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What Is Financial Analysis?
Financial analysis entails the process of evaluating businesses, projects, budgets, and other finance-related transactions to determine their performance and feasibility. Generally, financial analysis is used to assess, at any particular time, whether an entity is stable, solvent, liquid, or, by some measures, profitable enough to warrant a monetary investment.
KEY TAKEAWAYS
- When conducted internally, financial analysis provides insights that support better business decision-making or explain historical trends of past successful investments.
- When conducted externally, financial analysis allows investors to choose the best investment opportunities.
- The two most important types of financial analysis are fundamental analysis and technical analysis.
- Fundamental analysis uses ratios and financial statement data to determine intrinsic value for a security.
- Technical analysis on the other hand assumes the value of the security has been determined already by its price and focuses on its trends in value with respect to time.
Understanding Financial Analysis
Financial Analysis It is the one type of analysis which is used to evaluate the economic trends, set a financial policy, design a long-range plan of a business activity, and determine the projects or companies suitable for investment.
The report includes an analysis of financial statement data in combination with various financial statistics. A company has to be a good financial analyst who will study its financial performance properly, covering aspects such as the income statement, the balance sheet, and the cash flow statement. Financial analysis is conducted in both corporate finance and investment finance settings.
Ratio analysis is one of the most frequently employed methods for examining financial data. This involves computing the ratios from the financial statement data and comparing them for benchmarking with other companies or against the performance of the company itself when compared to some previous period(s).
For example, return on assets (ROA) is a common ratio that measures a company’s efficiency in using its assets and that reflects its profitability. This type of ratio can be calculated for any number of companies within an industry, with comparisons made between them in a greater analysis.
Corporate Financial Analysis
In corporate finance, the analysis is done internally through the accounting department and thus flows into management for decision-making. Some internal analyses are based on ratios such as the net present value (NPV) and internal rate of return (IRR) to weed the projects that should be executed.
Credit given to customers by many companies has the effect of delaying cash receipts from sales. Days’ sales outstanding (DSO) measure can be seen as useful for any company with significant receivable balances because it indicates the time taken to convert a credit sale into cash. It is one of the important measures in the cash conversion cycle.
Another area of corporate financial analysis involves, say, extrapolating a company’s historical performance from such performance measures as net earnings or profit margin to a forecast of the company’s future performance. Historical trend analysis is particularly useful in recognizing seasonal trends.
For example, retailers may see an extraordinary increase in sales during the few months approaching Christmas. This allows the business to forecast budgets and make decisions-such that it has determined the necessary minimum inventory levels-based on past trends.
Investment Financial Analysis
An analyst external to the company conducts an analysis for investment purposes in investment finance. Analysts can either conduct a top-down or bottom-up investment approach.
A top-down approach looks for macroeconomic opportunities, from high-performing sectors and drill down to the best companies within that sector. At this point, the analysts then perform further analysis of specific companies’ stocks to choose potentially successful investments by looking last at a particular company’s fundamentals.
A bottom-up approach, on the other hand, begins with the analysis of a specific company and basically involved ratio analysis that was indeed similar to what was seen in corporate financial analysis. The distinguishing point is basically that ratios were considered as investment indicators in terms of both past performance and expected future performance.
Bottom-up investing convinces investors to look at microeconomic factors first and foremost; this includes factors such as a company’s overall financial health, analysis of financial statements, the products and services offered, supply and demand-and other such unique indicators of corporate performance over time.
Types of Financial Analysis
Equity investments have two types of financial analysis: fundamental analysis and technical analysis.
Fundamental Analysis
The fundamental analysis evaluates the value of a firm based on several ratios derived from data contained in the financial statements, including the company earnings per share (EPS).
The analyst employs ratio analysis and an exhaustive study of the economic and financial circumstances surrounding the company to arrive at an intrinsic value for the security. In other words, it assigns to each security one number that an investor would compare against the current price of a security to see if it was undervalued or overvalued.
Technical Analysis
Technical analysis employs statistical trends based on trading activity, such as moving averages.
Basically, technical analysis assumes that a security’s price already reflects all publicly available information, directing its emphasis onto the statistical analysis of price behaviour. Technical analysis attempts to forecast market movement based on trends and patterns in price and volume, rather than relying on fundamental analysis of a security’s characteristics.
Horizontal versus Vertical
There are two general types of financial analysis when reviewing financial statements of a company: horizontal and vertical analyses. While both use the same set of data, the degree of analysis varies between them.
Horizontal analysis consists of selecting several years of comparable financial data. A year typically serves as the baseline, usually the oldest year. Each account for each of the next years is then compared to this baseline, effectively calculating a percentage that allows one to easily see which accounts are growing (hopefully revenue) and which are decreasing (hopefully expenses).
Vertical analysis involves selecting a specific line item benchmark and determining how all other components on a financial statement compare to that benchmark.
Against the most common benchmark-net sales-A company would compare cost of goods sold, gross profit, operating profit, or net income as a percentage of this benchmark. This helps companies track the change over time in terms of percentage.
Examples of Financial Analysis
In Q1 2024, Amazon.com reports a net income of $10.4 million-$3.2 million less than last year’s Q1 income of $3.2 million.
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U.S. Securities and Exchange Commission.”Amazon.com Form 10-Q for the Quarter Ended March, 31,2024,”Page 4.
The information can be utilized by analysts in the performance of certain corporate finance analyses. For instance, consider Amazon’s operating profit margins as below, obtained from the results found by dividing operating income by net sales.
- 2024: $15,307 / $143,313 = 10.7%
- 2023: $4,774 / $127,358 = (3.7%)
The operating margin rose from Q1 2023 to Q1 2024. This allows a financial analysis showing an increase in operating income earned for each $1 of sales.
Why is financial analysis important?
Financial analysis is the primary tool used to determine whether in its current condition an enterprise is stable, liquid, solvent, or in sufficient profit to justify an investment with monetary resources. Financial analysis is made use of for analyzing economic trends, setting financial policy, devising long-range plans of business, and selecting candidates for investment.
Methods of Financial Analysis
Financial analysis can be performed within the corporate finance world and investment finance. Analysts will look in minute detail into a company’s financial statements including the income statement, balance sheet, and cash flow statement.
Analyzing financial data almost always incorporates an analysis of ratios, which allow comparison with other companies, or review of the same company’s historical performance. A significant area of corporate finance analysis involves projecting past performance-measured in terms such as net earnings or profit margins-into estimates of future performance.
Common Techniques Used in Financial Analysis
Vertical analysis allows an analyst to compare any single element of a financial statement to a base figure that is deemed standard, so that a cost is a percentage of one of the total sales. By contrast, horizontal analysis compares the results of financial statements of one baseline year to those of a number of other years.
Many techniques of financial analyses involve looking at growth rates. The analyses include regression analysis, year-over-year growth, top-down analysis, such as market share percentage, and bottom-up analysis, such as revenue driver analysis.
Financial analysis almost always involves the use of ratios and financial ratios. These include quotients relating to the liquidity, solvency, profitability, or efficiency of a company.
What is basically fundamental analysis?
Fundamental analysis uses ratio analysis, among other data within financial statements, such as the company’s earnings per share (EPS), to determine the value of a business. In this way, an analyst can derive an intrinsic value for a security, aided by ratio analysis and a comprehensive analysis of both economic and financial conditions regarding the firm. This assignment usually encompasses generating amounts representing the general number against which an investor compares a security’s present price to identify if the security is overvalued or undervalued.
What is basically technical analysis?
Technical analysis is based on statistical trends drawn from market activity, among which moving averages (MA) is one of them. Technical analysis is basically a belief that the current price of a security incorporates all the publicly available information regarding it, and then price movements are continued to be analyzed from a statistical point of view. Instead of analyzing the fundamental attributes of a security, technical analysis tends to forecast market sentiments behind the price trends, that is, it seeks connections and patterns.
The bottom line
Financial analysis underlies the reasoning behind an intelligent, strategic decision-making process vested on the underlying financial inspiration of the concern. An analyst uses data for deciding trends, growth, assessment of risk, and decision-making, whether it be corporate, investment, or technical; financial analysis can mean the investigation of the shifts in financial statements, calculations based on financial ratios, or observations on operating variance.
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