Importance of Financial Analysis

Financial Analysis

When we talk about financial analysis, we are looking at 3 broad issues. One, we select data that we want to analyze. Secondly, we appraise the data by evaluating it for the understanding of financial data. Thirdly, the financial analysis helps in the determination of the current positions or future outcomes.  The macroeconomic data would help in the provision of historical data such as inflation, GDP among other economic indicators.

Is Past Financial Data Relevant in Decision Making?

Such is the question that financial analysis helps to answer. Firms rely on such information to gauge their financial health, financing options, and future expansion. Using past data, the firm would be able to tell which aspect of its operations would bring in the highest return on investment (ROI) based on past performance.

The industry growth drivers help in knowing the market saturation point, substitute products, or the decline in the market. The study of the market trends and sales growth and the existence of the complementary products offer a better understanding of the future. Any firm must be aware of such changes. Otherwise, it would be at a heightened risk of losing its grip of the market share or closing down due to competition.

When a firm is competing with other firms offering similar or complementary products, it is important to know the strengths and weaknesses of its competitors. By looking at its competitors’ financial data, a company would be able to compete effectively. Some of the financial data it would need include sales reports, operating expenses, and gross margins, going by industry standards.

When we talk about financial analysis, we are looking at three broad issues. One, we select data that we want to analyze. Secondly, we appraise the data by evaluating it for the understanding of financial data. Thirdly, the financial analysis helps in the determination of the current positions or future outcomes.  The macroeconomic data would help in the provision of historical data such as inflation, GDP, among other economic indicators.

Who Benefits from Financial Analysis

There are two primary users of financial data. They are internal and external users who use it for both the decision making and building confidence in the firm by others. Let us look at each category of the users of the financial analysis.

Internal Users

They include the management, key executives, and auditors. The management would need the data to assist in decision making. Take the case of the financial managers would require the financial ratios to decide whether to extend the credit limit or not. The auditors would use the same information to scale the auditing procedures of the financial statements. The analytical methods used by the auditors assist them in identifying any material misstatements so that corrective measures can be undertaken.

Then some external users include the current and prospective shareholders. The share value of the stock gives the shareholders a glimpse of the future and how the stocks are likely to behave. For those who are thinking about investing in the shares of the firm, such financial information would prove handy. The past shareholders may decide to invest in the stocks while the current ones may determine whether to increase or reduce their shareholding depending on the performance of the share stocks in the securities market.

Banks and Creditors will not just agree to extend credit facilities to a firm on the strength of the management and business. They would want to know how the firm has paid back its other creditors. If a firm has bad debts or unable to service its current liabilities (both short and long), it will not attract creditors. For this reason, such companies ensure that they maintain sound financial records on their financial undertakings. The creditors will be looking at the credit ratios such as Earnings before Interest and taxes (EBIT). If the ratio is high, it means that the firm is in a sound financial position and would be able to meet its credit obligations.

Suppliers and customers form an essential part of a firm. The suppliers would look into the financial statements for a guarantee that they would be paid promptly for their supplies. If the firm is not liquid enough, there would be a delay in payments. For customers, healthy financial statements show that the firm is a going concern. They need to be assured that they would get the goods and services that they require.