Financial Analysis: Definition, Importance, Types, and Examples (2023)

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.

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.

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.

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.

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.

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.

Examples of Financial Analysis

As an example of fundamental analysis, Discover Financial Services reported its fourth quarter 2021 diluted earnings per share (EPS) at $3.64. That was a significant gain from the fourth quarter of the previous year, when Discover reported a diluted EPS of $2.59. A financial analyst using fundamental analysis would take this as a positive sign that the intrinsic value of the security is increasing.

With that information, analysts may raise their forecasts of the company's future performance. These consensus changes, or "estimate momentum," may be used to predict future prices.

For example, during January 2022, the consensus among analysts for Discover's projected 2022 estimated EPS was raised from 13.49 to 13.89, a 2.45% increase over the average estimates a month prior. Of the 15 analysts who made predictions, 13 raised their targets and only 2 lowered them.