Financial analysis is the examination of financial information to reach business decisions. This analysis typically results in the reallocation of resources to or from a business or a specific internal operation. This type of analysis applies particularly well to the following situations:
- Investment decisions by external investor. In this situation, a financial analyst or investor reviews the financial statements and accompanying disclosures of a company to see if it is worthwhile to invest in or lend money to the entity. This typically involves ratio analysis to see if the organization is sufficiently liquid and generates a sufficient amount of cash flow. It may also involve combining the information in the financial statements for multiple periods to derive trend lines that can be used to extrapolate financial results into the future.
- Investment decisions by internal investor. In this situation, an internal analyst reviews the projected cash flows and other information related to a prospective investment (usually for a fixed asset). The intent is to see if the expected cash outflows from the project will generate a sufficient return on investment. This examination can also focus on whether to rent, lease, or purchase an asset.
The key source of information for financial analysis is the financial statements of a business. The financial analyst uses these documents to derive ratios, create trend lines, and conduct comparisons against similar information for comparable firms.
The outcome of financial analysis may be any of these decisions:
- Whether to invest in a business, and at what price per share.
- Whether to lend money to a business, and if so, what terms to offer.
- Whether to invest internally in an asset or working capital, and how to finance the acquisition.
Financial analysis is one of the key tools needed by the managers of a business to examine how their organization is performing. For this reason, they are constantly querying the financial analyst about the profitability, cash flows, and other financial aspects of their business.