What Is Financial Analysis & Reports?

• What is financial analysis?
• How is a financial analysis done?
• Types of financial analysis
• Investment financial analysis
• Corporate financial analysis
• Examples of financial analysis
• Why is financial analysis useful?

The financial status of a company can be studied through financial analysis. The financial analysis process helps determine if the company is financially stable, solvent, profitable, and an attractive investment. Financial analysis can also be applied to budgets, projects, businesses, or other finance-related entities. A company can analyze itself to make decisions based on its present and past performance. The two types of financial analysis are fundamental analysis and technical analysis. Fundamental analysis is helpful to find the intrinsic value of securities, while technical analysis studies its trends in value. Investors must always perform financial analysis before making investments.

What is financial analysis?

Financial analysis is the study of a company, business, project, or other financial entity to determine its financial status, performance, and potential. Companies use financial analysis to decide on their policies and plans, and determine if a project is likely to do well financially. Before investing money into a company, investors and potential buyers study a company's investment potential.

The company’s financial statements, such as the balance sheet, income statement, and cash flow statement, hold the information required for the company's financial analysis. The analyst can also calculate ratios from the financial data and compare them with those of other companies or with the company's past performance.

How is a financial analysis done?

Financial analysts use statements such as income statements, balance sheets, and cash flow statements, as the basis for their study. The current financial period will be sufficient if the company is being analyzed for its current status. If the analyst wants to study the company’s historical trends, past financial statements would also be required. Financial analysis can also use past trends to predict a future trend.

Types of financial analysis

There are two general types of financial analysis; fundamental and technical analysis.

Fundamental analysis: Fundamental analysis aims to determine the value of the business. It uses data such as the earnings per share (EPS) and other ratios. These ratios must be analyzed based on the company’s economic and financial situation. The financial analyst calculates the actual intrinsic value of the security and compares it with the current price to determine if it is undervalued or overvalued. This is an essential process for an investor to prevent investing in an overvalued company. An undervalued one has more opportunities for a good return on investment.

Technical analysis: Technical analysis of a company ignores its financial statements and studies its performance in the markets. The market activity, such as moving averages, reveals how much the security prices fluctuate and the market sentiments driving the changes. It is an external analysis as opposed to an internal analysis. It uses market trends and publicly available information to assess the company's finances.

The types of financial analysis can also be classified based on which aspect of the financial information is being studied, as follows:

Vertical analysis: Vertical analysis aims to determine how the company has utilized its resources and how these resources are allocated. The reports that are studied are the balance sheet and the income statement. The information such as assets, liabilities, and shareholder’s equity are converted into percentages. These percentages are then compared with other companies in the same industry or of the same size. This helps assess the company against similar ones.

Horizontal analysis: This method of financial analysis compares the previous years' financial statements to find the company's growth rate. The comparison can go back three to five years and may also include forecasts based on the historical data. This shows the company’s performance trends. It is useful to compare this with the industry standard for a more meaningful interpretation.

Liquidity analysis: Liquidity is the availability of the means to meet a company’s short-term goals and commitments. The ratios that are commonly studied for this purpose are:

• Current ratio
• Quick ratio
• Cash ratio
• Net working capital

Turnover analysis: The turnover information of the company is studied by determining the following:

• Accounts receivable turnover
• Inventory turnover ratio
• Working capital turnover ratio
• Asset turnover ratio
• Equity turnover ratio
• Days Payable Outstanding DPO

Profitability analysis: It is important to study how profitable a company is by analyzing the following numbers from the income statement:

• Profit margin
• Operating profit margin
• EBIT margin
• EBIDTA margin
• Earnings before taxes

Risk and leverage analysis: The debt that the company is carrying, repayment capability, and the level of risk involved are studied through the following financial analysis metrics:

• Operating leverage
• Degree of operating leverage
• Financial leverage
• Degree of financial leverage
• Debt/equity
• Debt/EBITDA
• EBIT/interest (interest coverage)
• Dupont analysis – this is a combination of ratios

Stability analysis: The stability ratio is used to calculate the stability of a company in the long run.

Fixed asset ratio = Fixed assets / Capital employed

Coverage analysis: The interest due to lenders and the dividends to be paid to the shareholders are studied.

Control analysis: This is the analysis used by the company’s management to check their performance. Control analysis uses three ratios:

• Capacity ratio formula = Actual hours worked / Budgeted hours x 100
• Activity ratio formula = Standard hours for actual production / Budgeted standard hours x 100
• Efficiency ratio formula = Standard hours for actual production / Actual hours worked x 100

Valuation analysis: The following help a financial analyst determine the fair value of a company:

• DDM (Dividend Discount Model)
• Discounted cash flow formula
• Trading multiples
• Transaction multiples valuation
• The sum of the parts valuation

The two types of valuation analysis are:

Cost analysis

• Cost to build/replace

Relative value market analysis

• Comparable company analysis
• Precedent transactions
• Intrinsic value analysis
• Discounted cash flow analysis

Scenario and sensitivity analysis: This analyzes the degree of sensitivity to risk. Both valuation and financial modeling techniques are used to envision the best case and worst-case scenarios for the company and then predict its sensitivity to it. It is useful to plan budgets and forecast the sensitivity of the company’s value in different scenarios.

Variance analysis: In internal planning, a forecast or budget is compared to the actual results. The variance is analyzed to see how the company has performed against its planned performance. Variability can be due to controllable or uncontrollable reasons.

Rates of return: The goal of every business is to make a profit based on the investments. The company's rate of return is of interest to the management, investors, lenders, and other stakeholders. Some of the metrics that are analyzed are:

• Return on Equity (ROE)
• Return on Assets (ROA)
• Dividend yield
• Return on Invested Capital (ROIC)
• Capital gain
• Accounting rate of return (ARR)
• Internal Rate of Return (IRR)

Investment financial analysis

One of the main reasons for a company's financial analysis is investment purposes. An investor would want to know how attractive an investment the company is. Mergers and acquisitions only happen after due diligence, which includes financial analysis. Financial analysts generally study a group of companies in a particular category to determine the most suitable ones to invest in. They may follow a top-down or bottom-up approach. A top-down approach identifies the sectors and verticals that offer the most growth opportunities. The financial analysts then study companies within this category to find the best ones to invest in.

A bottom-up approach starts with specific companies and their performance. They are more focused on the microeconomic factors that affect its performance, such as its financial statements, product or service offerings, supply and demand, financial health, and other similar factors. They are more interested in the individual company’s performance and prospects.

Corporate financial analysis

Companies conduct internal financial analysis to assess performance and make better decisions. This internal analysis is called corporate financial analysis. The net present value (NPV) and internal rate of return (IRR) ratios are also studied to determine if proposed projects should be executed. When credit is extended to customers, cash receipts may be delayed. In such companies, it is essential to track the day sales outstanding (DSO) to assess how long it takes for cash collection from a sale and determines the health of the cash collection cycle. This analysis is helpful to spot recurrent periods of peak demand and be prepared to take advantage of them. For example, suppose there is a festival season that always generates more demand and sales. In that case, the company can adjust its production and inventory levels to fulfill the demand and generate maximum sales. Similarly, the company should also be prepared for periods of a lull in the business.

Examples of financial analysis

We can take the example of a larger company analyzing a smaller one for acquisition. They may study the data and see that the earnings per share for each quarter in the current year is consistently higher than the earnings in the corresponding quarter in the previous year. So, since the intrinsic value of the shares is rising, the company looks like an attractive one to acquire.

They can also look at the trend in the share prices for the last five years and see if the increase has been consistent. The performance average can help the company generate estimates of how the share value will grow.

Why is financial analysis useful?

Financial analysis is useful for the company to make long-term plans. Investors use financial analysis to identify companies for investment, and it helps them decide when and how much to invest. When there are multiple attractive investment options, financial analysis helps pick the better investment options. A financial analysis quantifies and simplifies the information available in a company’s financial statements, and it helps in the easy and quick interpretation of its financial status and prospects.

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