may anticipate what will happen. The methods used in financial analysis are known as trends. It may be categorized as a mathematical technique that predicts future outcomes based on historical data. Trend analysis may compare two organizations over the same period or one company during a different time period. A trend is a collection of data from financial accounts that have been analyzed to draw relevant conclusions. The user needs to use the methods of financial statement analysis to identify the course of financial trends.

Ratio Analysis

The most popular financial analysis tool utilized by analysts, internal financial planners, specialists, the analysis department, and other stakeholders is ratio analysis. It has a variety of ratios that may be used to make comments.

Calculating profitability ratios
Rate of return analysis
Liquidity
Solvency ratios
Interest or any other expense coverage
Using turnover to compare any component

Additionally, an entity may oversee the activities and produce the ratios for their examination based on their needs.

Benchmarking

Benchmarking is the practice of contrasting the actual results with the senior management's goals. Additionally, it makes reference to comparisons with the best practices and aims to replicate them.

The following actions must be taken throughout this process: -

Decide which area needs to be optimized.
Find the trigger points so you can compare them.
Try to establish a higher bar or use industry norms as the benchmark.
Analyze the periodic results and quantify the trigger points.
Determine whether the same results are obtained; if not, perform variance analysis.
When a goal is attained, work to raise the bar.

Ratios, an operating margin matrix, etc., may be used for benchmarking. Comparing your operating margin to the industry average should help you position yourself better. Benchmarking may be seen as one of the major tools and techniques of financial statements for improvement with customer-oriented activities driven by internal organizational demands as well as the needs of the consumer. Ultimately, it is the practice of having the humility to acknowledge that someone else is superior at something and the knowledge to figure out how to equal and outperform them.

Why is it necessary to use financial analysis tools?

When making stock market investments, knowing how well a company is performing and where it's heading in the short and long terms is crucial. The major tools and techniques of financial statement are useful in this situation. Examining a company's financial statements in detail is not sufficient. One must use financial statement analysis techniques to make sense of the data to gain important insights into the performance of the business.

These major tools and techniques of financial statement, however, are far more useful than simply in the stock market. A few intriguing applications of financial analysis techniques are listed below:

To provide advice on mergers and acquisitions, valuation specialists use them.
Using these measures, banks may assess a company's creditworthiness and solvency.
Financial analysis approaches might be used by insurance firms and credit rating organizations to evaluate various risks.
These might be used by auditors and authorities to spot any inconsistencies in a company's financial statements or commercial operations.
Businesses may use these to make strategic choices on how to allocate resources and which divisions to close.

Different Types of Financial Analysis

Regarding investing in a company's stock using Financial Analysis Techniques, there are primarily two categories:

Fundamental Analysis - To ascertain a company's worth, fundamental analysis analyses ratios derived from the information found in the financial statements, such as its profits per share (EPS). The analyst can determine the intrinsic value of the security by using ratio analysis together with a comprehensive investigation of the economic and financial circumstances around the firm. The ultimate objective is to develop a figure that an investor may use to determine whether an asset is cheap or overpriced by contrasting it with its present price.

Technical Analysis - Technical analysts might use Moving Averages (MA) to extract statistical patterns from trade behavior. Technical analysis focuses primarily on the statistical study of price changes, assuming that the security price already accurately reflects all readily available information. Technical analysis aims to comprehend the market mood behind price changes by concentrating on patterns and trends as opposed to a security's intrinsic qualities.

FAQs

Q1. What are the Uses of Financial Analysis?

Ans. The financial analysis aims to determine if a company is secure, liquid, solvent, or sufficiently lucrative to justify a financial investment. It is employed to determine projects or businesses for investment, analyze economic trends, establish financial policies, and create long-term strategies for corporate activities.

Q2. What are the types of financial decision-making?

Ans. Financial managers must choose between three options:

Investment Decision.
Financing Decision and.
Dividend Decision.

Q3. What is financial analysis for decision-making?

Ans. The financial analysis assesses the performance and appropriateness of enterprises, projects, budgets, and other financial-related operations.

Q4. What is financial analysis?

Ans. Examining a company's financial accounts is known as financial analysis. The balance sheet, income statement, and cash flow statement are examined to evaluate a company's financial situation.

Q5. What are the common financial analysis techniques?

Ans. Financial statement analysis frequently employs several methodologies. Horizontal, vertical, and ratio analyses are three of the most crucial methods.

Q6. What is the purpose of financial statement analysis?

Ans. The goal of financial statement analysis is to make it possible to create effective strategies and carry them out by effectively managing financial resources. It offers the chance to compare financial facts in a meaningful way.

Q7. What are the limitations of financial analysis?

Ans. Changes in the cost price level are not taken into account in the Financial Analysis Techniques. The financial analysis might be unclear without prior awareness of changes in an organization's accounting practices.

Q8. What are decision analysis tools?

Ans. Decision-making tools are techniques and activities that people may use to approach problem-solving and scenario-based problems successfully.

Conclusion

In the competitive business environment of today, monitoring the performance of the business and its rivals is essential for the company's survival and growth. There are a variety of Financial Analysis Techniques available on the market to do financial analysis depending on various requirements. Depending on their conditions, organizations also design various internal systems to track their requirements.

The financial sector has a vast and expanding reach. The range of this industry keeps growing, creating more opportunities with special incentives and challenges. You may speak with the professionals at NorthStar Academy if you want to learn more about the chances in this industry.