Financial analysis is an important part of investing, especially if investor wants better results from his investments. Of course it is possible to ignore financial analysis and make investment decisions based on intuition, rumors and brokers’ or friends’ recommendations but all those will disappoint sooner or later.
Yet, another true is that financial analysis will not guarantee a safety or striking investment results, but only unbiased and professional financial analysis may provide serious foundation for investment decisions. Every financial analysis has some level of error and the reliability of such analysis depends on the realistic side of the assumptions and experience of the analyst.
Financial analysis is based on financial ratios and there are really many financial ratios that are used for different purposes. Very often financial analysis is used for analysis of stock investments but also is widely applicable in corporate finance for which financial analysis and planning is very important trying to achieve the success and stability of the business.
The term ‘financial analysis’ is very wide and in reality there are so many financial practices of analysis that is even hard to mention them all. But basically financial analysis is performed for some specific purpose and those can be classified in such categories:
- Profitability analysis measures company’s profit on the basis of revenue and compares it to the similar businesses or previous periods. Profitability analysis may say a lot about company’s effectiveness and competitiveness.
- Return analysis compares company’s earnings to some assets or investments required to earn those earnings. Also return analysis measure the attractiveness of an investment.
- Solvency analysis is very important for creditors of the business and should help to measure the risk of crediting various companies or investment projects.
- Stock analysis should pick the best stocks for investing according to many criteria. Mostly stock analysis is based on stock valuation.
- Financial planning includes many financial ratios and models that should help to predict future cash flows and balance sheet positions.
- Working capital management is a part of financial planning that is mentioned above; however, working capital is attracting extra attention from managers and deserves to be analyzed separately.
Despite the purpose of financial analysis, usually every process of analysis starts from analysis of financial statements that represent the financial situation of every business. However, financial data of single company may not tell everything about company’s situations because it also depends on many factors of an environment which cannot be affected by company’s management. In addition to analysis of financial statements (including many financial ratios) market research and industry analysis should be another task to do.