Financial analysis definition
/What is Financial Analysis?
Financial analysis is the examination of financial information to reach business decisions. This analysis typically involves an examination of both historical and projected profitability, cash flows, and risk. It may result in the reallocation of resources to or from a business or a specific internal operation. This type of analysis applies particularly well to the situations noted below:
Investment decisions by external investors. In this situation, a financial analyst or investor reviews the financial statements and accompanying disclosures of a company to see if it is worthwhile to invest in or lend money to the entity. This typically involves ratio analysis to see if the organization is sufficiently liquid and generates a sufficient amount of cash flow. It may also involve combining the information in the financial statements for multiple periods to derive trend lines that can be used to extrapolate financial results into the future.
Investment decisions by internal investors. In this situation, an internal analyst reviews the projected cash flows and other information related to a prospective investment (usually for a fixed asset). The intent is to see if the expected cash outflows from the project will generate a sufficient return on investment. This examination can also focus on whether to rent, lease, or purchase an asset.
The Advantages of Financial Analysis
There are multiple advantages to the use of financial analysis. One is that ongoing analyses within a business will result in a more efficient allocation of capital. Some projects or products will prove to be less profitable, and so can be eliminated in favor of more profitable alternatives. The result should be a more fine-tuned organization that generates greater profits. A second advantage is that investors can gain a better understanding of which companies are more likely to generate a better return on investment. This results in a higher stock price for the selected companies. Third, financial analysis can be used to spot trends in revenues and expenses within a business that can be exploited with forward-looking investments. These investments may be able to generate greater returns than is currently possible with a firm’s existing investments.
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Sources of Analysis Information
The primary sources of information used for a financial analysis are as follows:
Company financial statements. These include the income statement, balance sheet, cash flow statement, and statement of shareholders' equity. These documents provide raw financial data directly from the company.
Annual reports (10-K) and quarterly reports (10-Q). Publicly traded companies file these reports with the Securities and Exchange Commission (SEC) in the U.S., which provide detailed financial and operational information.
SEC filings. Filings such as Form 8-K (for significant events), Form S-1 (for IPOs), and Proxy Statements offer in-depth insights.
Earnings calls and investor presentations. These are sessions where companies discuss their quarterly and annual results, often revealing management's outlook and strategic plans.
Corporate press releases. Major events like mergers, acquisitions, new product launches, or significant strategic shifts are announced here.
In addition, you might consider deriving additional information from these secondary sources:
Analyst reports. These are in-depth reports from equity research analysts at investment banks or independent research firms that include financial forecasts, valuation analyses, and industry insights.
Financial news outlets. Publications like Bloomberg, Reuters, The Wall Street Journal, and Financial Times provide up-to-date information on market trends, economic indicators, and company news.
Market data platforms. Platforms like Bloomberg Terminal, Refinitiv Eikon, and FactSet aggregate and analyze data, offering financial statements, metrics, news, and analysis.
Credit rating agencies. Agencies such as Moody’s, Standard & Poor’s (S&P), and Fitch provide credit ratings, research, and risk assessments for companies and countries.
Economic data and indicators. Government and international bodies, like the Federal Reserve, Bureau of Economic Analysis (BEA), and World Bank, offer economic reports that provide context for the financial environment.
Industry reports. Industry-specific reports from firms like IBISWorld, Statista, or Technavio provide insights into industry trends, benchmarks, and projections.
Financial Analysis Outcomes
The outcome of financial analysis may be any of these decisions:
Whether to invest in a business, and at what price per share.
Whether to lend money to a business, and if so, what terms to offer.
Whether to invest internally in an asset or working capital, and how to finance it.
Financial analysis is one of the key tools needed by the managers of a business to examine how their organization is performing. For this reason, they are constantly querying the financial analyst about the profitability, cash flows, and other financial aspects of their business.