What is Financial Analysis

Financial analysis involves assessing businesses, projects, budgets, and other finance-related activities to gauge their performance and suitability. It's commonly used to determine if an entity is stable, solvent, liquid, or profitable enough to justify an investment.

Understanding Financial Analysis

Financial analysis is utilized to assess economic trends, establish financial strategies, devise long-term business plans, and pinpoint investment opportunities. This involves synthesizing financial figures and data. A financial analyst meticulously scrutinizes a company's financial statements—the income statement, balance sheet, and cash flow statement. This analysis is applicable in both corporate finance and investment finance environments.

A common method to analyze financial data is by computing ratios derived from the financial statements to compare against other companies or the company's own historical performance.

For instance, return on assets (ROA) serves as a standard ratio to gauge a company's asset utilization efficiency and profitability. This ratio can be computed for multiple companies within the same industry for comparative analysis.

Corporate Financial Analysis

In corporate finance, internal analysis is conducted by the accounting department and shared with management to enhance decision-making. This includes using ratios like net present value (NPV) and internal rate of return (IRR) to evaluate potential projects.

Many companies offer credit to customers, leading to delayed cash receipts from sales. Tracking metrics like days sales outstanding (DSO) helps assess how long it takes to convert credit sales into cash, influencing the company's cash conversion cycle.

Predicting a company's future performance often involves extrapolating from its past performance, such as net earnings or profit margin. Historical trend analysis aids in identifying seasonal trends, like increased retail sales before Christmas, enabling businesses to forecast budgets and adjust inventory levels accordingly.

Investment Financial Analysis

In investment finance, an analyst external to the company conducts an analysis for investment purposes. Analysts can either conduct a top-down or bottom-up investment approach. A top-down approach first looks for macroeconomic opportunities, such as high-performing sectors, and then drills down to find the best companies within that sector. From this point, they further analyze the stocks of specific companies to choose potentially successful ones as investments by looking last at a particular company's fundamentals.

A bottom-up approach, on the other hand, looks at a specific company and conducts a similar ratio analysis to the ones used in corporate financial analysis, looking at past performance and expected future performance as investment indicators. Bottom-up investing forces investors to consider microeconomic factors first and foremost. These factors include a company's overall financial health, analysis of financial statements, the products and services offered, supply and demand, and other individual indicators of corporate performance over time.

Types of Financial Analysis

Financial analysis can be categorized into two types: fundamental analysis and technical analysis.

Fundamental Analysis 

Fundamental analysis relies on ratios extracted from financial statements, like a company's earnings per share (EPS), to assess its value. By combining ratio analysis with a comprehensive examination of economic and financial factors affecting the company, analysts determine the security's intrinsic value. The objective is to derive a figure that investors can compare to the security's current price to gauge whether it's undervalued or overvalued.

Technical Analysis

Technical analysis utilizes statistical trends derived from trading activity, like moving averages (MA). It operates on the premise that a security's price incorporates all publicly available information and emphasizes statistical analysis of price movements. By identifying patterns and trends, rather than assessing a security's fundamental characteristics, technical analysis aims to grasp market sentiment driving price fluctuations.

Horizontal vs. Vertical Analysis

When examining a company's financial statements, two common types of analysis are horizontal analysis and vertical analysis. Although they both utilize the same data, each approach differs in its analytical method.

Horizontal analysis involves selecting multiple years of comparable financial data, with one year designated as the baseline, typically the oldest. Subsequently, each account for subsequent years is compared to this baseline, yielding a percentage that highlights growth (typically in revenue) or decline (typically in expenses).

Vertical analysis, on the other hand, involves choosing a specific line item as a benchmark and then comparing every other component on the financial statement to that benchmark. Usually, net sales serves as the benchmark, and the company evaluates cost of goods sold, gross profit, operating profit, or net income as a percentage of this benchmark. This allows companies to monitor changes in percentages over time.

Why is Financial Analysis Useful

Financial analysis serves to assess whether an entity is stable, liquid, solvent, or sufficiently profitable for investment. It aids in evaluating economic trends, establishing financial policies, devising long-term business plans, and pinpointing investment opportunities.

How Is Financial Analysis Done

Financial analysis is performed in both corporate finance and investment finance contexts. A financial analyst meticulously reviews a company's financial statements—the income statement, balance sheet, and cash flow statement.

A prevalent method of financial data analysis is computing ratios from the financial statements to compare with other companies or the company's historical performance. A critical aspect of corporate financial analysis involves projecting a company's past performance, like net earnings or profit margin, to estimate its future performance.

What Techniques Are Used in Conducting Financial Analysis?

Analysts can utilize vertical analysis to assess each component of a financial statement as a percentage of a baseline, like each component as a percentage of total sales. Alternatively, they can conduct horizontal analysis by comparing the financial results of one baseline year to other years.

Various financial analysis techniques involve examining growth rates, such as regression analysis, year-over-year growth, top-down analysis like market share percentage, or bottom-up analysis such as revenue driver analysis.

Additionally, financial analysis often involves employing financial metrics and ratios. These techniques encompass ratios related to liquidity, solvency, profitability, or efficiency (resource turnover) of a company.

The Bottom Line

In essence, financial analysis serves as a fundamental tool for making informed, strategic decisions rooted in a company's financial data. Whether it's corporate, investment, or technical analysis, analysts leverage data to identify trends, grasp growth opportunities, identify risks, and facilitate decision-making. Financial analysis encompasses tasks such as examining changes in financial statements, computing financial ratios, and scrutinizing operating variances.

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