What Is Financial Analysis?
Let me explain financial analysis directly: it's about digging into a company's financial data to gauge its health, performance, and future potential. You pull this from financial statements and reports, and it's crucial for both insiders and outsiders making decisions.
If you're an investor, this helps you decide if buying shares makes sense. For company management, it's about figuring out how to operate more effectively and set realistic goals.
Key Takeaways
Financial analysis means scrutinizing a company's financial data to understand its health, performance, and potential, which directly improves decision-making. Ratios play a central role here, and you use historical data to project forward.
This process aids management in running the business better and helps investors determine if the company is a solid investment. You'll encounter types like vertical and horizontal analysis, along with leverage, liquidity, and profitability analysis.
How Financial Analysis Works
A company's success shows up in its financials, packed with numbers from accounts and statements. Financial analysis converts these figures into something you can act on.
I prefer ratios over raw numbers because they reveal relationships by dividing one figure by another. You then compare these to the company's past or to competitors. Plus, it's forward-looking, using data to make projections.
Who Uses Financial Analysis?
Beyond company leaders, stakeholders like investors, analysts, lenders, and auditors rely on financial analysis. Investors and analysts check ratios on liquidity, cash flow, leverage, and profitability to see if the company is healthy compared to its history or peers. They also assess if it's fairly valued, which matters for stocks, auditors, unions, regulators, and private equity.
Inside the company, accountants use it to spot weaknesses early, set budgets, manage inventory, evaluate ROI on strategies, and price assets or acquisitions fairly.
Types of Financial Analysis
Let's cover the main types. Vertical analysis expresses each line item as a percentage of a base, like revenue on the income statement or total assets on the balance sheet. For instance, if operating expenses are 20% of revenue, you compare this over time, across companies, or against industry norms to spot issues like low gross margins indicating pricing or efficiency problems.
Horizontal Analysis
Horizontal analysis tracks changes over time, showing dollar and percentage shifts across periods. Say revenue grows from $1 million in 2021 to $1.4 million in 2024 but dips in the last year—this reveals trends like costs outpacing revenue or inventory issues, highlighting areas needing investigation.
Leverage Analysis
Companies use debt for growth, but balance is key. Compare debt to revenue or use ratios like debt-to-equity or debt-to-EBITDA to see if borrowing is sustainable.
Liquidity Analysis
This checks if a company can cover short-term debts with liquid assets, using tools like the quick ratio that focuses on cash, securities, and receivables.
Profitability Analysis
Profit is the core measure; tools like return on invested capital and profit margins show how effectively the company generates earnings from sales.
Efficiency Analysis
Efficiency means maximizing output from inputs; ratios like inventory turnover and asset turnover evaluate resource use for revenue generation.
Cash Flow Analysis
Cash flow is vital and hard to fake; assess it with free cash flow, operating cash flow, or liability coverage ratios to ensure sustainability.
Examples of Financial Analysis
In an internal review, if cash flow drops, analyze accounts receivable turnover to tighten credit and collections. For investing, compare weight-loss drug companies using P/E, EV-to-revenue, and return on capital to pick the best stock.
The Bottom Line
Financials hold hidden insights; analysis with ratios uncovers problems, trends, and opportunities for efficiency. Investors use it to compare against peers and assess share value directly.
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