What is financial analysis?
Financial analysis is the process of evaluating businesses, projects, budgets and other finance-related transactions to determine their performance and relevance. Typically, financial analysis is used to determine whether an entity is stable, solvent, liquid or sufficiently profitable to justify a monetary investment.
Key points to remember
- If done in-house, financial analysis can help managers make future business decisions or review historical trends from past successes.
- If performed externally, financial analysis can help investors choose the best possible investment opportunities.
- There are two main types of financial analysis: fundamental analysis and technical analysis.
- Fundamental analysis uses ratios and financial statement data to determine the intrinsic value of a security.
- Technical analysis assumes that the value of a security 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, define financial policy, develop long-term business plans and identify projects or companies to invest. This is done through the synthesis of figures and financial data. A financial analyst will scrutinize a company’s financial statements – the income statement, the balance sheet and the statement of cash flows. Financial analysis can be carried out both in the context of 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 it to that of other companies or historical performance of the business.
For example, return on assets (ROA) is a common ratio used to determine the effectiveness of a business 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.
How financial analysis is used
Corporate financial analysis
In corporate finance, the analysis is carried out internally by the accounting department and shared with management in order 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 that are worth executing.
Many companies extend credit to their customers. Therefore, the cash sales receipt may be delayed for a period of time. For companies with large accounts receivable balances, it is useful to track the days of current sales (DSO), which allows the company to identify the time it takes to turn a sale on credit into cash. The average collection period is an important aspect of a company’s overall cash conversion cycle.
A key area of business financial analysis is to extrapolate 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 beneficial in identifying seasonal trends.
For example, retailers could see a large increase in sales in the few months leading up to Christmas. This allows the company to plan budgets and make decisions, such as minimum stock levels needed, based on past trends.
Financial analysis of investments
In investment finance, an analyst external to the company performs an analysis for investment purposes. Analysts can take a top-down or bottom-up investment approach. A top-down approach first searches for macroeconomic opportunities, such as high-performance sectors, and then explores the best companies in that sector. From that point on, they analyze the stocks of specific companies in more detail to choose potentially successful investments by finally examining the fundamentals of a particular company.
A bottom-up approach, on the other hand, examines a specific company and performs a ratio analysis similar to those used in financial analysis of companies, examining past performance and expected future performance as investment indicators. Bottom-up investment forces investors to consider microeconomic factors first and foremost. These factors include the overall financial health of a business, analysis of financial statements, products and services offered, supply and demand, and other individual indicators of business performance over time.
Types of financial analysis
There are two types of financial analysis: fundamental analysis and technical analysis.
Fundamental analysis uses ratios gathered from data contained in financial statements, such as a company’s earnings per share (EPS), to determine the value of the business. 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 security. The ultimate 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 uses statistical trends from trading activity, such as moving averages (MA). Essentially, technical analysis assumes that the price of a security already reflects all the information available to the public and focuses instead 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 by analyzing the fundamental attributes of a security.
Examples of financial analysis
As an example of fundamental analysis, Discover Financial Services published second quarter 2019 earnings per share (EPS) at $ 2.32. This was up from 2019 quarterly EPS of $ 2.15. A financial analyst using fundamental analysis would see this as a positive sign of an increase in the intrinsic value of the security.
Therefore, future EPS projections are also estimated to be higher. For example, according to Nasdaq.com, estimated EPS for the third quarter of 2019 is up $ 2.29 compared to estimated EPS for the second quarter of 2019 of $ 2.11 and estimated EPS for the first quarter of 2019 of $ 2.00 . Also note that the EPS reported for the first two quarters of 2019 has exceeded the estimated EPS for the same quarters.
On the other hand, a technical analysis was carried out on the exchange rate of the British pound (GBP) / American dollar (USD) after the results of the Brexit vote in June 2020. Looking at the graph of the exchange rate, it was obvious that the value of GBP had dropped significantly, to a 31-year low, against the dollar after the vote to leave the European Union on June 23, 2020.