The framework for financial analysis describes the approaches to be followed for analyzing financial statements of a firm.
It provides a systematic way to evaluate a firm’s financial health, profitability, risk profile, and funding needs. It helps managers, investors, and creditors make informed decisions regarding investments, lending, and strategic planning.
A possible framework for financial analysis are as follows:
1. Analyzing Funds Requirements of the Firm
This step involves identifying how much capital the firm requires to run its operations and to finance future growth. The analysis includes both short-term funds (for working capital such as cash, inventory, and receivables) and long-term funds (for investments in fixed assets such as machinery, technology, and expansion projects).
- By estimating the funds requirement, financial managers ensure that the firm neither suffers from a shortage of capital nor keeps idle funds that reduce profitability.
2. Analyzing Financial Condition and Profitability of the Firm
The financial condition of a firm is assessed using its financial statements, particularly the balance sheet and the income statement. Profitability is evaluated by examining how efficiently the company generates profits from its revenues and assets.
- Tools such as ratio analysis (e.g., liquidity ratios, solvency ratios, and profitability ratios) are commonly used.
- This analysis helps determine whether the firm is financially sound, able to meet obligations, and generating adequate returns for its shareholders.
3. Analyzing Business Risk Associated with the Firm
Business risk refers to the possibility that the firm’s profits may fluctuate due to internal or external factors. This includes risks related to market demand, competition, production efficiency, changes in government policies, and economic conditions.
- By analyzing business risks, financial managers can prepare strategies for risk mitigation—such as diversification, insurance, and strong internal controls—to protect the firm’s earnings and stability.
4. Determining the Financing Needs of the Firm
Once the funds requirement and risk factors are known, the firm must decide how to finance these needs. This involves determining the optimal capital structure, which is the right mix of debt and equity financing.
- Too much debt increases financial risk, while excessive reliance on equity may dilute ownership and lower earnings per share.
- The objective is to minimize the cost of capital while maintaining financial flexibility and stability.
5. Negotiations with Suppliers of Capital
After estimating the financing needs, the firm must negotiate with suppliers of funds such as banks, financial institutions, bondholders, and equity investors. Effective negotiation ensures that the firm obtains funds at the lowest possible cost and under favorable terms.
- This process also involves maintaining investor confidence, providing transparency, and balancing the expectations of lenders and shareholders.
