A company’s financial statements are used by various stakeholders such as investors, regulatory authorities, creditors, and so on to judge a company’s creditworthiness and its ability to generate adequate returns over a long period of time.

Most investors use financial statements such as income statements and balance sheets for verifying a company’s profitability position, identifying the company’s expansion and diversification plans, and so on.

Investors are interested in making investments in those companies which may offer maximum return (in the form of capital appreciation) with minimum risk. In order to identify the best investment opportunities, individuals have to rely on the financial analysis performed by industry experts (such as equity analysts).

These industry experts evaluate a company’s performance on various grounds (such as financial performance of the current and previous three years) before recommending a company’s stock for investment purposes.

Financial analysis involves a study of various financial statements with the use of tools such as ratio analysis to judge a company’s liquidity and solvency position.

Financial analysis can also be used to measure a company’s ability to generate profits in the long run. While a company’s net income may show a positive figure, it is quite possible that this income is not sufficient to meet the expansion plans of the company.

Further, expansion plans proposed by the company may not give adequate returns to the investor. Hence, it is important to analyze the overall financial position of the company from a long-term perspective in order to assess the risks associated with a particular type of business/project. Financial analysis may prove to be a useful tool for measuring a company’s overall risk profile.

Two Important Components Of Financial Analysis

Liquidity Analysis

Financial analysis involves a study of the liquidity position of the company. Liquidity position indicates a firm’s ability to meet its short-term obligations in time. Ratios such as current ratio and quick ratio are frequently used to perform liquidity analysis.

While overall analysis of these two ratios may vary from industry to industry, company and to company and even from one financial analyst to another, a general indication of the status of the company’s current/liquid assets and current liabilities can be obtained with the help of these two ratios.

Solvency Analysis

While some investors may prefer to receive a constant amount of income in the form of interest from debentures/bonds issued by the company, other investors may prefer to earn high returns in the form of capital appreciation of their investments made by them in the company.

Irrespective of the motive behind investment, the achievement of a company’s growth objective depends on its ability to survive in the long run and offer adequate returns to its investors over a long period of time. Solvency analysis involves the measurement of the proportion of debt and equity in a company’s capital structure.

Investment in a company with a large amount of debt may appear to be a risky proposition to investors (expecting capital appreciation of their investments) because of a fixed liability in the form of interest which is required to be paid on the amount of debt borrowed by the company.

Some investors may use earning per share (EPS) as a criterion for making an investment in the company which can again be ascertained with the help of the EPS formula used in financial analysis.