Financial Analysis Explained: A General Overview

What is Financial Analysis?

Simply put, financial analysis is the entire process involved with appraising projects, budgets, businesses, or any finance-related transaction to identify if their overall performance is not only viable but sustainable. It involves reviewing and analyzing financial information to help make critical business decisions. It uses metrics like benchmark ratios, industry averages, and data from financial reports to help assess performance. This can include determining if an entity is liquid, stable, solvent, or worth investing in and if investing in said entity will provide a monetary return.

However, that's not the only thing it's used for in the financial world. Financial analysis can also help identify and determine economic patterns and trends, manage long-term goals and plans, make recommendations on how to best proceed, and select suitable businesses or projects for investment. These things are typically determined through the analyzing of data or numbers, hence, financial analysis.

A comprehensive examination of a company's financial statements completes the evaluation process. This includes cash flow and income statements, balance sheets, virtually anything that has to do with their financial data and numbers, whether it's for investment or corporate finance use.

Types of Financial Analysis

There are a few different types of financial analysis, which run the full gamut. These different types include:

Fundamental Analysis

Simply put, fundamental analysis again uses those ubiquitous ratios that are pulled from financial statement data. This can be determined from things like a business's earnings per share or EPS. It's then used to determine a company's overall value by using ratio analysis and assessing a company's financial and economic health. Eventually, a number calculated that potential investors can compare to see whether the company's security is overvalued or undervalued.

Technical Analysis

On the other side of things, technical financial analysis is different from fundamental. It uses statistical trends and patterns that are pulled from trading activity. This can include things like moving averages to find the pertinent information. The technical analysis is ultimately performed to understand market attitudes regarding price trends. It does this by identifying financial trends and patterns instead of attempting to calculate the fundamental aspects of security.

Horizontal Analysis

Horizontal financial analysis is very effective. The process consists of a side-by-side comparison of statements between several years of consecutive financial reporting periods for a company. Taking several reports for comparison allows for an in-depth analysis to identify patterns in the data that can be the foundation for changes and improvements. It's a good idea to have at least three years of financial statements and five years of predictive data to provide enough information to allow for a comprehensive and thorough analysis.

Horizontal analysis example

Vertical Analysis

Essentially, vertical analysis is dividing revenue by all the different factors of your company's income statements. The final numbers are then turned into percentages. Again, this is where benchmark ratios are crucial because they heavily use this type of financial analysis. Benchmarking against similar companies is an effective way to judge performance. It also allows for a broader range of comparisons by appraising via margins instead of dollars.

Vertical analysis example

Leverage Analysis

Leverage analysis is another necessary type of financial analysis. It uses the full spectrum of economic data to appraise company performance instead of just a single metric. It helps to compare everything overall to get the bigger picture of a company's financial health, to determine things like debt/equity ratio.

Examples of Financial Analysis

For the sake of an example, pretend there's a financial services company named Business XYZ. The fourth-quarter EPS of Business XYZ is currently at $3.09. However, their third-quarter EPS was $3.15. Suppose a financial analyst was to use the information from the EPS statements to determine the overall security and inherent value of Business XYZ. They would ultimately decide that the numbers show Business XYZ's EPS has gone down, which means they're not performing well financially and might not be a wise investment. However, this is an elementary example of financial analysis.

Inversely, if the fourth-quarter EPS were higher than the third-quarter EPS, this would be an excellent sign that the company's overall value was improving. Financial analysis can also predict how a company's overall financial numbers will behave in the future. It uses data and patterns pulled from a company's financial information to predict patterns and forecast future EPS or overall financial health for the upcoming quarters.

Here you can find detailed example of financial analysis report.

Ratio Benchmarks

Ratio benchmarks are significant and incredibly useful in financial analysis. They can help attain goals, compare similar companies, and determine valuable data to utilize for your best interests. In fact, calculating financial ratios is an effective way to identify and determine long-term progress. They can also help shine a light on problem areas and show the places where focus and attention are needed the most.

If you're wondering why they're so important, think about it: the ratios are essentially useless if there's nothing to compare it against. Benchmarks are essentially just general guidelines that relate to any particular industry or business niche. However, when measuring a company's financial health, it's not necessarily about how many dollars or assets they have. It's more about proportion and how the items relate to one another and then expressing that as a ratio or percentage. It allows for comparison of things that might not seem related but can actually provide pertinent and invaluable information. The best part is that they're relatively simple to calculate and a great tool to utilize in any industry.

Current Ratio

Ratio benchmarks also go hand in hand with the current ratio, which is how to evaluate your company's capacity to pay all of your debts or financial obligations within a one-year period. This also includes all your current assets.

Current ratios example calculation

Speaking in general terms, a good ratio to have for your company is anywhere in between 1.5 and 3. If you're at less than 1, that means that you would not be able to meet your debts if there were to all of a sudden become simultaneously due. However, it's actually quite common for businesses to operate this way, so don't feel too bad if your numbers are below one.

Why is Industry Average Important?

Industry average is essential to financial analysis. In fact, it's also crucial to stock investors, too, which use industry averages to determine the inherent value of a business before they decide to invest. The process involves applying industry averages to financial ratios and using a company's financial statements and data. The point of this application and analysis is to evaluate a company's financial performance and determine if it's ultimately profitable or has room for growth and expansion.

Benchmarking table

However, the industry averages can also be advantageous for all different kinds of companies. They can be used as a basis for performance comparison against similar companies and the current averages for their specific industry. In fact, industry averages are very similar to benchmark ratios because they both allow for comparison against the national standards and allow for an effective and in-depth way to evaluate performance, making it an invaluable tool for businesses in all industries of all sizes.

Financial Analysis is Essential to Evaluate the Economic Health of a Company

Financial analysis is an invaluable tool when it comes to determining your company's overall financial and economic performance. Whether you're using horizontal, vertical, fundamental, or technical analysis, the trends, patterns, and pertinent information that can be determined through financial analysis can be literally invaluable. It's also an essential tool for investors to decide whether it's ultimately worth investing in a specific company. No matter why it's being used, financial analysis is an essential part of running a business and allowing for economic growth and expansion.

Is it complicated to make a financial analysis by oneself?

It's easy to make analysis based on financial statements data if you use special financial analysis software. ReadyRatios web service carries out an intellectual analysis of a company’s financial position. All that has to be done is to enter the data of financial reports (prepared according to the IFRS or US GAAP) and to receive the results of the analysis, which does not differ from the analysis made by a professional analyst!

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