what is the importance of financial analysis essay

What is the Importance of Financial Analysis?

• April 15, 2024

Last updated on April 17th, 2024 at 10:10 am

What is financial analysis? - In simple words, the F inancial statements analysis is the process of reviewing and analysing a company's financial statements to make better economic decisions. In other words, financial analysis is the process of determining the financial strengths and weaknesses of the entity by establishing the strategic relationship between the items on the balance sheet, profit and loss account, and other financial statements.

Importance of Financial Analysis

The importance of financial analysis cannot be overstated. It serves as the bedrock for understanding a company's financial health, revealing its strengths, weaknesses, and potential opportunities. Financial analysis helps the company understand its financial condition. It is also useful to learn the creditworthiness, profitability, and ability to generate wealth. Therefore, it gives a more in-depth look at how well it operates internally. 

The analysis of financial statements is crucial for the following reasons.

• The shares investment and holding

Shareholders own the company; such investments happen with repeated transfers and shares. Time and again, they may have to decide on whether to continue based on the price, profit, and reliability factors. This is where the importance of financial analysis comes into the picture. Therefore, a company's analysis of the financial statement is crucial to making decisions. As it reflects all information that is meaningful to the shareholder's decision process.

• Plans, decisions, and management

Financial statement analysis is essential for a company's decisions, planning, and management. As a result, the company management makes smart and intelligent calls on investment plans. These are backed by data analytics when planning for a bright future and maximum profits accrual.

Thus, compared to statements in the recent past, the future goals and predicted performances are endemic to the decision-making of shareholders, companies, and analysts.

• Providing credit

This signifies the importance of financial analysis in its own way. Shareholders offer loans to the company as its capital. The decision to provide and extend capital credit is based on a financial examination. The examination is based on the company's financial statements and performance over time. All capital loans carry an interest rate and determine the best rate. They are also a part of the decision process in making credit loans to companies.

• Decisions on investments

Investors with surplus investable capital always look for opportunities to place their funds as investments in profitable and profit-potential companies. Before investing such capital funds, investors look at the past performance and predicted profits.

Why conduct a financial analysis of your company?

Financial analysis is used to evaluate businesses, projects, budgets, and other finance-related transactions to determine their performance and suitability. Typically, financial analysis is done to analyse whether an entity is stable, solvent, or liquid.  It also checks the profitability to warrant a monetary investment.

What is the role of a financial analyst? 

The financial analyst's job is to use the company's financial statement data and records. They analyse them and understand the company's strengths, financial position, and weaknesses. You need to have certain skills required for being  a Financial Analyst.

How to do a financial analysis of a company?

Check the financial statements.

A company's balance sheets and income statement reflect the profits, losses, and earning potential over a given period. The liabilities, assets, capital, debt positions, and such financial data are vital to budget, plan, and ensure profitability.

• Capital statement

Current assets, liabilities, and working capital statements of the previous and present year help track the expenses and working capital changes. This is a helpful factor in budgeting, evaluation, and strategy planning.

• Comparative statements

Size-revealing statements of multiple companies help one understand and compare the current position against the others in the industry.

• Analysis of ratios

This method is helpful in asset management, liquidity, debt management, market value, the financial performance of the various departments, and profitability of the business parts.

• Financial analysis tools

One can’t discuss the importance of financial analysis without disucssing the associated tools . Data is the foundational backbone of the analysis. A lot depends on the inferences drawn from data in the financial records, the type of decision-making involved, and your analysis of financial information.

Using such parameters for constructive feedback and financial analysis makes the software a crucial tool. In addition, tools should have the potential to give a clear, concise, and personalised analysis.

What software tools are used by financial analysts?

• Investors prefer the stock screener by finviz and customised financial analysis by the big bench. On the other hand, accountants, bookkeepers, and managers/analysts favor SWOT analysis by providing software and cloud storage tools and software. 
• The VBA macro tool in Microsoft Excel continues to be the foundational and most widely used tool for beginners. And, especially for those who use simple but effective solutions to function.
• Management tools and cloud storage reporting software like balanced scorecard can help assess the overall returns. It helps to assess the current position, capital financing, analysis of specific firm processes, performance history, and operating income. 
• Prevision's EPM financial reporting is also widely used and rated as a good tool for enterprise management. It is also used in the maintenance of report books/accounts and for budget analysis combined with real-time data from various IT departments.
• QlikView, SAS, and MATLAB are preferred for customisable financial analysis and include statistical analysis accounting tools in their sophisticated software. It is an excellent tool for analysts, traders, and programmers.

Key take away

To make a career in financial analysis , then the financial analysis course at Imarticus Learning can help you. You can learn the best tools for assessing the company's financials, weaknesses, reliability, profit potential, and financial strength.

Imarticus Learning's course is particularly advantageous to career-makers. As it includes the certification, robust global curriculum, and an industry-relevant project involving real-time live data. In addition, hands-on practice on popular tools, and excellent industry-relevant mentorship kick-starts your career from day one.

In essence, the importance of financial analysis cannot be overstated. By meticulously analyzing financial statements, stakeholders gain crucial insights into a company's financial health, guiding decisions on investments, credit, and strategy. Equipped with essential skills and advanced tools, financial analysts play a pivotal role in driving informed decision-making for sustainable growth. Imarticus Learning offers a comprehensive course to equip aspiring analysts with expertise and tools for a rewarding career in financial analysis.

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The Role and Importance of Financial Analysis in Business Decision Making

1. introduction.

In business decision making, financial analysis is an extremely important instrument that provides an informed, rational perspective to the decision makers, be it the creditors, the investors, or stockholders. The analysis uses many quantifying tools to evaluate the company's past and current performances, so as to understand their situation, and make an informed decision. However, like in any field, an analysis can provide an unprejudiced and rational view only if a few strict guidelines are adhered to while the study is being conducted. This paper shall aim to highlight these guidelines and to inculcate an acute sense of understanding regarding the role to be played by the analysis in the areas of investment and finance.

1.1. Definition of Financial Analysis

It is the process of evaluating businesses, projects, budgets and other finance-related entities to determine their suitability for investment. Typically, financial analysis is used to analyze whether an entity is stable, solvent, liquid, or profitable enough to warrant a monetary investment. When looking at a specific company, a financial analyst conducts analysis by focusing on the income statement, balance sheet, and cash flow statement.

1.2. Purpose of Financial Analysis

Financial analysis is done for the purpose of taking business decisions. The objectives of analysis are the determination of value and the improvement of value. The value can be created in the business by choice of appropriate investments, raising capital, new product lines, and improving the operating results through improvement in capital productivity and working capital. The value can also be destroyed by bad investment policies, excessive borrowing, inappropriately designed capital structure, poor control on performance measured through various standards, and high operational costs. Thus, the purpose of financial analysis is to utilize the information contained in the financial statements to evaluate and determine the value and safety of investment in the business.

1.3. Importance of Financial Analysis in Business Decision Making

Financial analysis determines how sound is the financial position of a company. It is crucial when it comes to making decisions about investing in a company. Possible investors look at trends and the returns before investing in the company. Employees and stakeholders, therefore make immediate use of the output from financial analysis, to assess the company. Each department also makes use of this analysis to make decision. Financial analysis, helps in strategic planning and decision-making. It helps companies in making a similar investment. The analysis would help the manager in evaluating the return of the investments, the profit margin and the resources utilized in taking a particular decision. The organization would take short term and long-term decision. Financial analysis, is an important aspect the company needs to consider not only in terms of analysing the health of the company.

2. Methods of Financial Analysis

The analysis of financial statements allows organizations to make decisions considering the future. Sound understanding of financial statements is crucial. At least basic working knowledge of financial statement analysis is important for accountants, investors, auditors, managers, entrepreneurs, policymakers, regulatory authorities etc. Therefore, it is considered as one of the most important subjects in accounting and finance. A wide range of techniques is used to evaluate the financial statements of organizations so that a comprehensive understanding of an organization's financial position can be indicated. Financial analysts use tools to sift through raw data, identify key data points and interpret them.

2.1. Ratio Analysis

Ratio analysis is a method used by companies to conduct a quantitative analysis of information in a company's financial statements. Ratios are calculated from current year numbers and are then compared to previous years, other companies, the industry or even the economy to judge the performance of the company. Ratio analysis can predict business failure, as in the case of Enron and WorldCom. Ratios measure the company's liquidity, activity, profitability and leverage. This section provides a description of each category of ratios.

2.2. Trend Analysis

Declining profits, decreasing experience, increasing managerial efficiency and decreasing management expenses are just some of the many factors which may be detected via isual examination of financial statements. Trends in these figures can provide a better understanding of the financial health of the company and facilitate more robust decision making.

2.3. Comparative Analysis

Now that we have had a look at the different types of analysis, we will focus specifically on the comparative analysis. As mentioned above, this type of analysis involves comparing certain financial information to a previous period, or to the information of another company in the same industry. Most often, you will use comparative analysis when conducting ratio or trend analysis, to see what the numbers actually mean.

3. Benefits of Financial Analysis

Modern industries are circulatory connected by each other. They are also highly competitive. So in order to sustain, the companies must always be in the forefront in every way. So they must always be equipped with enough capital. Their strategies must be dynamic and should be able to adapt according to the changes. For these companies to fare well, have the necessary information of their competitors as well as their internal workings, they must conduct a thorough financial analysis. After analyzing the companies financial statements, they can have a better understanding of whether to invest in their company or not. In the long run it does not only help to mitigate your tax problems, but also saves your time and helps take the necessary action at the right moment.

3.1. Identifying Financial Strengths and Weaknesses

First, although it may seem obvious that identifying strengths and weaknesses would be done through financial analysis, understanding what financial data needs to be considered is crucial. Financial data should represent the financial position or performance of the business. However, care needs to be taken to ensure that the data is reliable, accurate and is not incorrect due to errors or fraud. Analysis can be the key to evaluating the strengths and weaknesses of a business and identifying the financial implications of major projects or decisions. This allows us to better manage our finances, balance our profit and costs and make informed decisions based from our financial predicaments. Qualified persons can conduct financial analysis by creating special and sometimes complicated budgets, forecasting sales and financial outcomes. By creating a number of different financial forecasts, financial analysts can compare different forecasts or analyse different scenarios for the financial predicaments and relationships of the business.

3.2. Evaluating Performance and Efficiency

With this analysis in more detail, it can be used in different ways, but generally, it would measure performance and indices of efficiency within a company. It helps in identifying poor performance, to fit operational problems, and to resolve them for the organization to reach its objectives with easier. The financial analysis gives conclusions about success, failure, and overall financial obligations. Evaluation of data with framework will bring positive changes within the company, and it will be organized.

3.3. Assessing Risk and Making Informed Decisions

Financial analysis is a helpful tool in the business decision-making process. As a part of analysis, businesses are able to assess the risk in business decisions and make informed decisions. A company’s risk profile consists of several different factors such as liquidity, solvency, profitability, turnover, leverage and so on. Each one of these components relates to financial statement analysis. For example, operating profit margin and debt to equity ratio are all ratio analysis components in method of analysis and financial indicators. In order to make strategic business decisions, it is important to engage in financial analysis, as you need to know the structure and efficiency of your business processes as well as the market structures and financial position.

3.4. Supporting Strategic Planning and Forecasting

This is the ultimate goal of financial analysis. Any business involved in the investment process will go a step further to forecast financial performance of the investment over a period of time. In this process, a company’s sales and expenses are estimated by the Analysts in order to predict investment performance. Financial model can be divided into components: Operational model, Accretion/dilution analysis and merger model. Financial Analysis can also make employ capital budgeting techniques to allocate resources to investments which are better and can improve business process. It is essential as it helps in setting goals and to meet them in time through proper utilization of finance. This largely involves making a company’s financial model and then reviewing it.

4. Limitations of Financial Analysis

Financial analysis is highly dependent on historical data and past financial performance, typically used to gauge the future expectations. Critics of financial analysis argue that past financial performance cannot be the sole determinant of future performance. Financial analysis may be limited by the very nature of the financial statements used, limitation as it pertains to the fact that financial statements record what has taken place, and not what is necessarily to take place in the future. Industry experts argue that financial analysis is purely a quantitative measure and lacks sentiment and emotional approach that the user/firm may have. Although attempts to develop a certain uniformed rules and regulations when it comes to the interpretability of financial statements, one cannot derive away from the underlying subjectivity and the personal opinions of the financial analysts who undertake the procedure. A certain level of professional judgement is necessary when it comes to matters of financial interpretation – however, it is this very point that leaves gaps for personal bias and subjectivity to arise, thus leading to limitations of financial analysis.

4.1. Reliance on Historical Data

Historical financial information is a critical input in the financial analysis process where analysts look at a company’s performance over time to understand its historical accomplishments and the causes to the results they enjoy today. (The Association of Chartered Certified Accountants, The role and importance of financial analysis in business decision making, 2007). The analysis is used for steering the organisations future, for providing external financial statements needed for a particular time period and also in deciding on how to structure a potential business combination (Sharon Sherman, Research and Markets - Financial Analysis, 2013).

4.3. Subjectivity and Interpretation Challenges

Another limitation to financial analysis lies in the potential subjectivity introduced during interpretation. When attempting to establish some understanding of an entity's performance, whether positive or negative, an appropriate basis and set of accounting standards need to be found in order to ensure the most accurate results possible. When contemplating these interpretations however, a number of accounting tools and theories can be used to formulate what will likely be a number of outcomes. There is subjectivity present in not only the figures analysed, but also in determining which set of tools to use and how to go about handling the data. Different practitioners in the field of accounting and finance are likely to offer a different perspective given the freedom of interpretation and data manipulation that exists.

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