Why Financial Analysis is Vital for Entrepreneurs? Alberto Neyra Estens | January 04, 2016

Entrepreneurs and managers have to make sure that scarce resources are employed to best accomplish business goals.

Entrepreneurs and managers also carry out decision analysis for new investments aimed to secure the objectives of:

(i) Net Present Value (NPV) and Internal Rate of Return (IRR);

(ii) Payback Period;

(iii) Break-even Point;

What is Investment Decision Analysis?

Is the evaluation process to determine whether an investment in a project or a company is worthy to be implemented.

The company must survive in the long term by having good levels of liquidity and being profitable. Otherwise the investment should not be undertaken.

How to secure informed investment decisions?

Understanding the fundamentals of accounting, the recording of financial transactions, the preparation of financial statements, ratio analysis, cash flow management, changes in equity are a must for entrepreneurs and investors before taking the plunge.

Let’s look at financial ratios. Their analysis allows to measure management effectiveness in employing capital, and if the business is both, solvent and profitable. Where to search for the information that is essential to calculate financial ratios?

In Income Statements and Balance Sheets. Beforehand is necessary to be able to read them.

Here are some other ideas.

For a running business “What if” analysis quantifies management actions as: (i) market share; (ii) increase in unit prices; (iii) decrease in purchase costs; (iv) increase in Supplier’s Credits, in relation to achieving the targets of liquidity and profitability (ROIC, ROE). It is an excellent support to master analytical process.

For a future business, or a new investment, quantitative techniques are used to assess the investment quality by looking into the “future” streams of costs and benefits. The aim is to ascertain whether the investment is worthy to be carried forward or not.

These future streams of costs and benefits happen in the planning horizon of a financial plan, say, one, two, three, four years, or more. The time horizon depends on each type of investment. For an infrastructure project as a road, or an airport, or a dam, the time horizon could be as long as 10 years or even more as the recovery of the investment and the profitability of the project will take those many years to be realised.

If we look at a case of a bakery that is set to spread in more locations, then four years is an appropriate time horizon to judge the quality of the investment, if it is worthy or it should be dropped.

The financial plans, consisting of cash flows and financial statements, are the basis on which to obtain the yearly information on revenue and costs that are used in the application of quantitative techniques in investment appraisal.

Investment decision analysis can be mastered by making extensive use of cash flows for several years of operations, of the theory and practice of time value of money, net present value (NPV), internal rate of return (IRR), break-even point (B/E) and payback period.

Could it be done out of scratch and just reading some articles? Probably yes, but 100% more confidently with simulations or ‘what if scenarios,’ after having grasped the basics of financial statement analysis.

It will allow a clear understanding of the effect of changes in unit prices, or increase in market share, or decrease in expenses, or increase in borrowing on the main financial indicators of the quality of an investment.

Ocean bottom with treasure

Further more, with a Business Game you can practice in a ‘business laboratory’ to undertake critical actions such as increasing capital, or borrowing, or market share, or unit prices, decrease of costs.

Then you will appraise whether the firm attains its objective of long term survival through the necessary liquidity and profitability. Later on it will help you run the business with confidence and to ensure a raise of te bottom line.

Want to see it in practical terms? See our case study: How a Small Business Owner Built a Successful Global Chain.