Definition of Financial Analysis

What is financial analysis?

Financial analysis is the process of evaluating businesses, projects, budgets, and other finance-related transactions to determine their performance and suitability. Generally, financial analysis is used to determine whether an entity is sufficiently stable, solvent, liquid or profitable to justify a monetary investment.

Key points to remember

  • If done in-house, financial analysis can help fund managers make future trading decisions or examine historical trends of past success.
  • 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 that a security’s value is already determined by its price and instead focuses on trends in value over time.

Understanding Financial Analysis

Financial analysis is used to assess economic trends, set financial policy, develop long-term plans for business activity, and identify projects or companies for investment. This is done by summarizing figures and financial data. A financial analyst will take an in-depth look at a company’s financial statements – the income statement, balance sheet, and cash flow statement. Financial analysis can be performed in both corporate finance and investment finance.

One of the most common ways to analyze financial data is to calculate ratios from financial statement data to compare them to those of other companies or to the company’s historical performance.

For example, return on assets (ROA) is a common ratio used to determine a company’s efficiency in using its assets and as a measure of profitability. This ratio could be calculated for several companies in the same sector and compared with each other as part of a broader analysis.

Business financial analysis

In corporate finance, analysis is conducted internally by the accounting department and shared with management to improve business decision-making. This type of internal analysis can include ratios such as net present value (NPV) and internal rate of return (IRR) to find projects worth running.

Many companies extend credit to their customers. Therefore, the collection of sales may be delayed for some time. For businesses with large debit balances, it is useful to track Days of Sale Outstanding (DSO), which helps the business identify how long it takes to turn a sale on credit into cash. The average payback period is an important aspect of a company’s overall cash conversion cycle.

A key area of ​​business financial analysis is extrapolating a company’s past performance, such as net profit or profit margin, into an estimate of the company’s future performance. This type of historical trend analysis is useful for identifying seasonal trends.

For example, retailers may see a drastic increase in sales in the few months leading up to Christmas. This allows the business to forecast budgets and make decisions, such as minimum inventory levels needed, based on past trends.

Financial analysis of investments

In investment finance, an analyst external to the company carries out an analysis for investment purposes. Analysts can conduct a top-down or bottom-up investment approach. A top-down approach first looks for macro opportunities, such as high performing sectors, then drills down to find the best companies in that sector. From this point on, they analyze the stocks of specific companies in more detail to choose potentially successful investments, lastly looking at the fundamentals of a particular company.

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

Types of financial analysis

There are two types of financial analysis: fundamental analysis and technical analysis.

Fundamental analysis

Fundamental analysis uses ratios gathered from data in financial statements, such as a company’s earnings per share (EPS), to determine the value of the company. By using ratio analysis in addition to a thorough examination of the economic and financial situations surrounding the company, the analyst is able to arrive at an intrinsic value for the stock. The end goal is to arrive at a number that an investor can compare with the current price of a security to see if the security is undervalued or overvalued.

Technical analysis

Technical analysis uses statistical trends gathered from trading activity, such as moving averages (MAs). Essentially, technical analysis assumes that a security’s price already reflects all publicly available information and instead focuses on 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 Examples

As an example of fundamental analysis, Discover Financial Services reported fourth quarter 2020 earnings per share (EPS) at $2.59. That was up from third-quarter 2019 EPS of $2.25. A financial analyst using fundamental analysis would view this as a positive sign that the intrinsic value of the stock is increasing.

With this, future EPS projections may also increase. For example, according to Nasdaq.com, estimated Q1 2021 EPS is expected to reach $2.78, up from Q1 2020 EPS of $1.36.

Why is financial analysis useful?

The objective of financial analysis is to analyze whether an entity is stable, solvent, liquid or sufficiently profitable to justify a monetary investment. It is used to assess economic trends, set financial policy, develop long-term plans for business activity, and identify projects or companies for investment.

How is the financial analysis done?

Financial analysis can be performed in both corporate finance and investment finance. A financial analyst will take an in-depth look at 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 financial statement data to compare them to those of other companies or to the company’s historical performance. A key area of ​​business financial analysis is extrapolating a company’s past performance, such as net profit or profit margin, into an estimate of the company’s future performance.

What is fundamental analysis?

Fundamental analysis uses ratios gathered from data in financial statements, such as a company’s earnings per share (EPS), to determine the value of the company. By using ratio analysis in addition to a thorough examination of the economic and financial situations surrounding the company, the analyst is able to arrive at an intrinsic value for the stock. The end goal is to arrive at a number that an investor can compare with the current price of a security to see if the security is undervalued or overvalued.

What is Technical Analysis?

Technical analysis uses statistical trends gathered from market activity, such as moving averages (MAs). Essentially, technical analysis assumes that a security’s price already reflects all publicly available information and instead focuses on 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.

Sarah J. Greer