Financial Analysis: Definition, Importance, Types, and Examples (2024)

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. Typically, financial analysis is used to analyze whether an entity is stable, solvent, liquid, or profitable enough to warrant a monetary investment.

Key Takeaways

If conducted internally, financial analysis can help fund managers make future business decisions or review historical trends for past successes.
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 a security's value is already determined by its price, and it focuses instead on trends in value over time.

Financial Analysis: Definition, Importance, Types, and Examples (1)

Understanding Financial Analysis

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.

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 conclusion.

Corporate Financial Analysis

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.

Investment Financial Analysis

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'sfundamentals.

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 considermicroeconomicfactors 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.

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 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

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 thestatistical 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.

Horizontal vs. Vertical Analysis

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, then seeing how every other component on a financial statement compares to that benchmark. Most often, net sales is used as the benchmark. A company would then compare cost of goods sold, gross profit, operating profit, or net income as a percentage to this benchmark. Companies can then track how the percent changes over time.

Examples of Financial Analysis

In the nine-month period ending Sept. 30, 2022, Amazon.com reported a net loss of $3 billion. This was a substantial decline from one year ago where the company reported net income of over $19 billion.

Financial Analysis: Definition, Importance, Types, and Examples (2)

Financial analysis shows some interesting facets of the company's earnings per share (shown above. On one hand, the company's EPS through the first three quarters was -$0.29; compared to the prior year, Amazon earned $1.88 per share. This dramatic difference was not present looking only at the third quarter of 2022 compared to 2021. Though EPS did decline from one year to the next, the company's EPS for each third quarter was comparable ($0.31 per share vs. $0.28 per share).

Analysts can also use the information above to perform corporate financial analysis. For example, consider Amazon's operating profit margins below.

2022: $9,511 / $364,779 = 2.6%
2021: $21,419 / $332,410 = 6.4%

From Q3 2021 to Q3 2022, the company experienced a decline in operating margin, allowing for financial analysis to reveal that the company simply earns less operating income for every dollar of sales.

Why Is Financial Analysis Useful?

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.

How Is Financial Analysis Done?

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.

What Techniques Are Used in Conducting Financial Analysis?

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.

Last, 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.

What Is Fundamental Analysis?

What Is Technical Analysis?

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.

The Bottom Line

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.

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Financial Analysis Overview:

Financial analysis is a critical process involving the evaluation of businesses, projects, budgets, and financial transactions to assess their performance and suitability for investment. The key takeaways highlight its significance for both internal decision-making by fund managers and external decision-making by investors.

Types of Financial Analysis:

Fundamental Analysis:
- Definition: Fundamental analysis utilizes ratios and financial statement data to determine the intrinsic value of a security.
- Goal: Evaluate a company's value by considering factors like earnings per share (EPS), economic conditions, and financial situations.
- Application: Analysts aim to determine whether a security is undervalued or overvalued by comparing intrinsic value with the current market price.
Technical Analysis:
- Definition: Technical analysis focuses on statistical trends derived from market activity, such as moving averages.
- Assumption: Assumes that a security's price already reflects all publicly available information and concentrates on analyzing price movements.
- Application: Examines patterns and trends to understand market sentiment and make investment decisions based on statistical analysis.

Corporate Financial Analysis:

Internal Analysis:
- Purpose: Enhance business decision-making within a company.
- Tools: Involves ratios like net present value (NPV) and internal rate of return (IRR) for project evaluation.
- Example: Tracking days sales outstanding (DSO) helps manage credit sales and assess the cash conversion cycle.
Historical Trend Analysis:
- Application: Extrapolates a company's past performance into an estimate of its future performance.
- Example: Identifying seasonal trends to forecast budgets and make informed decisions.

Investment Financial Analysis:

External Analysis:
- Purpose: Conducted by external analysts for investment decisions.
- Approaches: Top-down approach looks for macroeconomic opportunities; bottom-up approach focuses on individual companies.
- Factors Considered: Microeconomic factors, financial health, products/services, supply and demand.

Types of Financial Analysis Techniques:

Horizontal Analysis:
- Definition: Compares financial data over several years to identify trends.
- Application: Identifies accounts that are growing or shrinking by comparing them to a baseline year.
Vertical Analysis:
- Definition: Compares each component of a financial statement as a percentage of a benchmark, often net sales.
- Application: Tracks percentage changes over time for components like cost of goods sold, gross profit, and net income.

Examples of Financial Analysis:

Amazon.com Case:
- Earnings Per Share (EPS): Highlights the decline in EPS from -$0.29 to $1.88, indicating a net loss in a specific period.
- Operating Profit Margin: Reveals a decline in operating margin, signaling reduced operating income for every dollar of sales.

Why Financial Analysis is Useful:

Financial analysis is crucial for assessing stability, liquidity, solvency, and profitability, guiding economic trends, setting financial policies, and making informed investment decisions.

How Financial Analysis is Done:

Conducted in both corporate and investment finance settings, financial analysts thoroughly examine financial statements, employing common techniques like ratio analysis.

Techniques Used in Conducting Financial Analysis:

Analysts use vertical and horizontal analysis, growth rate analysis, and financial metrics such as liquidity, solvency, profitability, and efficiency ratios to evaluate a company's financial health.

Fundamental Analysis:

Fundamental analysis involves the use of ratios, such as earnings per share (EPS), combined with a review of economic and financial situations to determine a business's intrinsic value.

Technical Analysis:

Technical analysis relies on statistical trends derived from market activity, focusing on price movements and patterns to understand market sentiment.

Conclusion:

Financial analysis, whether in corporate, investment, or technical realms, serves as the cornerstone for informed decision-making. Analysts leverage data to explore trends, understand growth, identify areas of risk, and support strategic decision-making based on a company's underlying financial data.