Why is financial analysis important?

In a previous article we touched on the importance of accounting and the role that it plays in understanding the innerworkings of a company and keeping important financial information organized and understandable.

Read more: Why is accounting so important?

When we in turn talk about financial analysis, in reality we are discussing what is in many ways an extension of accounting. In fact, accounting is so important to financial analysis without it there would be nothing to analyze and many important insightful information about the company would be unobtainable.

What does financial analysis help us with?

When reading a book, we may understand the words that are on the page, but do we understand how the characters are developing and changing as the story progresses? Is the author doing a subtle commentary on real world situations or is it just coincidence? Did the author foreshadow how the book will end from the beginning? Being able to read does not mean that we will always have a complete understanding of what we are reading.

In a similar manner we may be able to understand or read what a set of financial statements says, but our comprehension or depth of that understanding can have various levels, just like our understanding of a narrative is much more than being able to understand the meaning of the words arranged into sentences.

Simply put, to get the bigger more insightful and interconnected picture, financial analysis provides us with the knowledge and tools to do just that based on information we already have from our statements.

What is the greater understanding we are trying to obtain?

When utilizing financial analysis assessments there are typically 4 things that we want to have a greater understanding of, this being as follows:

1. Growth

Is the company growing? How fast? What is contributing to this growth? What threats exist that may affect growth?

2. Liquidity

Does the company have sufficient liquidity in order to repay short term liabilities? If not, why? How can liquidity be improved?

3. Profitability

Is the profit that is being earned satisfactory? What is driving profit? What areas of our company and ways of doing business can be changed so that profitability can be improved?

4. Solvency

Is the company able to face its liabilities? If not, why? What liabilities can be paid? What will be the cost of not paying? Can negative consequences be mitigated?

When the possibility exists to obtain a greater understanding of your company’s financials such as outlined herein this can provide the opportunity to decision makers to take less risk and make more significant improvements in the manner the company is managed.

So do not underestimate the opportunities that financial analysis may offer you!