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Financial Analysis

Financial Analysis

Financial analysis is a process of analyzing a company’s performance, strengths, weaknesses, and future prospects. Financial analysis is an essential tool used by Business valuators, Equity research analysts, Asset managers, management of the subject company, debt providers, etc. Financial analysis is used to make more informed economic decisions while carrying out valuations, lending money to the company, and investing in the company’s stock. Financial analysis is also used by the subject company’s management to better understand the potential opportunities and risks in the business to help in more insightful strategic decision-making. Financial analysis is performed using various analytical tools such as Ratio analysis, Common size & comparative analysis, Regressions, etc.

In business valuation, financial analysis helps the valuator come out with financial projections for the company. Financial analysis helps in understanding the relative position of the subject company among its competitors, which helps in performing valuations using the Market approach. Equity research analysts and debt providers perform financial analysis to make investment recommendations/decisions. The subject company’s management also uses financial analysis to make better strategic decisions regarding the business. Business budgeting and planning also rely on financial analysis for relevant assumptions.

 

Financial analysis involves an in-depth analysis of historical financials, industry, and economy. There are various types of financial analysis that can be used according to their suitability in different circumstances. Some of the most common types are:

  • Vertical and horizontal analysis: In vertical analysis, all items of the Income statement/Balance sheet are presented as percentages of Revenues/Total assets (also known as common size analysis). This result can be benchmarked against other companies in the same industry to analyze the company’s relative position. In horizontal analysis, several years of data are taken and analyzed to assess the trends in the company.
  • Ratio analysis: Ratio analysis can be performed to gauge the profitability, liquidity, solvency, and efficiency of the company. For e.g., Gross margins and EBITDA margins can be used for profitability. Similarly, the debt-to-equity ratio and debt service coverage ratio can be used for solvency.
  • Valuation analysis: Here, the subject company is valued using various techniques such as the Income approach, Market approach, Asset-based valuation, etc. A valuation provides a great deal of detail and insights into the business, and it can be used to make investing decisions.
  • Cashflow analysis: As they say, “Cash is the king”. The cash-generating capacity of the company is important to be analyzed. There are various measures of cash flow such as Cash from operation (CFO), Free cash flow to the firm (FCFF), Free cash flow to Equity (FCFE), etc.

Every type of analysis can be performed using multiple tools such as Ratios, regressions, charts, etc.

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