Data analysis

Financial analysis: definition, importance and types

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Written by tonyday

In today’s data-driven economy, financial analysis has become an important part of any successful business or organization, so the usual financial statements of organizations do not make any significant contribution to the owners of the organization, unless analyzed and compared with the figures of past years or with competitors. Therefore, financial analysis is a milestone step in assessing the financial performance of an enterprise, revealing possible problems and opportunities for improvement.

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What is financial analysis
Financial analysis refers to the use of various financial statements of companies, to gain a deep insight into and evaluate their performance, with the aim of identifying and making informed decisions about their future prospects. The financial analysis process usually involves analyzing the company’s financial statements, such as the income statement, balance sheet, cash flow statement, ratios, and other financial trends.

Who are the beneficiaries of financial analysis
Although the primary users of financial analysis are usually investors and lenders, there are many other beneficiaries, namely:

Management: because financial analysis serves as a crucial tool for it in making strategic decisions about the future of the company.
Employees: provides them with a real understanding of the financial situation of the company in which they work.
Customers: enables them to assess the financial situation of the company, make their decisions about whether they should do business with that company or not.
Suppliers: helps them in assessing the creditworthiness of their customers on granting credit.
Competitors: enables them to gain insight into the strengths and weaknesses of their competitors, develop strategies to compete more effectively, as well as identify potential acquisition targets or strategic partnerships.

The importance of financial analysis

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Financial analysis is used to evaluate the performance of companies in detail to achieve a set of important functions, such as:

1. Assessment of financial health:
Financial analysis is used to assess the financial health of the company, as it helps investors to understand the profitability of the company, the availability of liquidity and solvency, and determine the extent of its financial stability, and the consequent investment decisions. Financial analysis thus avoids investors making costly investment mistakes.

2. Identify strengths and weaknesses:
One of the advantages of financial analysis is that it helps to identify the strengths and weaknesses of the examining the company’s financial statements, a financial analyst can identify areas where the company is performing well and those that need improvement. Of course, this information helps the company’s management in making better decisions, improving the overall performance of the company.

3. Identify growth opportunities:
By studying the trends in the company’s financial statements, a financial analyst can identify areas in which the company can increase its revenues or reduce its expenses, which is important information that helps to achieve long-term goals.

4. Risk management:
Financial analysis is also used for risk management. By examining the company’s financial statements, it is possible to identify areas in which the company may be exposed to risks, such as high debt levels or dependence on, for example, a specific category of customers. This information helps the company’s management to develop strategies to mitigate these risks.

5. Facilitate comparison:
Financial analysis facilitates comparison between companies and their competitors to identify differences, superiority and decline, in order to improve performance, productivity and maximize profit. As well as facilitating the comparison between the units of the same company or different products of the same company for the purpose of competitive and targeted analysis, to improve the efficiency of all departments in the work.

Types of financial analysis
There are several different types of financial analysis used to assess the financial performance of a company, and they vary according to the method of analysis, including:

-Ratio analysis
Ratio analysis is the most widespread type of financial analysis, as it involves analyzing the company’s financial statements to calculate various financial ratios. These ratios are used to assess the profitability of the company and other key financial metrics.

-Trend analysis
Trend analysis involves analyzing the company’s financial statements over time to identify trends and patterns, this type of analysis is useful for identifying areas in which the company is experiencing growth or decline, to identify opportunities for improvement. Trend analysis can be performed using financial ratios or by analyzing individual financial data items, such as revenue, expenses, or assets.

-Comparative analysis
This type of analysis is useful to identify areas in which the company is outperforming or is performing poorly relative to its peers, and to identify opportunities for improvement.

-Cash flow analysis
Cash flow analysis aims to assess the company’s ability to generate cash and meet its financial obligations, as it includes calculating various cash flow ratios such as: cash flow coverage ratio, operating cash flow ratio, and free cash flow ratio.

-Risk analysis
Risk analysis involves analyzing a company’s financial statements to identify areas where it may be exposed to risk, such as high levels of debt or dependence on a single client. It is an important analysis for the development of potential risk mitigation strategies, it can be carried out using financial ratios or by analyzing individual financial data elements.

-External analysis
External analysis is carried out by investors and stakeholders who are not partners of the enterprise, relying on information published in various reports, such as the profit and loss statement and the balance sheet. It involves examining the financial statements and other financial information of the company from an external perspective, with the aim of assessing its financial health and stability.

-Internal analysis
It is the analysis carried out by the internal management of the enterprise, to obtain detailed and accurate information that enables it to identify areas in which they can reduce costs or increase revenues and improve efficiency. It is based on a thorough examination of the public and confidential financial statements of the company.

-Horizontal analysis
Horizontal analysis compares financial statements for several years with each other in order to understand the profitability and growth of a business, it is also called time series analysis. It helps to determine whether the company is growing or declining, as well as to identify trends and changes in its financial performance.

This analysis particularly highlights any major changes or events that may have affected the company’s financial performance. For example, if we compare the Income Statement of a company for two years, we can determine the change in sales revenue, the cost of goods sold, gross profit, operating expenses, net income and other significant financial ratios.

-Vertical analysis
The analysis of one-year financial statements is known as vertical analysis or static analysis; it is an analysis that involves studying the relationship between various items of the profit and loss statement, balance sheet, and other financial statements in one financial year. It helps to identify areas in which the company allocates a disproportionate amount of resources, or areas that may experience an increase or decrease in investment.

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