Financial analysis definition
/What is Financial Analysis?
Financial analysis is the examination of financial information to reach business decisions. This analysis typically involves an examination of both historical and projected profitability, cash flows, and risk. It may result in the reallocation of resources to or from a business or a specific internal operation. This type of analysis applies particularly well to the situations noted below.
Investment Decisions by External Investors
In this situation, a financial analyst or investor reviews the financial statements and accompanying disclosures of a company to see if it is worthwhile to invest in or lend money to the entity. This typically involves ratio analysis to see if the organization is sufficiently liquid and generates a sufficient amount of cash flow. It may also involve combining the information in the financial statements for multiple periods to derive trend lines that can be used to extrapolate financial results into the future.
Investment Decisions by Internal Investors
In this situation, an internal analyst reviews the projected cash flows and other information related to a prospective investment (usually for a fixed asset). The intent is to see if the expected cash outflows from the project will generate a sufficient return on investment. This examination can also focus on whether to rent, lease, or purchase an asset.
The Advantages of Financial Analysis
There are multiple advantages to the use of financial analysis. One is that ongoing analyses within a business will result in a more efficient allocation of capital. Some projects or products will prove to be less profitable, and so can be eliminated in favor of more profitable alternatives. The result should be a more fine-tuned organization that generates greater profits. A second advantage is that investors can gain a better understanding of which companies are more likely to generate a better return on investment. This results in a higher stock price for the selected companies. Third, financial analysis can be used to spot trends in revenues and expenses within a business that can be exploited with forward-looking investments. These investments may be able to generate greater returns than is currently possible with a firm’s existing investments.
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Sources of Analysis Information
The key source of information for financial analysis is the financial statements of a business. The financial analyst uses these documents to derive ratios, create trend lines, and conduct comparisons against similar information for comparable firms.
Financial Analysis Outcomes
The outcome of financial analysis may be any of these decisions:
Whether to invest in a business, and at what price per share.
Whether to lend money to a business, and if so, what terms to offer.
Whether to invest internally in an asset or working capital, and how to finance it.
Financial analysis is one of the key tools needed by the managers of a business to examine how their organization is performing. For this reason, they are constantly querying the financial analyst about the profitability, cash flows, and other financial aspects of their business.