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. Based on these reports, management may:
- 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 equipments in the production of its goods;
- Issue stocks or negotiate for a bank loan to increase its working capital.
- other decisions that allow management to make an informed selection on various alternatives in the conduct of its business.
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, 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.
Financial analysts often compare financial ratios (of solvency, profitability, growth...):
- 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 and / or the income statement, by another, for example :
- Net profit / equity = return on equity
- Gross profit / balance sheet total = return on assets
- Stock price / earnings per share = P/E-ratio
Comparing financial ratios are 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.
- They fail to account for exogenous factors like investor behavior that are not based upon economic fundamentals of the firm or the general economy (fundamental analysis)