What is Financial Analysis?

Financial analysis is the evaluation of a business in order to determine its profitability, liabilities, strengths and future earnings potential.  A wide variety of techniques may be utilized to assess an organization’s financial viability including the most common methodologies of horizontal analysis, vertical analysis and ratio analysis.  Most analytical methods involve the company’s financial statements, internal or external audits, and investigations. 

Financial analysis is a critical aspect of all commercial activity as it provides actionable insights into the organization’s health and future potential.  Not only does this information provide investors and lenders with critical data that may affect the price of stocks or interest rates, these reports also allow company managers to gauge their performance with regard to expectations or industry growth.  From a management point of view, financial analyses are critical to the success of the company because they highlight weaknesses and strengths that directly affect competitiveness.

Types of Financial Analysis

There are a myriad of techniques that can be used to analyze the performance of a commercial enterprise, but the most common methods use the following strategies:

  • Horizontal Analysis—This method uses past performance as a baseline metric for the success of the company.  There are variations in this method that may use some number of years as a standard; for example, if the company has been in existence for some time, the two years prior may be used as a comparison. If the company is relatively new, it is common to use the initial year as a baseline and plot performance in relation to it.
  • Vertical Analysis—Also known as component percentages, this type of analysis compares the profits to assets, liabilities and equities.  This method is generally helpful when comparing a large number of similar companies.  The limitation of this method is that it often does not weight factors that impact future viability appropriately, like long-term partnerships, and one-time losses or investments.
  • Ratio Analysis –This method analyzes various aspects of the company’s financial health.  For example, a current ratio is the comparison of assets to liabilities. This type of analysis is extremely popular due to the analyst’s ability to choose two key features of businesses to analyze.  Many analysts utilize this type of analysis to support their evaluations of organizations even if conventional analytical methodologies may not be as positive.  The weakness in this type of analysis is that if the two characteristics are poorly chosen, an unreliable estimation of financial viability may be produced.
  • Stock Price Movement—This technique relies on analyzing the performance of the company’s stock rather than their financial health.  In essence, this method uses the financial markets as an analytical tool.  Various methods may be used to evaluate the stock’s performance including enlarging or narrowing the window of evaluation, comparison to similar companies and trend analysis.  There are some serious drawbacks to this technique. If the markets are relying on inaccurate data or analytical methodologies, it may be pricing stocks higher than their actual value.  Stock analyses often ignore the company’s intrinsic sustainability in order to profit from stock price fluctuations, and are unreliable foundations for establishing long-term investment relationships.

The Role of Financial Analysis

Although many investors are eager for financial analysis to advance to the point that projections of success and future earnings can be accurately provided, that is impossible to achieve.  In the real world there will always be unpredictable events that limit the accuracy of analyses and projections.  The financial community’s desire for perfect evaluation may be out of reach, nevertheless the goal for financial analysts should be to attain perfection. 

Financial analysts are rarely expected to predict the performance of organizations beyond a few years into the future. By extrapolating from present circumstances, the reports provided by financial analysts give investors and company managers enough information to prepare for the short window ahead in time.  Though these projections are subject to external or unforeseen events, in most cases this is enough information to produce a business strategy that optimizes impending opportunities and limits risks.

The role of the financial analyst is to provide reliable information that managers can utilize to anticipate impending events.  In larger companies, analysts may evaluate only a portion of the organization’s performance, and then relay this information to the appropriate managers.  They must be able communicators who have the ear of influential managers. If their analyses predict drastic perturbations in the immediate future, they must convince management to take precautionary measures.  On the other hand, if the company is expected to perform extremely well, then the window of expectations may be elongated in order to emphasize that performance in the long term may require careful re-investment of profits.

The analytical teams of some organizations may produce conflicting information, in which case, managers must attribute more weight to certain analyses.  This comprehensive evaluation may involve placing more faith in multiple reports with similar outcomes or in reports that produce the most problematic outcomes.  In situations where analyses conflict, the financial analyst may be asked to present their methodology and produce external support for their findings.  The analyst may be asked to take on the role of a critic and deconstruct their own techniques as well as those of other analysts.

Within the larger financial community, analysts are responsible for providing insights into the businesses they examine.  These analyses must be accurate enough to determine the risks associated with securities purchases and fees related to loans.  Although internal and external analysts are expected to produce accurate evaluations, the window of reliability for external analysts may be shortened.  Many investors may only wish to enter into a relationship with the business for a short period of time, which may require a narrow analysis of viability.

The scope of external analyses may also be quite different than for internal analysts.  While managers require more broad based analyses to develop budgets and strategies, analyses for investors and lenders may be only concerned with the broad outlines of success and profitability. Banks may only wish to know if the company will remain in existence long enough and reap enough profits to pay back a loan.  The scope of financial analyses often depend on the client’s impending relationship with business.