Financial analysis is the process of evaluating businesses, projects, budgets, and other finance-related transactions to determine their performance and suitability. Typically, financial analysis is used to analyze whether an entity is stable, solvent, liquid, or profitable enough to warrant a monetary investment.
Key Takeaways
- If conducted internally, financial analysis can help fund managers make future business decisions or review historical trends for past successes.
- If conducted externally, financial analysis can help investors choose the best possible investment opportunities.
- Fundamental analysis and technical analysis are the two main types of financial analysis.
- Fundamental analysis uses ratios and financial statement data to determine the intrinsic value of a security.
- Technical analysis assumes a security’s value is already determined by its price, focusing instead on trends in value over time.
Understanding Financial Analysis
Financial analysis is used to evaluate economic trends, set financial policy, build long-term plans for business activity, and identify projects or companies for investment. This is done through the synthesis of financial numbers and data. A financial analyst will thoroughly examine a company’s financial statements—the income statement, balance sheet, and cash flow statement. Financial analysis can be conducted in both corporate finance and investment finance settings.
One of the most common ways to analyze financial data is to calculate ratios from the data in the financial statements to compare against those of other companies or against the company’s own historical performance.
For example, return on assets (ROA) is a common ratio used to determine how efficient a company is at using its assets and as a measure of profitability. This ratio could be calculated for several companies in the same industry and compared to one another as part of a larger analysis.
There is no single best financial analytic ratio or calculation. Most often, analysts use a combination of data to arrive at their conclusion.
Corporate Financial Analysis
Incorporate finance, the analysis is conducted internally by the accounting department and shared with management to improve business decision-making. This type of internal analysis may include ratios like net present value (NPV) and internal rate of return (IRR) to find projects worth executing.
Many companies extend credit to their customers, resulting in delayed cash receipts from sales. For companies with large receivable balances, it is useful to track days sales outstanding (DSO), which helps the company identify the length of time it takes to turn a credit sale into cash. The average collection period is an important aspect of a company’s overall cash conversion cycle.
A key area of corporate financial analysis involves extrapolating a company’s past performance, such as net earnings or profit margin, into an estimate of the company’s future performance. This type of historical trend analysis is beneficial for identifying seasonal trends.
For example, retailers may see a drastic upswing in sales in the months leading up to Christmas. This allows the business to forecast budgets and make decisions, such as necessary minimum inventory levels, based on past trends.
Investment Financial Analysis
In investment finance, an analyst external to the company conducts an analysis for investment purposes. Analysts can either undertake a top-down or bottom-up investment approach. A top-down approach first looks for macroeconomic opportunities, like high-performing sectors, and then drills down to find the best companies within that sector. They further analyze the stocks of specific companies to choose potentially successful ones by examining the company’s fundamentals.
A bottom-up approach, on the other hand, looks at a specific company and conducts similar ratio analysis to those used in corporate financial analysis, examining past performance and expected future performance as investment indicators. Bottom-up investing forces investors to consider microeconomic factors first and foremost, including a company’s overall financial health, analysis of financial statements, products and services offered, supply and demand, and other individual indicators of corporate performance over time.
Financial analysis is only useful as a comparative tool. Calculating a single instance of data is usually meaningless; comparing that data against prior periods, other general ledger accounts, or competitor financial information yields useful insights.
Types of Financial Analysis
There are two types of financial analysis: fundamental analysis and technical analysis.
Fundamental Analysis
Fundamental analysis uses ratios derived from financial statement data, like a company’s earnings per share (EPS), to determine the intrinsic value of the business’s security. Using ratio analysis in addition to a thorough review of economic and financial situations surrounding the company, analysts can arrive at an intrinsic value for the security. This number is then compared to the security’s current price to determine whether the security is undervalued or overvalued.
Technical Analysis
Technical analysis uses statistical trends derived from trading activity, such as moving averages (MA). Essentially, technical analysis assumes that a security’s price already reflects all publicly available information and instead focuses on the statistical analysis of price movements. Technical analysis attempts to understand the market sentiment behind price trends by identifying patterns and trends rather than analyzing a security’s fundamental attributes.
Horizontal vs. Vertical Analysis
When reviewing a company’s financial statements, two common types of financial analysis are horizontal analysis and vertical analysis. Both use the same set of data, though each analytical approach is different.
Horizontal analysis entails selecting several years of comparable financial data. One year is selected as the baseline, often the oldest. Then, each account for each subsequent year is compared to this baseline, creating a percentage that easily identifies which accounts are growing (hopefully revenue) and which accounts are shrinking (hopefully expenses).
Vertical analysis involves choosing a specific line item benchmark, then scrutinizing how every other component on a financial statement contrasts with that benchmark. Net sales is typically used as the benchmark. A company would then compare cost of goods sold, gross profit, operating profit, or net income as percentages relative to this benchmark. Companies can then track how these percentages change over time.
Examples of Financial Analysis
For an incisive illustration of financial analysis, consider the financial performance of Amazon.com leading up to Q3 2022. In this period, Amazon reported a net loss of $3 billion, a significant decline from the previous year’s net income of over $19 billion. The company’s earnings per share (EPS) also reflected this downturn, registering -$0.29 through the first three quarters compared to $1.88 per share the prior year.
However, analysts noted that this drop was less dramatic when comparing Q3 2021 to Q3 2022, showing EPS of $0.31 per share vs. $0.28 per share. Evaluating Amazon’s operating profit margins also underscores the financial decline:
- 2022: $9,511 / $364,779 = 2.6%
- 2021: $21,419 / $332,410 = 6.4%
From Q3 2021 to Q3 2022, financial analysis revealed a decline in operating margin, signifying that Amazon earned less operating income for every dollar of sales.
Why Is Financial Analysis Useful?
Financial analysis aims to examine whether an entity is stable, liquid, solvent, or profitable enough to warrant a monetary investment. It is utilized to evaluate economic trends, set financial policies, build long-term business plans, and identify promising projects or companies for investment.
How Is Financial Analysis Done?
Financial analysis can be conducted in both corporate finance and investment finance settings. A financial analyst will meticulously review a company’s financial statements, including the income statement, balance sheet, and cash flow statement.
One of the most common ways to analyze financial data is through ratio calculation derived from financial statements, comparing against those of other companies or the company’s historical performance. A key area of corporate financial analysis includes projecting a company’s past performance, such as net earnings or profit margin, into an estimate of its future performance.
What Techniques Are Used in Conducting Financial Analysis?
Analysts employ vertical analysis to compare each component of a financial statement as a percentage of a baseline (e.g., every component as a percentage of total sales). Conversely, horizontal analysis compares one baseline year’s financial results to subsequent years.
Various financial analysis techniques include analyzing growth rates like regression analysis, year-over-year growth, top-down approaches like market share percentage, or bottom-up methods like revenue driver analysis.
Moreover, financial analysis often involves financial metrics and ratios, assessing a company’s liquidity, solvency, profitability, or efficiency.
Fundamental Analysis
Fundamental analysis uses ratios gathered from data within financial statements to determine a business’s value. Through ratio analysis and reviewing economic contexts, analysts can reach an intrinsic value for a security, comparing it to its current price to ascertain whether it’s undervalued or overvalued.
Technical Analysis
Technical analysis leverages statistical trends gathered from market activity, such as moving averages (MA). They assume a security’s price reflects all publicly available information, focusing instead on analyzing price movements. Analysts look for patterns and trends istead of the security’s fundamental attributes.
The Bottom Line
Financial analysis is a cornerstone of making strategic, informed decisions based on a company’s underlying financial data. Whether it’s corporate, investment, or technical analysis, analysts explore trends, growth, risk areas, and support decision-making. This holistic approach includes investigating financial statement changes, calculating financial ratios, or examining operating variances.
Related Terms: solvency, liquidity, profitability, return on assets, net present value, internal rate of return, earnings per share
