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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.
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 conclusions.
In corporate finance, the analysis is conducted internally by the accounting department and shared with management in order to improve business decision-making. This type of internal analysis may include ratios such as net present value (NPV) and internal rate of return (IRR) to find projects worth executing.
Many companies extend credit to their customers. As a result, the cash receipt from sales may be delayed for a period of time. 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 to identify seasonal trends.
For example, retailers may see a drastic upswing in sales in the few 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.
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.
Financial analysis is only useful as a comparative tool. Calculating a single instance of data is usually worthless; comparing that data against prior periods, other general ledger accounts, or competitor financial information yields useful information.
There are two types of financial analysis as it relates to equity investments: fundamental analysis and technical analysis.
Fundamental analysis uses ratios gathered from data within the financial statements, such as a company's earnings per share (EPS), in order to determine the business's value.
Using ratio analysis in addition to a thorough review of economic and financial situations surrounding the company, the analyst is able to arrive at an intrinsic value for the security. The end goal is to arrive at a number that an investor can compare with a security's current price in order to see whether the security is undervalued or overvalued.
Technical analysis uses statistical trends gathered 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 predict market movements by looking for patterns and trends in stock prices and volumes rather than analyzing a security’s fundamental attributes.
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 entails choosing a specific line item benchmark, and then seeing how every other component on a financial statement compares to that benchmark.
Most often, net sales are used as the benchmark. A company would then compare the cost of goods sold, gross profit, operating profit, or net income as a percentage of this benchmark. Companies can then track how the percentage changes over time.
In Q1 2024, Amazon.com reported a net income of $10.4 billion. This was a substantial increase from one year ago when the company reported a net income of $3.2 billion in Q1 2023.
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Analysts can use the information above to perform corporate financial analysis. For example, consider Amazon's operating profit margins below, which can be calculated by dividing operating income by net sales.
From Q1 2023 to Q1 2024, the company experienced an increase in operating margin, allowing for financial analysis to reveal that the company earned more operating income for every dollar of sales.
The financial analysis aims to analyze whether an entity is stable, liquid, solvent, or profitable enough to warrant a monetary investment. It is used to evaluate economic trends, set financial policies, build long-term plans for business activity, and identify projects or companies for investment.
Financial analysis can be conducted in both corporate finance and investment finance settings. A financial analyst will thoroughly examine a company's financial statements—the income statement, balance sheet, and cash flow statement.
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. 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.
Analysts can use vertical analysis to compare each component of a financial statement as a percentage of a baseline (such as each component as a percentage of total sales). Alternatively, analysts can perform horizontal analysis by comparing one baseline year's financial results to other years.
Many financial analysis techniques involve analyzing growth rates including regression analysis, year-over-year growth, top-down analysis, such as market share percentage, or bottom-up analysis, such as revenue driver analysis.
Lastly, financial analysis often entails the use of financial metrics and ratios. These techniques include quotients relating to the liquidity, solvency, profitability, or efficiency (turnover of resources) of a company.
Fundamental analysis uses ratios gathered from data within the financial statements, such as a company's earnings per share (EPS), in order to determine the business's value. Using ratio analysis in addition to a thorough review of economic and financial situations surrounding the company, the analyst is able to arrive at an intrinsic value for the security. The end goal is to arrive at a number that an investor can compare with a security's current price in order to see whether the security is undervalued or overvalued.
Technical analysis uses statistical trends gathered from market 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 looking for patterns and trends rather than analyzing a security’s fundamental attributes.
Financial analysis is a cornerstone of making smarter, more strategic decisions based on the underlying financial data of a company.
Whether corporate, investment, or technical analysis, analysts use data to explore trends, understand growth, seek areas of risk, and support decision-making. Financial analysis may include investigating financial statement changes, calculating financial ratios, or exploring operating variances.
