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Financial analysis is an aspect of the overall business finance function that involves examining historical data to gain information about the current and future financial health of a company. Financial analysis can be applied in a wide variety of situations to give business managers the information they need to make critical decisions. The inability to understand and deal with financial data is a severe handicap in the corporate world. In a very real sense, finance is the language of business. Goals are set and performance is measured in financial terms. Plants are built, equipment ordered, and new projects undertaken based on clear investment return criteria. Financial analysis is required in every such case.
The finance function in business organizations involves evaluating economic trends, setting financial policy, and creating long-range plans for business activities. It also involves supplying a system of internal controls for the handling of cash, the recognition of sales, the disbursement of expenses, the valuation of inventory, and the approval of capital expenditures. In addition, the finance function reports on these internal control systems through the preparation of financial statements, such as income statements, balance sheets, and cash flow statements.
Finally, finance involves analyzing the data contained in financial statements in order to provide valuable information for management decisions. In this way, financial analysis is only one part of the overall function of finance, but a very important one. The mathematical tools produce data, not explanations; information, not interpretation; measurement, not meaning.. To these tools, you must ad judgment, which develops slowly, mostly out of experience.
Documents used in financial analysis
The two main sources of data for financial analysis are a company’s balance sheet and income statement. The balance sheet outlines the financial and physical resources that a company has available for business activities in the future. It is important to note, however, that the balance sheet only lists these resources, and makes no judgment about how well they will be used by management. For this reason, the balance sheet is more useful in analyzing a company’s current financial position than its expected performance.
The main elements of the balance sheet are assets and liabilities. Assets generally include (cash or equivalents that will be converted to cash within one year, such as accounts receivable, inventory, and prepaid expenses) and noncurrent assets (assets that are held for more than one year and are used in running the business, including fixed assets like property, plant, and equipment; long-term investments, and intangible assets like patents, copy rights, and goodwill). Both the total amount of assets and the makeup of asset accounts are of interest to financial analysts.
The balance sheet also includes two categories of liabilities, current liabilities (debt that will come due within one year, such as accounts payable, short-term loans, and taxes) and long-term debts (debts that are due more than one year from the date of the statement). Liabilities are important to financial analysts because businesses have same obligation to pay their bills regularly as individuals, while business income tend to be less certain. Long-term liabilities are less important to analysts, since they lack the urgency of short-term debts, though their presence does indicate that a company is strong enough to be allowed to borrow money.
The balance sheet also commonly includes stockholders’ equity accounts, which details the permanent capital of the business. Total equity usually consists of two parts: the money that has been invested by shareholders, and the money that has been retained from profits and reinvested into the business. In general, the more capital that is held by a business, the better the ability of the business to borrow additional funds.
In contrast to the balance sheet, the income statement provides information about a company’s performance over a certain period of time. Although it does not reveal much about a company’s current financial condition, it does provide indications of its future viability. The main elements of the income statement are revenues earned; expenses incurred, and net profit or loss.
Revenues consist mainly of sales, though financial analysts may also note the inclusion of royalties, interest, and extraordinary items. Likewise, operating expenses usually consist primarily of the cost of goods sold, but can also include some unusual items. Net income is the “bottom line” of the income statement. This figure is the main indicator of a company’s accomplishment over the statement period.

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