What is financial analysis?
Financial analysis is the process of examining a company’s financial statements and related data to assess its past performance, current financial health, and future prospects. It turns raw numbers into actionable intelligence for decision‑makers — investors deciding whether to buy a stock, lenders judging credit risk, managers setting strategy, and auditors or regulators verifying financial soundness. (Source: Investopedia: https://www.investopedia.com/terms/f/financial-analysis.asp)
Key takeaways
– Financial analysis uses relationships (ratios, trends, cash flows) to evaluate profitability, liquidity, leverage, efficiency, and cash generation.
– Analysis is most useful when normalized (adjusted for one‑offs and accounting differences), compared to peers, and placed in time series (trend analysis).
– Practical financial analysis is a workflow: collect statements, clean/adjust data, compute ratios and trends, benchmark, forecast/scenario test, then present clear conclusions and recommended actions.
Who uses financial analysis (and why)
– Investors and equity analysts: decide buy/hold/sell, value the company, and assess growth vs risk.
– Creditors and lenders: evaluate ability to repay (liquidity, coverage ratios, leverage).
– Company management: monitor operations, set budgets, optimize working capital, evaluate M&A or capital projects.
– Auditors, boards, regulators, private equity and unions: validation, oversight, negotiation, and valuation.
Core types of analysis, what they show, and how to do them (with practical steps)
1) Vertical analysis (common‑size)
– What it is: Express each line on a financial statement as a percentage of a base figure (income statement base = revenue; balance sheet base = total assets or total liabilities+equity).
– Why use it: Reveals structure and margin trends independent of company size; good for peer comparisons.
– Practical steps:
1. On the income statement, divide each expense line by total revenue (e.g., operating expense / revenue).
2. On the balance sheet, express major accounts as % of total assets (e.g., inventory / total assets).
3. Compare with historical common‑size percentages and industry norms.
– Example: Revenue = $10M; operating expense = $2M → operating expense = 20% of revenue.
2) Horizontal analysis (trend analysis)
– What it is: Compare financial statement items across multiple periods to show absolute and percentage changes.
– Why use it: Detects growth patterns, sudden swings, and cyclical effects.
– Practical steps:
1. Put several years (or quarters) of financials in a table.
2. Compute year‑over‑year dollar change and percent change for each line item.
3. Flag outsized moves (positive or negative) and investigate causes (one‑offs, accounting changes, acquisitions).
– Example: Revenue grows from $10M → $12M (20%) → $15M (25%) — identify accelerations or slowdowns.
3) Leverage analysis (capital structure & solvency)
– What it is: Measures how much debt the firm uses and whether it can service it.
– Key ratios: Debt‑to‑equity = Total debt / Total equity; Debt/EBITDA = Total debt / EBITDA; Interest coverage = EBIT / Interest expense.
– Practical steps:
1. Compute debt and equity totals (use book values for balance sheet but consider market values for some comparisons).
2. Calculate Debt/EBITDA to assess repayment capacity.
3. Assess covenant risks (look at loan agreements if available) and maturities (when debts come due).
– Red flags: rising debt/EBITDA, falling interest coverage (<2 often concerning, but depends on industry).
4) Liquidity analysis (short‑term solvency)
– What it is: Ability to meet short‑term obligations.
– Key ratios: Current ratio = Current assets / Current liabilities; Quick ratio = (Cash + marketable securities + AR) / Current liabilities; Operating cash flow coverage = Operating cash flow / Current liabilities.
– Practical steps:
1. Reconcile current assets and liabilities.
2. Compute quick ratio for a conservative view.
3. Check AR aging and inventory turns if current assets are inflated.
– Practical rule: Quick ratio industry median; positive and stable operating margin.
2. Balance sheet: manageable leverage (Debt/EBITDA below industry threshold); adequate liquidity (quick ratio).
3. Cash conversion: consistent positive free cash flow.
4. Valuation: relative multiples (P/E, EV/EBITDA) vs peers; run a basic DCF for intrinsic value range.
– Deeper diligence:
1. Check revenue quality (recurring vs one‑time), customer concentration, and contract terms.
2. Read MD&A for strategic initiatives and risks.
3. Stress test a DCF with slower growth or margin compression.
4. Decide entry price, exit criteria, and position size based on risk tolerance.
Common adjustments and cautions
– One‑time items: separate recurring from nonrecurring income and expenses (restructuring, impairment, gain/loss on sale).
– Accounting differences: leases (ASC 842/IFRS 16), revenue recognition (ASC 606), and tax treatments can distort comparisons.
– Seasonality & cyclicality: use trailing‑12‑month (TTM) figures or seasonally adjusted comparisons.
– Quality of earnings: high accruals, low cash conversion, or heavy related‑party transactions are red flags.
– Industry context: acceptable leverage or margin levels differ widely across sectors (banks vs software vs utilities).
Useful formulas & quick reference (common ratios)
– Gross margin = (Revenue − COGS) / Revenue
– Operating margin = Operating income / Revenue
– Net margin = Net income / Revenue
– Current ratio = Current assets / Current liabilities
– Quick ratio = (Cash + Marketable securities + AR) / Current liabilities
– Debt/equity = Total debt / Total equity
– Debt/EBITDA = Total debt / EBITDA
– Interest coverage = EBIT / Interest expense
– ROIC = NOPAT / (Debt + Equity − Cash)
– Asset turnover = Revenue / Average total assets
– Inventory turnover = COGS / Average inventory
– Free cash flow = Operating cash flow − CapEx
Tools, data sources, and frequency
– Primary sources: company 10‑K (annual) and 10‑Q (quarterly) filings via SEC EDGAR, audited financial statements, and investor presentations.
– Tools: Excel or Google Sheets for models; financial terminals (Bloomberg, Capital IQ) or free sites (Yahoo Finance, Morningstar) for quick ratios and peer lists.
– Frequency: monthly for internal cash reviews; quarterly for formal financial statement analysis; annual for deep strategic reviews and valuation updates.
How to present findings (management or investor audience)
– Start with a one‑paragraph executive summary (top 3 conclusions and recommended actions).
– Present three to five key charts/tables: trend of revenue/margins, liquidity trend, leverage trend, and cash flow chart.
– Include a short sensitivity table showing how valuation or solvency changes under stress scenarios.
– Provide appendices with calculations, assumptions, and source documents.
The bottom line
Financial analysis converts financial statement data into insights and decisions. The process is methodical: gather and normalize data, compute ratios and trends, benchmark against peers, test forecasts under scenarios, and present actionable recommendations. Done well, it helps managers fix problems early, helps lenders avoid losses, and helps investors separate firms that merely look good on paper from those with durable economic value.
Source
Primary reference: Investopedia — “Financial Analysis” (https://www.investopedia.com/terms/f/financial-analysis.asp)
If you’d like, I can:
– Build an Excel template with the core ratios and a dashboard.
– Walk through a worked example with a specific company (using its recent 10‑K).
– Create a one‑page checklist tailored for management or for an equity investor. Which would you prefer?