Financial analysis is the process of evaluating businesses, projects, budgets, and other finance-related entities 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.
Financial analysis involves using financial data to assess a company’s performance and make recommendations about how it can improve going forward. Financial analysts primarily carry out their work in Excel, using a spreadsheet to analyze historical data and make projections of future performance.
Types of financial analysis include:
- Horizontal analysis: This is the review of the performance of a company over a series of reporting periods, while the vertical analysis is a review of the proportion of accounts in the financial statements over a single reporting period.
- Vertical analysis: This involves looking at different parts of a business to see their share of the total, i.e., how different costs compare to total revenue.
- Ratio analysis: This is the calculation of ratios to compare different facets of a company’s operating performance.
- Trend analysis: This compares the overall growth of key financial statement line items within a company over the years to identify trends.
- Financial forecasting: This predicts what future results will be, using the results from past periods.
- Variance analysis: This compares the budgets of businesses to their actual results to identify variances.
Financial analysis is a method for interpreting these financial metrics in a meaningful way, comparing metrics over time, against competitors, or across industries. The objective is to identify financial strengths and weaknesses by properly establishing relationships between items on the balance sheet and income statement. From this analysis, actionable strategies can be formed to improve the financial performance of the firm.
Example of Financial Analysis
Let’s take the example of a fictitious company, “TechGrowth Inc.” We’ll use a few basic financial ratios for our analysis.
- Profit Margin: This measures how much out of every dollar of sales a company actually keeps in earnings. For example, a profit margin of 5% means the company has a net income of 5 cents for each dollar of revenue. Suppose TechGrowth Inc. had revenue of $500,000 and net income of $50,000 last year. The profit margin would be $50,000/$500,000 = 0.10, or 10%.
- Current Ratio: This measures a company’s ability to pay short-term obligations. It is calculated as current assets divided by current liabilities. If TechGrowth Inc. has current assets of $200,000 and current liabilities of $100,000, then the current ratio is $200,000/$100,000 = 2. This implies that TechGrowth Inc. has twice as many current assets as its short-term obligations, indicating good short-term financial strength.
- Debt to Equity Ratio: This measures a company’s financial leverage and is calculated as total liabilities divided by shareholder’s equity. Suppose TechGrowth Inc. has total liabilities of $250,000 and shareholder’s equity of $350,000. The Debt to Equity ratio would be $250,000/$350,000 = 0.71. A lower value generally suggests that a company is using less leverage and has a stronger equity position.
- Return on Equity (ROE): This measures the financial performance of a company and is calculated as Net Income divided by Shareholder’s Equity. If TechGrowth Inc. has a net income of $50,000 and shareholder’s equity of $350,000, then the ROE would be $50,000/$350,000 = 0.143, or 14.3%. This means that TechGrowth Inc. generated a return of 14.3% on the equity invested in the company.
By analyzing these ratios over time and comparing them to other companies in the same industry, an analyst can determine whether TechGrowth Inc. is efficiently managed, whether it has a strong capacity to pay its debts, and whether it is using leverage wisely. Furthermore, the analyst can also see if the company is profitable and generating a good return on the equity invested in it.