Financial analysis involves undertaking calculations that determine the fiscal health of a company. Recommendations on how operations should be improved to increase performance are founded on the data obtained.
Financial analysts base their calculations on several key elements that form the subject of this article. They then summarise them in three important documents which investors and traders focus on before trading stocks. These include balance sheets, income statements, and cash flow statements.
Key Elements of Financial Analysis
- Revenue: Important parameters that financial analysts seek include revenue growth, company’s productivity which is the revenue per employee; and revenue concentration which is the ratio of the revenue from a single client who contributes the highest proportion of the revenue to the total revenue.
- Profits: A business’ sustainability is reliant on its productivity. If a company cannot produce profits regularly, it may collapse in the long run. The important parameters that are calculated include the operating profit margin, net profit margin, and gross profit margin.
- Liquidity: The analysis of a company’s liquidity probes whether it has the capacity to generate enough finances which can cover expenses. The liquidity should be strong. Importantly, the ratios include operating cash flow ratio, quick ratio, and current ratio.
- Solvency and capital efficiency: Solvency refers to the extent to which a business’s current assets exceed its current liabilities. Capital efficiency, on the other hand, relates to the ratio of the cash expenses to the money used to produce a particular product or service. It indicates a company’s ability to maximize shareholder value by managing capital effectively. The return on capital employed (ROCE) shows capital efficiency while debt to equity ratio is used to calculate a firm’s solvency.
- Operational efficiency: this element of financial research indicates the extent to which a business uses its resources. Notably, when a firm lacks operational efficiency, it experiences slow to no growth and its profits are condensed compared to when it has a high level of operational efficiency. The measures of operational efficiency include inventory turnover, which is the ratio of the cost of sold products to the average inventory and the accounts receivable turnover. Others include total asset turnover and net asset turnover.
How To Do A Financial Analysis
Conducting financial analysis does not involve assessing the amount of cash a company has in its books in terms of equity, liability, and assets. Rather, it entails calculating the ratio of one of these fiscal parameters to each other. In this regard, the financial analysis process involves using known formulas to establish the ratios.
The numerical components of balance sheets, cash flow statements, and income statements provide the essential data that aids in the calculation of the proportions. For instance, given that the balance sheet contains a summary of assets, equity, inventory, and liabilities, it is the document used to calculate liquidity, leverage, and efficiency ratios.
Why Traders Need To Do Financial Analysis?
Financial analysis is critical as it helps determine a firms’ fiscal health. Without it, traders and investors would be using their cash blindly. Potentially, they would not get the real value for their money. As such, it is crucial for such individuals to understand how to do and write a financial analysis before trading. The resultant ratios should guide them.
Financial analysis is about estimating enterprises, projects, capitals, and transactions in case to determine their efficiency and sustainability.
The main idea of financial analysis is to make a forecast of economical tendencies, establish a financial strategy, and find projects to invest in.