Financial analysis means different things to different people. A trade creditor, for example, is primarily interested in the liquidity of the firm being analyzed. His claim is short-term in nature, and the ability of the firm to pay this claim can best be judged by an analysis of its Jiquidity. The claim of a bondholder, on the other hand, is long-term. Accordingly, he is interested in the cash-flow ability of the firm to service debt over a long period of time. The bondholder may evaluate this ability by analyzing the capital structure of the firm, the major sources and uses of funds, the firm’s profitability over time, and projections of future profitability. Finally, an investor in a company’s common stock is concerned principally with present and expected future earnings as well as with the stability of these earnings about a trend. As a result, the investor usually concentrates his analysis on the profitability of the firm.
The point of view of the analyst may be either external or internal. In the cases described, it was external, involving suppliers of capital. From an internal standpoint, the firm needs to undertake financial analysis in order to effectively plan and control. To plan for the future, the financial manager must assess the firm’s present financial position and evaluate opportunities in relation to their effect on this position. With respect to internal control, the financial manager is particularly concerned with return on investment in the various assets of the company and in the efficiency of asset management. Finally, in order to bargain effectively for outside funds,the financial manager needs to be attuned to all aspects of financial analysis that outside suppliers of capital use in evaluating the firm. We see then, that the type of financial analysis varies according to the particular interests of the analyst.
Financial analysis involves the use of financial statements. These statements attempt to do several things. First they portray the assets and liabilities of a business firm at a moment in time, usually at the end of a year or a quarter. This portrayal is known as the balance sheet. On the other hand, an income statement portrays the revenues, expenses, taxes, and profits of the firm for a particular period of time, again usually a year or a quarter. While the balance sheet represents a snapshot of the firm financial position at a moment in time, the income statement depicts its profitability over time. From these statements certain derivative information can be obtained, such as a statement of retained earnings and a source-and-use-of-funds statement.