Financial analysis and its importance to a company

Companies often do financial analysis to find out about the overall welfare of their business and what improvements need to be made. Read below to understand why such an analysis is essential to running a business and how it keeps a company’s financial position in good shape.

What is a company’s financial analysis?

Financial analysis is a process used to assess the current health of a business. It also helps to determine whether the existing financial policy works for the company’s benefit or requires specific changes. A financial analysis of a company can also pave the way for creating long-term plans to improve its operations and production processes.

What is the analysis of the financial position of а company?

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Analyzing a company’s financial position allows management to understand its performance relative to its competitors. It also helps assess the company’s overall financial strength and resilience to various market shocks and provides an opportunity to develop a long-term development plan.

Suppose, you decide to invest in a project that a company offers you. But how will you ascertain the financial soundness of a project? The answer is simple – find out its financial position.

Note! The financial position of a company informs investors about its overall health and reliability.

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How to evaluate financial performance of a company?

Let’s take an example of how to analyze a company’s solvency.

If a company borrows money from a bank, it must disclose the value of all of its significant assets and liabilities. The bank uses this information to assess the soundness of their financial position, meaning that it will evaluate the quality of the assets and give them a valuation. Thus, the total value of all assets of a company minus the total value of all its liabilities gives its net worth.

So, how do we ascertain the financial position of the business? A company’s financial analysis is often done by thoroughly examining and evaluating its balance sheets, current assets and liabilities, current ratios, non-current assets and liabilities, financial position at book value, and market-to-book-multiple, all of which are explained below. 

The balance sheet

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The balance sheet is a type of financial statement that contains a company’s record of its assets, liabilities, and shareholder equity. It is one of the most important documents required to evaluate a business successfully. One of the three core financial statements used in financially evaluating a business, it provides a snapshot or brief description of what the company owns and owes. In other words, it shows what assets the company owns and how much debt it owes other investors. 

Current assets and liabilities

Current assets refer to the assets or resources currently owned by the company at the time when financial analysis or company analysis is performed. These include cash on hand, cash equivalents, stock inventory, prepaid liabilities, accounts receivables, marketable securities, or any other asset that can be liquidated or converted into cash within one year. 

Liabilities, on the other hand, refer to debts that a company has. It can include bank loans, unpaid bills, mortgages, IOUs, or any money owed to another person or entity. Keeping a record of liabilities is an important part of accounting and bookkeeping. It is also essential as liabilities are important information that are considered when performing overall company financial analysis. 

Both a company’s current assets and liabilities can be found in the company’s balance sheet. 

The current ratio

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Current ratio is a financial metric used to measure a company’s ability to pay off short-term obligations. Also called the working capital ratio at times, it helps determine whether a company’s financial health is in distress or in default. An evaluation of the current ratio helps investors to determine whether a company can maximize the use of its current assets to pay off its debts and other payables. 

Non-current assets and liabilities

Non-current assets refer to the resources that the company owns, the full value of which are not likely to be realized or achieved within the account year. Non-current assets include land, long-term investments, trademarks, goodwill, properties, equipment, and plant and facilities. 

Non-current liabilities, on the other hand, refer to a company’s long-term debt obligations or those debts that are not to be paid within one fiscal year. They are resources that are borrowed from other entities and must be returned. 

Financial position: Book value

Book value, as pertains to the financial position of a company, refers to the accounting value of a company’s assets or their original costs, not including their permanent decline in value and total accumulated depreciation. Often, it is compared to the company’s market value when financial analysts want to assess the price of shares. 

Book value is often used to determine the following:

  • The amount shareholders could receive if the company is liquidated.
  • Whether a company’s stock is underpriced or overpriced.

Market-to-book multiple

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Market-to-book multiple or market-to-book ratio is a metric used to assess the current value of a company as compared to its book value. Listed in the balance sheet, it is the stock price of all of the company’s outstanding shares joined together. In other words, it is the current and perceived true value of the entire company in the stock market. The book value would be the true value of the company when all its liabilities are paid and all its assets are liquidated. 

The bottom line 

It is important for business owners to know what the current financial position of their company is as compared to other businesses in the industry. Knowing the current financial position of a company is essential not only in determining its overall financial health but also to know whether changes are to be made to keep it on the top of the competition. 

A company’s financial position determines whether it would get the trust of investors. Performing regular financial analysis and overall company analysis is important to make sure that it maintains the good reputation in the stock market and that its solvency is kept in check.

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