Introduction to Financial Analysis Example
A financial analysis example is the investigation of business results and financial reports with the aim to understand the performance of the entity. The analysis covers the facets of the profitability, liquidity, and solvency of the business. This, in turn, helps to make decisions with regards to investing, policy, or determining the future state of action. The analysis can take place in corporate finance or for investment finance. Corporate finance deals with NPV, IRR calculation of a prospective project whereas investment finance analysis deals with understanding the competitive benefit in investing amongst a slew of competitive firms for an investor.
Financial analysis exists in various forms and some of the forms are discussed below:
Examples of Financial Analysis (With Excel Template)
Let’s take an example to understand the calculation of the Financial Analysis in a better manner.
#1 Financial Analysis Example – Liquidity Ratio Analysis
It is a measure of the timeliness with which an entity would be able to clear out its imminent liabilities. The creditworthiness of an entity depends on how the number of liquid assets it possesses. An unfavorable ratio would mean uncertainty with regards to the fulfillment of the external liabilities and thereby raising questions on its future.
This ratio analysis though should be considered the payment cycle of the entity and the seasonal fluctuation. For example- if the payment cycle is in progress, the cash with the entity would obviously be low thereby not giving the correct picture of the financial situation. The ratios could be of the following kinds
Cash Ratio
- Cash Ratio compares the amount of cash to the immediate short term liabilities. If the business were to be dissolved today, would the cash be adequate to cover the short term liabilities that it has at that point?
Quick Ratio
- Quick Ratio is the measure of the cash and the future cash to be received (receivables from debtors) to repay the current liabilities that the firm has. Quick assets involve assets that can be converted into cash within 90 days. This ratio gives an indication of the ability of the firm to cover its liability obligations without resorting to the long term assets. More is the ratio, better is the ability of the firm to cover itself from foreseeable liabilities
Current Ratio
- It measures the current assets that a firm has against the payment of the current liabilities. Here, the current would mean either convertible into cash in the next one year or due to be re-payed in the next one year. It is one of the most important ratios to look at the liquidity ability of the concern.
The below example looks at Entity A and the determination of the liquidity ratios for a particular point of time:
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#2 Financial Analysis Example – Trend Analysis
This tool plots the performance of a given variable over a period of time to find out the various features, predict the future course of action, and weave methods around it considering such a trend to continue in the near future.
For example: if the profit of concern is decreasing every year by around 5%, there is a cause to check the factors that are influencing such movement. It could be due to external factors like changes in market conditions or could be driven by internal situations like cost increase or decrease in revenue. First, the trend analysis will tell us the cause and then it would indicate if such movement would continue in the future as well. If after the analysis, it is determined that the internal factors have very little to do with the movement and that it is beyond the control of the firm, then measures have to be taken to ensure that the unfavorable movement is minimal. This could involve expenditures on certain new assets and/or change the existing processes.
Generally, trend analysis is depicted by line graphs which are a good visual medium to understand the changes happening period over period.
#3 Financial Analysis Example – Rate of Return Analysis
This is generally used in the case of a capital purchase decision-making process. The rate of return is the measure of the increase in returns that the new asset will provide over the cost incurred on it. This analysis could be performed at two stages:
Pre-purchase: This would indicate the expected returns that an asset would bring over a period of time. If the returns are more than the cost incurred discounting at a decided rate of return then it worth to invest in the asset.
Post-purchase: After the asset is utilized in the production, the management might want to do a post facto analysis of how the asset is yielding and compare it to the expectation that they might initially have from the asset. In case, the yield is not up to the mark the management could decide to probably make a decision to sell it at the current market price and come up with an alternative solution that could help create better returns.
Conclusion
Financial analysis is important for decision-making to be it for the management or for potential investors. It helps understand the current health of the entity and simplifies the comparison between the entities of the same industry. Also, future forecasts could be made which will help management make decisions.
The analysis is subject to the time period at which it is done. Many times, an entity may be going through a temporary crisis. The analysis at that point will be skewed unfavorably. Also, given how the entity has performed in the past might not necessarily be the best indication of how it is going to perform in the future.
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This is a guide to the Financial Analysis Example. Here we discuss the introduction and practical example of liquidity ratio analysis, trend analysis, rate of return analysis along with a detailed explanation and downloadable excel template. You can also go through our other suggested articles to learn more –
