Financial Analysis Techniques

Introduction

Financial analysis is the process of evaluating businesses, budgets, projects, and other finance-related entities to determine their performance and suitability. It can be used to review past performance and present situation, and to forecast future cash flows and profitability. The main purpose of this analysis is to calculate indicators for assessing the financial strength, financial health and solvency of businesses.

The following common financial analysis techniques can be used for decision-making:

• Ratio Analysis
• Vertical Analysis
• Horizontal Analysis
• Cash Flows Analysis
• DuPont Analysis
• Bankruptcy Analysis

Ratio Analysis

Ratio analysis is a technique of financial analysis that is used to evaluate the performance, liquidity and solvency of a company by comparing line items from the financial statements. This technique is used to measure a variety of financial measures such as profitability, solvency, efficiency and liquidity of an entity.

Types of Ratios

There are four broad categories of ratios used in financial analysis: Profitability ratios, liquidity ratios, solvency ratios and efficiency ratios. Each category contains several specific ratios that provide valuable insights into the financial condition and performance of a company. Some of the more popular ratios include gross margin, net profit margin, current ratio, debt to equity ratio and inventory turnover.

Benefits

Ratio analysis provides a powerful tool to assess and compare the financial performance of companies. By comparing ratios across multiple companies, investors can understand the competitive landscape and identify opportunities for investment. Ratios also provide a basis for benchmarking a company’s performance against industry averages. Lastly, ratio analysis can assist in the interpretation of financial statements by helping to identify trends that may be overlooked when key balance sheet and income statement items are studied in isolation.

• Profitability Ratios
• Gross margin
• Net profit margin


• Liquidity Ratios
• Current ratio
• Quick ratio


• Solvency Ratios
• Debt to Equity ratio
• Interest coverage ratio


• Efficiency Ratios
• Inventory turnover
• Asset turnover

Discounted Cash Flow Analysis

Discounted cash flow (DCF) analysis is a popular method of financial analysis used to assess the intrinsic value of a business or asset based on the present value of its expected future cash flows. This method of measurement is common for business valuations, investment decisions, and capital budgeting.

Definition

The basis of DCF analysis is the concept of discounting future cash flows to the present date. This involves estimating the timing of all cash flows and assigning a discount rate that compensates the investors or owners for the time value of money and the risk associated with the cash flows. The fundamental principle is that $1 today is worth more than $1 tomorrow, mainly due to the promise of a return on investment.

DCF Formulas

The basic formula used to calculate the present value of future cash flows is:

• Present Value = Future Value / (1 + r)ⁿ

Where r is the required rate of return, and n is the number of time periods.

Benefits

DCF analysis provides an accurate approach to business valuation and other investment decisions. The benefits of using this method include the ability to:

• Analyze the value of an entire business, individual assets, or liabilities.
• Evaluate the impact of investment decisions on the future value of a business.
• Assess long-term projects or investments.

DCF analysis requires accurate predictions of future cash flows and a thorough understanding of the risk associated with these cash flows. These variables are only estimated and can be affected by changes in the market, technology, and the overall health of the economy.

Comparative Analysis

Comparative analysis is a technique used to compare one thing with another to identify its strengths and weaknesses. It is similar to benchmarking, but focuses primarily on analysis in order to identify areas of improvement. Comparative analysis can be used to compare businesses, products, markets, or financial data.

Examples

Comparative analysis can be used to compare different companies or sectors. For example, a company can compare itself to its competitors to identify areas of strength and weakness. This can help the company improve its own services and products. Comparative analysis can also be used to compare different products or services within the same industry. It can be used to compare markets, such as different countries, to identify potential investing opportunities.

Benefits

The main benefits of comparative analysis are that it can be used to identify areas of improvement within a company, product, or service. By comparing a company or sector to its peers, it is possible to identify areas that are lagging or need improvement. Comparative analysis can also be used to identify potential investing opportunities or markets for expansion. Finally, it can be used to compare products or services within the same industry, allowing for insight into which products or services are more successful.

• Identify areas of improvement
• Identify potential investment opportunities
• Compare products and services within the same industry

Funds Flow Analysis

Funds flow analysis is a method of studying the various sources and uses of cash within a business. It differs from cash flow analysis in that it excludes non-cash transactions such as depreciation, amortization and other non-cash expenses.

Funds Flow Statement

A funds flow statement is an organized report of a company's inflows and outflows of funds during a specific period of time and is used to analyze the company's liquidity and financial stability. The statement consists of three categories; operating, investing and financing activities.

Under the operating category, transactions resulting from the primary activities of the enterprise are listed. Such activities include; sales revenue, fees and commissions, merchandise expenses, salaries and wages, lease payments, and other operating expenses.

The investing category will provide information on any long-term investments the company has made in its business, such as purchasing new equipment or expanding existing operations. Any disposition of long-term assets or investments are also recorded in this category.

The financing category provides an overall look at how the company has funded its investments in the business. This may include obtaining debt or equity financing, dividend payments, or any other activities related to obtaining funding.

Benefits

Funds flow analysis is a powerful tool to assess the company's overall financial health. By providing information on how funds are being used, it can provide insight into what areas of the business require additional resources, or where funds can be used more efficiently.

It can also be used to monitor the company's liquidity, foreign currency exposure, and investment return on assets. Additionally, it can provide a comparative measure of the performance of a company against other companies in the same industry.

By helping to identify areas where the company may be prone to cash shortages or potential cash flow problems, funds flow analysis can help management make timely and effective decisions that will benefit the company's financial performance in the long-term.

Financial Statement Analysis

Financial statement analysis is the process of analyzing a company's financial statements for making better economic decisions. It helps to understand a company's past performance, predict its future performance, and assess its ability to pay off outstanding debt. Financial statements are the balance sheet, income statement, cash flow statement, and statement of changes in shareholders' equity.

Definition

Financial statement analysis is the process of analyzing and evaluating a company's financial performance, primarily on the basis of the historical financial statements. It includes examining a company's profitability, liquidity, solvency, stability, and financial performance. The analysis helps to understand the performance of the company by identifying the company's financial strengths and weaknesses. It provides an insight into the company's operation and assists in decision making.

Financial Statement Components

Financial statements consist of four main components:

• Balance Sheet – it is a snapshot of the company’s financial position at a particular point in time, listing all its assets and liabilities.
• Income statement – it reports the company’s profit or loss for a period of time, noting revenues, expenses, and any gains or losses.
• Cash flow statement – it measures the company’s cash inflows and outflows for a period of time. It helps to identify sources and uses of cash.
• Statement of changes in shareholders’ equity – it highlights changes in the company’s capital structure, such as any new share issuances, stock splits, or dividends.

Benefits

Financial statement analysis provides numerous benefits to analysts, investors, and other stakeholders. It helps to identify areas of improvement, determine the competitive advantage of the company, and make informed decisions. Financial statement analysis can also help to assess the financial risks a company is exposed to. In addition, it helps to compare the financial performance of the company with its industry peers.

Conclusion

Financial analysis techniques are essential tools for any investor or financial advisor. They can be used to identify undervalued companies, spot macroeconomic trends and anticipate market movements. With the right financial analysis skills, an advisor or investor can make smarter decisions and be better prepared for the future.

Summary

In this article, we explored the different financial analysis techniques used by investors and financial advisors. We looked at ratio analysis, trend analysis and cyclical analysis, as well as the potential for assigning a monetary value to intangible assets. We also examined the arguments for and against the use of quantitative and qualitative financial analysis.

Final Thoughts

Ultimately, successful financial analysis requires a deep understanding of a company’s balance sheet and financial statements, as well as its external economic environment. Additionally, investors and financial advisors must be aware of their own biases and assumptions when analyzing data. By using the right financial analysis techniques, investors and advisors can make more informed decisions and stay ahead of the competition.