Financial analysis
Encyclopedia
Financial analysis refers to an assessment of the viability, stability and profitability of a business
, sub-business or project
.
It is performed by professionals who prepare reports using ratios that make use of information taken from financial statements
and other reports. These reports are usually presented to top management as one of their bases in making business decisions.
1. Profitability -its ability to earn income and sustain growth in both short-term and long-term. A company's degree of profitability is usually based on the income statement
, which reports on the company's results of operations;
2. Solvency - its ability to pay its obligation to creditors and other third parties in the long-term;
3. Liquidity - its ability to maintain positive cash flow
, while satisfying immediate obligations;
Both 2 and 3 are based on the company's balance sheet
, which indicates the financial condition of a business as of a given point in time.
4. Stability- the firm's ability to remain in business in the long run, without having to sustain significant losses in the conduct of its business. Assessing a company's stability requires the use of both the income statement and the balance sheet, as well as other financial and non-financial indicators.
etc
, profitability
, growth, etc.):
These ratios are calculated by dividing a (group of) account balance(s), taken from the balance sheet
and / or the income statement
, by another, for example :
Comparing financial ratios is merely one way of conducting financial analysis. Financial ratios face several theoretical challenges:
Financial analysts can also use percentage analysis which involves reducing a series of figures as a percentage of some base amount. For example, a group of items can be expressed as a percentage of net income. When proportionate changes in the same figure over a given time period expressed as a percentage is known as horizontal analysis. Vertical or common-size analysis, reduces all items on a statement to a “common size” as a percentage of some base value which assists in comparability with other companies of different sizes. As a result, all Income Statement items are divided by Sales, and all Balance Sheet items are divided by Total Assets.
Another method is comparative analysis. This provides a better way to determine trends. Comparative analysis presents the same information for two or more time periods and is presented side-by-side to allow for easy analysis.
Business
A business is an organization engaged in the trade of goods, services, or both to consumers. Businesses are predominant in capitalist economies, where most of them are privately owned and administered to earn profit to increase the wealth of their owners. Businesses may also be not-for-profit...
, sub-business or project
Project
A project in business and science is typically defined as a collaborative enterprise, frequently involving research or design, that is carefully planned to achieve a particular aim. Projects can be further defined as temporary rather than permanent social systems that are constituted by teams...
.
It is performed by professionals who prepare reports using ratios that make use of information taken from financial statements
Financial statements
A financial statement is a formal record of the financial activities of a business, person, or other entity. In British English—including United Kingdom company law—a financial statement is often referred to as an account, although the term financial statement is also used, particularly by...
and other reports. These reports are usually presented to top management as one of their bases in making business decisions.
- Continue or discontinue its main operation or part of its business;
- Make or purchase certain materials in the manufacture of its product;
- Acquire or rent/lease certain machineries and equipment in the production of its goods;
- Issue stocksStocksStocks are devices used in the medieval and colonial American times as a form of physical punishment involving public humiliation. The stocks partially immobilized its victims and they were often exposed in a public place such as the site of a market to the scorn of those who passed by...
or negotiate for a bank loanLoanA loan is a type of debt. Like all debt instruments, a loan entails the redistribution of financial assets over time, between the lender and the borrower....
to increase its working capitalWorking capitalWorking capital is a financial metric which represents operating liquidity available to a business, organization or other entity, including governmental entity. Along with fixed assets such as plant and equipment, working capital is considered a part of operating capital. Net working capital is...
; - Make decisions regarding investing or lending capital;
- Other decisions that allow management to make an informed selection on various alternatives in the conduct of its business.
Goals
Financial analysts often assess the firm's:1. Profitability -its ability to earn income and sustain growth in both short-term and long-term. A company's degree of profitability is usually based on the income statement
Income statement
Income statement is a company's financial statement that indicates how the revenue Income statement (also referred to as profit and loss statement (P&L), statement of financial performance, earnings statement, operating statement or statement of operations) is a company's financial statement that...
, which reports on the company's results of operations;
2. Solvency - its ability to pay its obligation to creditors and other third parties in the long-term;
3. Liquidity - its ability to maintain positive cash flow
Cash flow
Cash flow is the movement of money into or out of a business, project, or financial product. It is usually measured during a specified, finite period of time. Measurement of cash flow can be used for calculating other parameters that give information on a company's value and situation.Cash flow...
, while satisfying immediate obligations;
Both 2 and 3 are based on the company's balance sheet
Balance sheet
In financial accounting, a balance sheet or statement of financial position is a summary of the financial balances of a sole proprietorship, a business partnership or a company. Assets, liabilities and ownership equity are listed as of a specific date, such as the end of its financial year. A...
, which indicates the financial condition of a business as of a given point in time.
4. Stability- the firm's ability to remain in business in the long run, without having to sustain significant losses in the conduct of its business. Assessing a company's stability requires the use of both the income statement and the balance sheet, as well as other financial and non-financial indicators.
etc
Methods
Financial analysts often compare financial ratios (of solvencySolvency
Solvency, in finance or business, is the degree to which the current assets of an individual or entity exceed the current liabilities of that individual or entity. Solvency can also be described as the ability of a corporation to meet its long-term fixed expenses and to accomplish long-term...
, profitability
Profit (accounting)
In accounting, profit can be considered to be the difference between the purchase price and the costs of bringing to market whatever it is that is accounted as an enterprise in terms of the component costs of delivered goods and/or services and any operating or other expenses.-Definition:There are...
, growth, etc.):
- Past Performance - Across historical time periods for the same firm (the last 5 years for example),
- Future Performance - Using historical figures and certain mathematical and statistical techniques, including present and future values, This extrapolation method is the main source of errors in financial analysis as past statistics can be poor predictors of future prospects.
- Comparative Performance - Comparison between similar firms.
These ratios are calculated by dividing a (group of) account balance(s), taken from the balance sheet
Balance sheet
In financial accounting, a balance sheet or statement of financial position is a summary of the financial balances of a sole proprietorship, a business partnership or a company. Assets, liabilities and ownership equity are listed as of a specific date, such as the end of its financial year. A...
and / or the income statement
Income statement
Income statement is a company's financial statement that indicates how the revenue Income statement (also referred to as profit and loss statement (P&L), statement of financial performance, earnings statement, operating statement or statement of operations) is a company's financial statement that...
, by another, for example :
- Net incomeNet incomeNet income is the residual income of a firm after adding total revenue and gains and subtracting all expenses and losses for the reporting period. Net income can be distributed among holders of common stock as a dividend or held by the firm as an addition to retained earnings...
/ equity = return on equityReturn on equityReturn on equity measures the rate of return on the ownership interest of the common stock owners. It measures a firm's efficiency at generating profits from every unit of shareholders' equity . ROE shows how well a company uses investment funds to generate earnings growth...
(ROE)
- Net incomeNet incomeNet income is the residual income of a firm after adding total revenue and gains and subtracting all expenses and losses for the reporting period. Net income can be distributed among holders of common stock as a dividend or held by the firm as an addition to retained earnings...
/ total assets = return on assets (ROA)
- Stock price / earnings per share = P/E ratioP/E ratioThe P/E ratio of a stock is a measure of the price paid for a share relative to the annual net income or profit earned by the firm per share...
Comparing financial ratios is merely one way of conducting financial analysis. Financial ratios face several theoretical challenges:
- They say little about the firm's prospects in an absolute sense. Their insights about relative performance require a reference point from other time periods or similar firms.
- One ratio holds little meaning. As indicators, ratios can be logically interpreted in at least two ways. One can partially overcome this problem by combining several related ratios to paint a more comprehensive picture of the firm's performance.
- Seasonal factors may prevent year-end values from being representative. A ratio's values may be distorted as account balances change from the beginning to the end of an accounting period. Use average values for such accounts whenever possible.
- Financial ratios are no more objective than the accounting methods employed. Changes in accounting policies or choices can yield drastically different ratio values.
- (fundamental analysisFundamental analysisFundamental analysis of a business involves analyzing its financial statements and health, its management and competitive advantages, and its competitors and markets. When applied to futures and forex, it focuses on the overall state of the economy, interest rates, production, earnings, and...
).
Financial analysts can also use percentage analysis which involves reducing a series of figures as a percentage of some base amount. For example, a group of items can be expressed as a percentage of net income. When proportionate changes in the same figure over a given time period expressed as a percentage is known as horizontal analysis. Vertical or common-size analysis, reduces all items on a statement to a “common size” as a percentage of some base value which assists in comparability with other companies of different sizes. As a result, all Income Statement items are divided by Sales, and all Balance Sheet items are divided by Total Assets.
Another method is comparative analysis. This provides a better way to determine trends. Comparative analysis presents the same information for two or more time periods and is presented side-by-side to allow for easy analysis.
External links
- http://www.sfaf.com SFAF - the French Society of Financial Analysts
- http://www.aciia.org ACIIA - Association of Certified International Investment Analysts
- http://www.effas.com EFFAS - European Federation of Financial Analysts Societies
- http://www.outsourcingbookkeepingservice.com/financial-services.php OBKS (Outsourcing Bookkeeping Service)- Financial analysis allow users to focus on their main business activity.