Purpose of Financial Analysis

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Purpose of Financial Analysis
Purpose of Financial Analysis (Image: paul goyette, Flickr)

Financial analysis determines the viability of a business. While it is related to accounting, it's less focused on manipulating the numbers of a business than it is in looking at the business or market sector as a whole and attempting to figure out how it will behave in the future. Financial analysts also conduct research into the business itself or the broader market to report to management a suggested course of action to improve profits and decrease liabilities.

Significance

A financial analyst either works as an employee of a company to determine how to improve its profitability or is hired or contracted by a company to analyze it or by a third party to analyze another company or market conditions. Analysts look to improve several key financial ratios for the businesses that they analyze--primarily profit to loss and assets to liabilities. Analysts also examine cash flow statements carefully for efficiency.

Types

The primary ratios that a financial analyst should record, examine and seek to optimize are leverage, liquidity, profitability, efficiency, shareholder return and market value. Leverage is the ratio between assets and debt. Liquidity ratios determine how well a company finances its debts. Profitability ratios determines a company's earnings generation. Efficiency is how well a company can use its assets to return greater profits. Shareholder return ratios show how well the company returns some of its profits to shareholders. Market value ratio is a more subjective judgment that decides how a company stands relative to the market at present and its future prospects.

Function

Financial analysts learn how to read balance sheets and cash flow statements to determine all of this information. They also need to know how to communicate with various managers and even employees to get a better sense of the company as it exists among the workers. Financial analysts can require years of data to create a thorough report on a company. The analyst will also need to create trend lines showing how all of the major ratios interact with one another over time.

Effects

Analysts can't change a company alone, but they can provide the crucial data necessary to make those improvements that it may need to thrive in a competitive marketplace. The ratios used in financial analysis are greatly affected by methods of accounting. A change in accounting can radically alter the operating ratios. Therefore, changes to accounting must be recorded carefully and remarked upon to make the analysis accurate.

Benefits

Financial analysts are employed to optimize businesses. They may do so on behalf of the company itself, investors or a third party. On occasion, an analyst will go over entire sectors of the economy and not just individual businesses to provide valuable information to investors. They have a particular advantage of working with objective data to formulate their analysis. This is the greatest strength of the profession--it relies primarily on the numbers to uncover the strengths and weaknesses of any company willing to open its books.

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