In the world of finance, financial analysis refers to a type of investigation conducted in an attempt to discover all the financial information about a particular company or a group of companies. Specifically, financial analysis aims at finding out the strengths and weaknesses of a company’s business model and management decision making. While market research is focused on finding target markets for products, financial analysis is mainly concerned with identifying the components that affect the success of a particular business.
What are the different types of financial analysis used in the share market?
There are broadly two schools of philosophy with regards to using the tools of financial analysis to invest in a company’s stock.
a) Fundamental analysis: In this case, information gleaned from the financial statement is used to determine what a business is really worth. This method involves calculating ratios such as price-to-equity, earnings-per-share etc to check how far removed a company’s stock is from its real value.
b) Technical analysis: Here it is believed that the fundamentals of a business are accounted for in the price of its stock. Consequently, the investor works through data on the trading momentum of the stock to get an indication of its movement.
What are the ingredients of financial analysis?
The financial analysis of a company is done using various data points from its financial statements — namely, the income statement and the balance sheet. The income statement, as the name suggests, speaks about how a company is faring with respect to its topline and bottomline indicators — gross sales, earnings, net income. Meanwhile, the balance sheet provides details of its assets and liabilities.
Techniques of financial analysis
Following is a list of some methods of financial statement analysis that an investor an use to decide whether or not to invest in a company:
Trend analysis
Trend analysis generally involves charting the path of stock prices to make a projection about where they are headed. Trends can be upward or downward and indicate a bull market or a bear market. This is one of the special tools of financial analysis as it can be used to predict the impact of a range of external factors on a stock.
The ratios of different items for various periods are find out and then compared under this analysis. The analysis of the ratios over a period of years gives an idea of whether the business concern is trending upward or downward. This analysis is otherwise called as Pyramid Method.
The comparison of three or more financial reporting periods can start to identify a trend. Management is especially interested in trends. For example, managers like to see sales trending upward and expenses headed down; these favorable movements lead to increased profits.
Vertical analysis
In the vertical analysis, all items of a financial statement are expressed as a percentage of a particular header. For example, a company’s net income, various expenses, input costs etc could be written as a percentage of the sales. This tool is generally used to gain an insight regarding the correlation between different factors of production and performance indicators.
Vertical analysis means looking at a company’s financial statements in a single financial reporting period. Typically, all the revenue and expense items on the income statement are reported as percentages of net sales.
Suppose a company’s sales are $1.2 million and administrative salaries are $96,000. The percentage would be $96,000 divided by $1,200,000 times 100, or 8 percent. This figure could be compared to the projected budget amount or last year’s percentage to gauge if this is good or bad.
Horizontal analysis
This is one of the most popular methods of financial statement analysis. You must have noticed that news anchors on television quite often say that XYZ company’s net income has increased by a certain percentage sequentially or annually. Horizontal analysis helps us understand how the various indicators in a financial statement such as income, sales, interest margin (for lenders) etc have grown or faltered over a period of time.
The comparison of financial data between two periods is horizontal analysis. Revenue and expense accounts are examined to determine the changes from one period to the other. These changes are usually expressed as a percentage.
For example, let’s assume that a company’s sales in one period were $768,000 and increased to $940,000 in the next period. The amount of the sales increase is $172,000. The percentage increase would be $172,000 divided by $768,000 times 100, or 22.4 percent.
Cash flow analysis
Cash flow analysis means tracking the expenses and income of a business during a specific period. It helps one gauge the working capital requirements of the company and consequently, its speed of expansion in the market and debt requirements.
Cash flow analysis is based on the movement of cash and bank balances. In other words, the movement of cash instead of movement of working capital would be considered in the cash flow analysis. There are two types of cash flows. They are actual cash flows and notional cash flows.
Ratio analysis
Ratio analysis is one of the few techniques of financial analysis that can help an investor evaluate a company with its peers — companies in the same industry and of the same size. A few examples are the earnings to price ratio, the net income to sales ratio and return on assets ratio. This is also a useful method to find the missing links of private companies.
Ratio analysis is an attempt of developing meaningful relationship between individual items (or group of items) in the balance sheet or profit and loss account. Ratio analysis is not only useful to internal parties of business concern but also useful to external parties. Ratio analysis highlights the liquidity, solvency, profitability and capital gearing.
Ratio Analysis is the most commonly used financial analysis tool used in the market by an analyst, experts, internal Financial Planning & Analysis department, and other stakeholders. Ratio Analysis has various kinds of ratios, which can help in commenting on
- Profitability Ratio Formula
- Rate of Return Analysis
- Solvency Ratios
- Liquidity
- Coverage of Interest or any cost
- Comparing any component with turnover
Moreover, an entity based on their requirement can prepare the ratios for their analysis and try to manage the operations.
However, below are the odd side of ratio analysis:
- Highly relying on past information
- Inflation impact is ignored
- Chances of manipulation/window dressing of financials, which can enhance the fairness of ratios
- Any seasonal changes, based on the nature of business will be ignored, as it cannot be directly adjusted in financials
Average Analysis
Whenever, the trend ratios are calculated for a business concern, such ratios are compared with industry average. These both trends can be presented on the graph paper also in the shape of curves. This presentation of facts in the shape of pictures makes the analysis and comparison more comprehensive and impressive.
Fund Flow Analysis
Fund flow analysis deals with detailed sources and application of funds of the business concern for a specific period. It indicates where funds come from and how they are used during the period under review. It highlights the changes in the financial structure of the company.
Cost Volume Profit Analysis
This analysis discloses the prevailing relationship among sales, cost and profit. The cost is divided into two. They are fixed cost and variable cost. There is a constant relationship between sales and variable cost. Cost analysis enables the management for better profit planning.
Income statement
All of a company’s revenues and expenses are reported on the income statement. The reporting period could be for a month, quarter, year or year-to-date. Accountants use Generally Accepted Accounting Principles to record these line items. For most business reporting, the recording of sales and expenses are on the accrual basis. This method of accounting calculates receipts and matches the related costs at the same time. For example, a sale is recorded at the time of the transaction, even if it is sold on credit and the cash is not collected until several months later.
Conclusion:
The primary tools of financial analysis include financial statements, ratios, and market data. Financial statements are reports that provide a snapshot view of a company as a whole or as segments of the company. Ratios help interpret the relationship between different numbers in the financial statements by comparing to a benchmark number. Market data is used to identify trends in a company’s industry and how it stacks up against the competition.