How do you know whether a business or project is likely to make for a successful investment? Financial analysis is the key to determining the viability and potential profitability of any venture.
What are the components of financial analysis?
When it comes to financial analysis, the most important things to assess are a company’s four main financial statements: the balance sheet, the income statement, the cash flow statement, and the statement of shareholder’s equity. Taken together, these statements can tell you the source of a business’ money, how it was used, and where it was allocated. Each of these financial statements also consists of multiple smaller components, including a company’s assets, earnings per share, and cash inflows/outflows, that can provide further insight into a business's financial health.
What is an example of financial analysis?
As an example, let’s say Company A reported its first quarter 2022 earnings per share (EPS) at $4.21, while Company B reported EPS of $3.96 for the same quarter. When comparing these two figures, Company A seems like a financially healthier business; however, let’s also say Company A’s EPS was $5.04 in the prior quarter, while Company B’s was $2.83. Given that Company B’s EPS rose by almost 40%, whereas Company A’s fell by nearly 16.5%, we can infer that the intrinsic value of the former business is currently growing. EPS is just one of the pieces of information taken into account when financial analysts make their forecast of a company's possible future performance and stock price.Learn More: Examples of Fixed Assets
What are the benefits of financial analysis?
Financial analysis is a crucial practice for business owners and upper management, as it enables them to better monitor the state of their businesses and identify areas for improvement. It is also an incredibly useful tool in an investor’s arsenal for comparing the performances of different public companies over time. Analyzing how businesses differ based on their revenue or earnings per share (EPS) growth can take some of the guesswork out of making a stock purchase.Learn More: Analyzing a Company's Capital Structure
What are the top skills for a financial analyst?
Outside of essential knowledge like accounting and financial literacy, a basic yet crucial skill that all financial analysts should have is proficiency in the use and organization of spreadsheets, databases, and presentation software. Other useful skills include leadership and management skills, especially for analysts responsible for departments or teams, as well as more advanced technical skills for using accounting and bookkeeping software. As in any business, personal and communication skills are also a must in order to establish good interpersonal relationships with coworkers, clients, and other industry connections.
In finance, econometrics is the application of inferential statistics when using economic data to develop theories, test existing hypotheses, or forecast future trends. There are two major categories of econometrics: theoretical, or the testing of an existing theory, and applied, or the use of collected data to develop new hypotheses. Econometrics is limited in that it relies on the inference of raw data without connecting it to established economic theory or looking for any causal relationships.
Financial modeling is the act of assembling a spreadsheet of a company's expenses and earnings in order to more accurately calculate the result of future actions or events. Financial analysts can use modeling to predict how external and/or internal factors will affect a company’s stock performance. Company executives, meanwhile, may use financial modeling to estimate how much a new project may cost and/or earn.
Statistics is a mathematical discipline concerned with collecting, analyzing, and interpreting data. The main areas of statistics are “descriptive statistics,” referring to the collection of sample and population data, and “inferential statistics,” referring to the use of descriptive statistics to test hypotheses and infer meaning from data. Financial analysts and investors use statistics when drawing conclusions from price and volume data about companies, industries, and markets.
Data analytics is a systematic analysis of statistical information. This type of analysis can be used to uncover trends and metrics that wouldn’t be readily apparent due to the amount of raw data. Data analytics is particularly useful for companies looking for opportunities to increase the overall efficiency of their businesses or systems.
A sample is a small amount of something that serves as a representation of a larger group. In statistics, samples are used when collecting data from an entire population is impractical or impossible due to its size. In order to make accurate inferences and/or predictions, samples must resemble a broader population and avoid any biases that could skew results.
Percentage change refers to the percentage difference between a starting value and a new value, which can be applied to any quantity that changes over time. Percentage change is often used in finance to track the growth of both individual stocks and market indexes. Companies will also typically include percentage changes in their quarterly reports to highlight trends in their revenues/profits.
EBITA, or earnings before interest, taxes, and amortization, is a measure of the profitability of a company’s operating business. EBITA doesn’t account for taxes owed, the interest on company debt, and the effects of amortization, as these can potentially distort the perception of a company's performance. This measure’s main advantage over others is that it more clearly indicates the amount of cash flow a business has to either reinvest or pay dividends.
Gap analysis is the act of comparing a company’s current state or performance with a target state or performance. This process provides a clear indication of whether a business is using its resources, capital, and/or technology effectively, which makes it easier for upper management to identify areas that need to be improved. Gap analysis is useful for companies of all sizes and can be applied to a variety of different areas, including a business’ sales and/or overall financial performance.
Explore Financial Analysis
U.S. Securities and Exchange Commission. "Beginners' Guide to Financial Statement." URL: https://www.sec.gov/reportspubs/investor-publications/investorpubsbegfinstmtguidehtm.html