What is financial analysis and why is it important?
Financial Analysis is the study of financial statements and ratios which can help you better understand a company’s financial condition and future prospects. The goal of financial analysis is to use this information to make better, more informed decisions as an investor or as an executive. There are numerous metrics that can be used for financial analysis, such as common stock price ratios like Price Per Share (P/S), Price / Book (P/B), Price / Cash Flow (P/CF), etc… But there are also more advanced metrics such as Return on Equity (ROE). These statistical indicators give insight into how well a company is managing its finances and provide a framework for making investment decisions.
Key Tools in Financial Analysis
Beyond numerous calculations in financial analysis, as an investor, you need to be able to recognize the value in the numbers and have an understanding of how to use them. The first thing you want to do as an investor is to look at the first and most important financial statement: the income statement. This is the first thing that investors look at because it shows how much money a company made and what its expenses were. The income statement also shows how much cash the company had on hand before any expenses were taken out. An income statement will look something like this:
The Income Statement (I/S) is a numerical summary of the information contained within the Balance Sheet (B/S). It breaks down all of a company’s revenues, costs, operating expenses, and operating cash flow into an easy-to-read format. The income statement can be used to answer the following questions:
By adding revenues and subtracting expenses, you can calculate earnings before interest and taxes (EBIT). This will be an important number to look at if you are buying shares of a company that has debt. If the EBIT is greater than the interest expense, then you will see that portion of the operating cash flow applied to paying down their debt rather than being used for other expenses.
Another way to calculate earnings before interest and taxes is by subtracting interest paid from EBIT. This number will give you a better picture of how much money was available for operational expenditures (the company’s day-to-day activities) rather than paying off their debts.
The income statement can be used to evaluate whether a company’s earnings are growing or shrinking over time. This goes by the name of “Trend Analysis” and is often referred to as the CAGR for Compound Annual Growth Rate. The formula to calculate a CAGR is:
Net Income – Cash Flow = Free Cash Flow (FCF)
Free Cash Flow – CapEx = Net Capital Expenditures (CapEx)
Net Capital Expenditures – Debt Repayment = Free Cash Flow Available for Dividends and Loan Repayments / Capital Spending
The book value of a company can be calculated from its balance sheet. The book value is the difference between the current assets and liabilities. This will give you a better idea of what your potential return on your investment will be if you were to liquidate all of the assets at their value.
The other thing that you need to look at are the balance sheet ratios. These are ratios that compare two different assets, such as debt to equity, revenue to expenses, etc… The ratio should be considered in context with each other because it only tells half the story. The important part of these ratios is to take them together with what you know about a company’s profitability and growth prospects to see how well they will perform over time. There are also some other ratios that could be used as an investment, such as Return on Equity (ROE) and Earnings per Share (EPS).
Benefits of Proper Financial Analysis
Being able to carry out adequate financial analysis will help you make better choices when investing. It will also help you better understand what impact your purchases have on the economy as well as your future quality of life when comparing competing products and services available in today’s marketplace.
Analyzing companies’ financial statements is a vital part financial analysis. It is important because:
- The company’s financial strength and potential for continued improvement and growth
- The company’s profitability and ability to continue earning profits over time
- The possible rate of price appreciation of the company’s stock over time, particularly its stock price performance relative to other stocks in the same industry or sector, or vs. more or less speculative stocks with less dependable earnings records, etc.
- Potential for future changes in income tax rates, legislation regarding business taxation, possible new laws regarding taxation of any activity by the company, etc.
- The company’s ability to raise its prices, increase the profitability of product lines, and grow its net income and earnings per share over time
- Market psychology regarding the prospects for growth in a related industry, sector or economy that may influence a company’s prospects for future growth and prosperity
- From the business owner/executive perspective, you will be able to use these metrics to track a company’s progress and make decisions on how the company should proceed. Financial ratios such as profit margin, debt to equity, and return on assets (ROA) can all be used in determining resource allocation and restructuring plans if needed.