Successful corporations analyze their financial positions regularly in order to determine the performance of the firm with respect to predetermined financial objectives. According to Lermack (2003), a business financial analysis entails evaluating the firm’s financial stability and profitability, which is undertaken by analyzing the financial statements of the business. Vance (2002) points out that financial analysis provides the framework for decision-making within any organization. A good analysis of the financial condition of any entity can help guide organizational decisions about issues such as recruitment, salaries, sales and marketing. Financial analysis can also provide early warnings of a looming crisis to come. This analysis characteristically starts with budget item projection from historical or logically based rates of growth and lead to an examination of various budget proportions and comparison with similar entities in the same industry. This paper discusses on the steps required to conduct a financial analysis.
Definition of Financial Analysis
Financial analysis, also known as financial statement analysis, is the process of evaluating financial and other information for decision-making (Vance, 2002). Financial statements include balance sheets, income statements, cash flows and shareholders equity statements (George & Schleifer, 2003). Financial analysis can also be vital in offering a detailed understanding of the financial condition of any particular investment opportunity. Financial analysis involves gathering pertinent financial data that plays an integral role in determining the decision to make an investment in a particular venture depending on the indicators analyzed by the financial analysis process. Numerical figures reported after financial analysis only provide indicators to trigger pertinent decisions.
Six Steps Approach in Financial Analysis
Lermack (2003) outlines a six-step approach of carrying out a financial analysis. A financial analyst is required to identify pertinent data to use in analysis. Part of this process is filtering all of the relevant data to identify what is most important. The steps discussed give an overview of how one might work his or her way through the whole process. The first step involves the identification and clarification the purpose of the financial analysis (George & Schleifer, 2003). It is extremely crucial for a financial analyst to frame the question at hand to prevent project or analysis creep. The purpose of the analysis acts as the guideline, hence ensuring that involved parties are within the scope of the process. Some of the key elements that form part of this step include the decision to be made, all stakeholders to be affected by the decision and how the findings of the financial analysis will be used in decision making. Stakeholders may include lenders, suppliers, employees, customers and equity investors (Vance, 2002).
The second step is generally termed as corporate overview. This step is also termed as industry analysis. It involves determining the business context in which the analyzed entity competes in. The identified industry should be specific to enable the analyst determine how the subject entity plans to succeed within the industry (Lermack, 2003). For instance, an analyst might be working on an entity in the mobile phone industry making reference to its competitors or its financial health five years ago. Other analyzed areas are future potential, core competencies, geographic presence, legal barriers, product differentiation and core leadership
The next step is termed as quantitative financial analysis. This involves determining an entity’s profitability and its liquidity leverage based on acquired financial statements.
Profit margin, cash flows and asset utilization are captured from availed financial statements to determine profitability (Vance, 2002). In this phase, historical financial records are used in an in-depth analysis for red flag items, but the focus is in the entity’s future performance. Analyzed financial statements provide financial ratio and growth or trend analysis (Lermack, 2003).
After quantitative financial analysis, a detailed accounting analysis is conducted. This is the most taxing step since it involves complex accounting issues such as foreign currency, pension, stock-based compensation, deferred taxes and leases. A financial analyst also determines whether the subject accounting information captures the underlying business reality. Accounting numbers can be recast in this step if need arises. Accounting policies and assumptions are also evaluated (George & Schleifer, 2003). The balance sheet is also managed in this step ensuring that debt is kept within desirable limits. The whole idea of carrying out a detailed financial analysis is to establish the faith that one can place on the reported numerical figures.
Before summing up the process, a comprehensive analysis is carried out. This involves incorporating the financial analysis with the industry’s analysis. Key points particularly crucial to decision making are summarized here. A financial analyst is expected to note red flags as he or she writes an executive summary. The basis of this step is to determine how effective an entity is in executing its strategy as well as it performance with regard to its competitors in the same industry (Lermack, 2003). All the generated data must also be reviewed at this phase.
Lastly, decisions or recommendation are presented to the relevant parties. The underlying reason behind financial statement analysis is to arrive at a timely and informed decision or recommendation. Decisions or recommendations presented must be based on the financial analysis and other analysis (Lermack, 2003). It is also crucial for an analyst to mention ration limitations.
From the discussion it is evident that financial statements are extremely vital, but they often do not provide adequate information to highlight realistic conclusion about an entity’s financial position. Financial analysis begins with financial statements, thus, financial statements must be well prepared to eliminate errors which might propagate wrong decision making. Ratio and trend analysis can be done on numbers extracted from these statements. Computed ratios can then be compared with the ones from prior years, competitors, and entities in the same industry. A financial analysis is the conduit between these financial statements and informed decisions. Financial analysis is, therefore, the additional evaluation or assessment of the numbers form financial statements with an intention of mining valuable information. Information obtained may be valuable to clients, the company's management, suppliers and potential investors. Financial analysts are often requested to give an opinion and recommendation on the health of a company.
The primary purpose of doing a financial analysis of an entity or project is to evaluate its profitability or cost-effectiveness with reference to some alternative investment or project within the same industry. Normally, the findings of the financial analysis are used to compare alternative investments to make an informed decision on which ones should be implemented.