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Fundamentals of Financial Analysis and Investment Decisions

Home Articles Fundamentals of Financial Analysis and Investment Decisions

What is Financial Analysis?

Financial analysis refers to the process of assessing the businesses, plans, resources and other finance-related entities to regulate their performance and aptness. Financial analysis is also known as the financial statement analysis or accounting analysis or analysis of finance, that evaluates the viability, firmness, and profitability of the business.

Financial analysis is the process of evaluating the business to determine the productivity, obligations, strengths and future earnings potential. A wide range of techniques is used to evaluate the financial capability of the business organization that includes most common methods of horizontal analysis, vertical analysis, and ratio analysis.

Types of Financial Analysis

There are myriad of methods that can be used to examine the performance of a viable enterprise, but the most common ones are:

Horizontal Analysis: In this method, the past performance is used as the base for the success of the company. There are deviations in this method that may use some fixed number of years as a standard; for instance, if the business organization is there in existence for quite some time, the comparison may be made with the prior 2 years. If the company is comparatively new, it is common to use the initial year as the baseline.

Vertical Analysis: This is also known as component percentages. It is the type of analysis that makes a comparison among the profits to assets, liabilities, and equities. This type of method is generally helpful at the time of comparing a large number of similar companies. One drawback of this method is that it does not weigh factors that have an impact on the future viability.

Ratio Analysis: This method scrutinizes various aspects of the financial health of the company. For instance; the current ratio is the comparison of assets to liabilities.

Stock Price Movement: This technique relies on analyzing the performance of the company’s stock rather than the financial condition.

What is Investment Decision?

In financial management, the investment decision means capital budgeting. In the business world, the two terms investment decision and capital budgeting are not considered to be different. The investment decision relates to the decision that is made by the investors with regard to the number of funds to be organized in the investment prospects.

Capital budgeting is also vital to the business because it creates a structured process that involves the following:

  1. Develop and formulate long-term strategic goals

The ability to set long-term objectives is important for the growth and prosperity of the business. The ability to value investment projects through capital budgeting develops an outline for business to plan future long-term direction.

  1. Seek out new investment projects

Knowing how to assess investment projects gives a business the model to seek and evaluate new projects.

  1. Estimate and forecast future cash flows

The forthcoming cash flows are what creates value for the business over time. Capital budgeting enables the officials to take up the potential project and approximate its future cash flows, which helps in determining if the project must be accepted.

  1. Facilitate the transfer of information

At the beginning of the project, several decisions need to be made at various levels of authority. The capital budgeting process helps in facilitating the transfer of information to make appropriate decision makers within the company.

  1. Monitoring and controlling expenditures

For the good project to not to turn to bad ones, there is a need of monitoring the expenditures. This step is considered to be a crucial benefit for the process of capital budgeting.

Have a look at the advantages and disadvantages of capital budgeting.

Advantages

  1. Helps the business organization to know and understand the different risks involved in the investment opportunity and find out how these risks affect the returns of the company.
  2. Helps the company to evaluate which investment option would become better resultant.
  3. From the various techniques of capital budgeting, the business organization may choose one method to estimate if it financially benefits.
  4. The company is able to make long-term strategic investments.
  5. In the competitive market, capital budgeting helps the companies to take investment decisions wisely.
  6. Capital budgeting helps in finding out if the investment would increase the value of the company or not.
  7. Capital budgeting offers enough control over the outflows.

Disadvantages

  • Capital budgeting decisions are for long term and are majorly irretrievable in nature.
  • Most of the times, these methods are based on the approximations and assumptions as the future is always unpredictable.
  • Capital budgeting remains introspective as the risk factor
  • If the wrong capital budgeting decision is taken, it may affect the long-term durability of the company

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