Financial Analysis

Financial analysis works with a company’s financials to

determine its health, performance, and potential. This
data, which comes from financial statements and other
reports, is used by investors and companies to make
strategic decisions. For outsiders, that could be deciding
whether to buy shares in the company. For management,
it could mean establishing how to run the business better
and set goals.
KEY TAKEAWAYS

 Financial analysis involves examining a company’s

financial data to understand its health, performance,
and potential and improve decision-making.
 Ratios are a key part of financial analysis and past
data is used to make projections.
 Financial analysis helps management to better run
companies and outside investors to determine
whether a company makes a good investment.
 Common types of financial analysis include vertical
and horizontal analysis, leverage analysis, liquidity
analysis, and profitability analysis .
What Is Financial Analysis?
A company's success is measured by its financials. Their
accounts and statements contain a lot of information
represented in figures. Financial analysis aims to turn
these numbers into actionable intel.
Who Uses Financial Analysis?
Other than company leaders, many stakeholders—
investors, investment analysts, lenders, and auditors—
have an interest in financially analyzing a firm.

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Investors and Analysts

Investors and analysts assess a company’s financials to

determine if investing in it or lending money to it is
worthwhile. They undertake ratio analysis, examining
liquidity, cash flow, leverage, and profitability to see if the
company is healthy and well-run compared with its past
performance or peer firms.

Company Management

Accountants and others within a company analyze

financial data to improve business decision-making.
Analyzing financials can help identify weaknesses before
they turn into a crisis and is also used to set budgets,
ensure the right amount of inventory is ordered, assess
the return on investment on specific strategies, and
calculate a fair price to pay for an asset or acquisition .

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 Who Uses Financial Analysis?
Table with 4 columns and 10 rows.

Key Analysis
User Group Focus Types Main Goals

• Efficiency analysis • Improve operational efficiency

Operational • Variance analysis • Strategic planning
Company Management
performance • Cash flow analysis • Resource allocation
• Budget analysis • Performance monitoring

• Profitability
• Evaluate investment opportunities
analysis
• Assess risk-return
Investors / Investment Analysts Investment potential • Valuation analysis
• Make buy/sell decisions
• Growth analysis
• Manage portfolios
• Risk assessment

• Liquidity analysis
• Ensure financial system stability
• Capital adequacy
Regulators & Government Compliance and • Monitor compliance with regulations
• Risk assessment
Agencies financial stability • Protect public interests
• Compliance
• Detect potential violations
metrics

• Income analysis
• Ensure tax compliance
• Transfer pricing
• Detect tax evasion
Tax Authorities Tax compliance • Capital structure
• Verify reported income
• Revenue
• Assess tax obligations
recognition

• Leverage analysis • Assess default risk

• Liquidity analysis • Evaluate collateral
Creditors & Lenders Credit worthiness
• Cash flow analysis • Determine lending terms
• Coverage ratios • Monitor loan compliance

• Variance analysis
• Verify financial statements
• Trend analysis
Accuracy and • Detect irregularities
Auditors • Ratio analysis
compliance • Ensure reporting compliance
• Substantive
• Assess internal controls
testing

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Types of Financial Analysis
Here are some of the most common types of financial
analysis:
Vertical Analysis

Vertical analysis compares each line item on a financial

statement as a percentage of a base figure within the
same statement. Revenue usually serves as the base
figure (100%) on the income statement, while total assets,
total liabilities, and equity serve as the base on the
balance sheet.
The real power of vertical analysis comes from
comparisons:
 Over time: A company can see if expenses are
taking up a growing part of revenue.
 Across companies: Businesses of different sizes
can be compared fairly since everything is converted
to percentages.
 Against industry benchmarks: Companies can
spot if their cost structures deviate from industry
norms.
Horizontal Analysis

Horizontal analysis (also called trend analysis) tracks how

financial items change over time by comparing multiple
periods of financial data. It shows both dollar and
percentage changes, helping identify growth patterns,
cyclical trends, and potential problems.
Leverage Analysis

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Companies borrow money (or use leverage) to finance
operations and their expansion. Using leverage to their
advantage is important, but it’s also crucial that companies
don’t overextend themselves.
Just looking at the amount of debt isn’t enough. To get a
more complete picture, you need to compare borrowing to
revenue, growth, and so forth.
Thus, analysts turn to tools like the debt-to-equity ratio,
which reveals how much the company relies on debt to
finance its operations, and the debt-to-EBITDA ratio, which
indicates how much income the company has available to
cover its debt and other liabilities.
Liquidity Analysis

Liquidity analysis assesses a company's ability to pay off

its short-term bills and debts. Tools used to analyze
liquidity include the acid test, or quick ratio,
which measures a company's capacity to meet its short-
term obligations payable within one year with its most
liquid assets such as cash, marketable securities, and
money owed from customers.
Profitability Analysis

Companies are mainly judged on how big a profit they

generate, and profitability analysis measures how well
they're doing at that.
Common profitability analysis tools include return on
invested capital, which tells us how well a company
invests its money, and various forms of profit margins,
which essentially calculate how many cents per dollar a
company receives from a sale.
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Efficiency Analysis

One of the keys to running a business successfully is

getting the best possible output from the smallest number
of inputs. Efficiency analysis evaluates how well an
organization utilizes its resources.
Cash Flow Analysis

Cash flow, the movement of money into and out of a

company, is crucial to a business. It’s harder to manipulate
than profit. It's used to pay dividends and expenses and
fund expansions, and it is perhaps the best indicator that a
company has a sustainable business model.
Examples of Financial Analysis
Here are two examples of financial analysis being put to
use.
Internal Review

Management at a retail company notices that cash flow is

dwindling and asks internal accountants to investigate
what the possible causes could be. After scouring the
accounts, one thing in particular stands out: accounts
receivable, which represents money owed to a company
by its customers, has been rising substantially.
The accountants look at the accounts receivable turnover
ratio and days sales outstanding to determine the
company’s efficiency at collecting payments from
customers. This analysis reveals not only that payments
must be collected sooner but also that credit criteria need
to be tightened to prevent defaults and ensure the
company has enough cash on hand to fund its day-to-day
operations.
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Choosing a Stock To Invest In

Let's say you're bullish about the potential for growth

in companies that produce weight-loss drugs . You compile
a list of the most prominent firms in this area and screen
them to determine the best stock to choose from.
You start with the price-to-earnings ratio, which tells you
how much investors are willing to pay for $1 of earnings in
a company. Then you might look at the enterprise value
(EV)-to-revenue multiple and the EV to earnings before
interest, taxes, depreciation, and amortization (EBITDA)
multiple. The lower the ratios, the better. (These ratios are
found for most stocks on major financial websites,
including Investopedia.)
Finally, you can look at each company’s return on invested
capital to gauge which firm has historically done a better
job investing its money. Comparing these valuations, you
then make a short list of companies whose stock you will
buy.
The Bottom Line
A lot of information is contained within a company’s
financials. Analyzing it can help uncover activity that was
not immediately apparent and can improve decision-
making. With the help of ratios, companies can identify
problems, trends, and prospects and maximize efficiency.
Investors, meanwhile, can see how a company stacks up
against its past performance and peer group and quickly
get an idea of its health, profitability, and the attractiveness
of its share price.