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. When looking at a specific company, a financial analyst conducts analysis by focusing on the income statement, balance sheet, and cash flow statement.
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.
One of the most common ways to analyze financial data is to calculate ratios from the data 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 similar companies and compared as part of a larger analysis.
Financial analysis can be conducted in both corporate finance and investment finance settings. In corporate finance, the analysis is conducted internally, using such ratios as net present value (NPV) and internal rate of return (IRR) to find projects worth executing. A key area of corporate financial analysis involves extrapolating a company's past performance, such as gross revenue or profit margin, into an estimate of the company's future performance. This allows the business to forecast budgets and make decisions based on past trends, such as inventory levels.
In investment finance, an outside financial analyst conducts a financial 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. A bottom-up approach, on the other hand, looks at a specific company and conducts similar ratio analysis to corporate financial analysis, looking at past performance and expected future performance as investment indicators.
There are two types of financial analysis: technical analysis and fundamental analysis. Technical analysis looks at quantitative charts, such as moving averages (MA), while fundamental analysis uses ratios, such as a company's earnings per share (EPS).
For example, technical analysis was conducted on the GBP/USD exchange rate after the results of the Brexit vote in June 2016. Looking at the exchange rate chart, it was determined that the rate dropped significantly after the vote on June 23, 2016, and then it recovered over a 48-hour period by 375 basis points (bps).
As an example of fundamental analysis, Discover Financial Services reported first-quarter 2016 results on July 19, 2016. The company had an EPS of $1.40, up from an EPS of $1.33 for the same quarter in 2015, which was a good sign.