Financial Analysis
What is Financial Analysis?
Financial analysis is the process of collecting, assessing and interpreting a company’s financial numbers reported in financial statements (income statement, balance sheet, and cash flow statement), as well as answering investment questions that cannot be answered solely by looking at the financials.
The goal of financial analysis depends on the user of the financial information. For example, investors might be more interested in a firm’s the long-term profitability, whereas creditors such as banks are primarily interested in whether the borrower can pay back the bank loans.
Types of Financial Analysis
Quantitative Analysis
Quantitative financial analysis involves assessing financial numbers reported by the company through its financial statements.
This means looking at various financial ratios, including profitability ratios, liquidity ratios, solvency ratios, capital allocation ratios, and valuation ratios.
These ratios, as well as other financial metrics, can be assessed in three major ways:
| Horizontal Analysis | Vertical Analysis | Competitor/Industry Analysis |
|---|---|---|
| Current numbers are compared to previously reported numbers. | Financial statement numbers are normalized, e.g. by net revenues or total assets, and presented as a percentage. | Financials are compared to industry averages and to specific competitors. |
Moreover, analyses such as DuPont analysis, which looks at the sources of a change in a firm’s return on equity (ROE), can be performed to get a more detailed picture of a company’s financials.
Qualitative Analysis
While quantitative financial analysis, which is focussed on getting a financial picture based on reported numbers, is important to understand a company’s performance, competitive position, valuation, and more, it is not enough to make an informed investment decision.
Peter Lynch summarizes it well:
“Investing in stocks is an art, not a science, and people who’ve been trained to rigidly quantify everything have a big disadvantage.” — Peter Lynch
Qualitative financial analysis is the “art” part of the investment equation. It involves answering questions that cannot necessarily be answered by reported numbers alone.
To get an idea of investment questions to ask, check out the investment questions page.