The basics of financial analysis | Learn more
In most of my individual articles on stock market outlook or forecast, the second and third sections are two forms of analysis. The first being fundamental analysis and the second technical analysis. These sections require basic financial analysis, although very different from that implemented in corporate finance. To help you with your own financial literacy, today we are going to review the basics of financial analysis.
Necessary documents and tools
The basics of financial analysis start with a few key documents and tools. The key documents are the company’s 10-K or 10-Q. These are the required annual and quarterly reports filed with the SEC. The main tools you need are a calculator, the company’s stock chart, and an Excel or Google spreadsheet. The two most important sections of either document will be the balance sheet and the income statement. Both sections will cover assets, liabilities, income, net income, shares outstanding, etc. of the society. Everything we need. Fortunately, once you practice reading these documents, entering the necessary information will be almost reflexive. Looking at the company’s stock chart, you will focus on perceived patterns. And also indicators that we will discuss later.
Keep reading to learn more about the basics of financial analysis.
Basics of fundamental analysis
Our fundamental analysis varies depending on whether we take a top-down or bottom-up approach. Top-down approaches first focus on the broader economy or sector, then focus on a specific company. If concerns about the economy are stated first, chances are this is an article that used a top-down approach. A bottom-up approach first examines a specific company. This type of approach emphasizes microeconomic factors. Bottom-up financial analysis will be more like corporate financial analysis in terms of complexity.
There is no correct answer to determine which approach you want to take. A top-down approach will generally focus on high growth opportunities. This is a high inflation economy. Keep in mind that growth companies generally don’t have the most attractive fundamentals. They will generally have low or no profitability, no dividends and high P/E ratios. Profitability is fairly easy to assess. Net income can be positive or negative. Dividends are also quite easy to spot.
You can find the P/E ratio by dividing the stock price by the earnings per share. You usually hope for a low (lower) ratio. P/E ratios also vary by industry, so be sure to take that into account as well. ROA and ROE are measures of profitability. These measures are taken by dividing net income by assets or equity. If a company has a high level of debt, the ROE will generally be higher than the ROA. Value companies will generally also have a strong ROA and ROE.
Acknowledging that much of fundamental analysis seems to focus on ratios and acronyms, I understand how confusing this can seem. However, with continued exposure and practice, it should become much less so. With this, we have completed the “fundamental” part of our financial analysis basics. Now let’s move on to technical analysis.
Technical Analysis Basics
When reviewing the basics of financial analysis, it is important to note that technical analysis is quite distinct from fundamental analysis. While fundamental analysis required calculations and business documentation, technical analysis requires a trained eye. Technical analysis focuses first on the price movement of stocks. As well as perceived patterns or trends. Some patterns and trends are bullish, some are bearish, while some are a combination of both. In general, technical analysis has been reserved for short-term investors, day traders, and swing traders. Given the reliance on short-term data, constructing long-term projections is a rather unreasonable request. Stock patterns can be quite random. And the best will have accuracy rates around 83%.
Beyond the chart and the patterns or trends you see on it, what other things do technical analysts look for? Increase volume, relative to average stock volume. The RSI, which is a momentum indicator, is used as an indicator of a reversal or pullback. An RSI above 70 is considered overbought. And an RSI below 30 is considered oversold. Other indicators include moving averages. This measures the average stock price at different time periods. Technical analysts combine these and other technical indicators with perceived stock patterns to illustrate an investment opportunity.
In covering the basics of financial analysis, I would like to make it clear that I am not advocating for one approach or the other. As I do in my articles, I believe there are benefits to using fundamental analysis and technical analysis together. If both forms led you to the same conclusion, wouldn’t you feel stronger in your decision(s)? Allowing both to work in your favor is a perk I don’t think you should quickly turn down.
Basics of financial analysis: conclusions
Although different, both forms of financial analysis serve the same purpose. To help you find good investment opportunities. While one focuses more on financial data and ratios, the other focuses more on stocks and consumer sentiment. Honing and understanding both should be the goal of any investor. Once you have, your ability to deploy both forms to your advantage becomes much easier. From there, finding better investment opportunities should also become easier.
Gabriel Shabat is a writer who focuses on financial literacy and investment topics. He has been studying and talking about the markets for over seven years. Last year, he became a faculty member at Boston University, teaching graduate finance courses as part of their master’s degree programs. When he’s not working, he enjoys playing guitar, working out and spending time with his loved ones.