Financial analysis is used by investors to better understand a company’s current operating position, its growth potential, and whether a company is overvalued or undervalued based on its operating performance.
Unfortunately, for some investors, financial analysis can seem like a daunting task that can lead to side effects such as: feelings of nausea, boredom or lack of energy (I hope this does not apply to any of you)!
But for those who can persevere, and maybe a few crazy investors out there, maybe even enjoy, incorporating disciplined financial analysis into their stock research can result in better investment decisions and more money in your pocket. .
In this article, we’ll cover a few key points:
- What is financial analysis and why is it important
- A few tips to help you maximize your analysis and
- Examples of how financial statement analysis can improve your investment strategy.
Ultimately, we hope this post will help you avoid all the potentially negative side effects of financial statement analysis and financial statement ratios and lead to better investment analysis in the future.
Purpose of financial analysis
Let’s get right to it: Analyzing a company’s financial statements is the process of evaluating a company based on its historical and current operating performance. Financial analysis primarily focuses on analyzing a company’s income statement, balance sheet, and cash flow statement.
For investors, the goal is to determine whether a company is stable, solvent, liquid, efficient, or profitable enough to warrant investing your hard-earned money.
For organizations, the goal is to identify strengths and weaknesses, which leads to better business decisions and accelerated growth.
Financial data analysis can also be used at a more macro level to assess economic trends, establish financial benchmarks, and benchmark key financial ratios against industry or sector best practices.
Why is financial analysis important?
At this point, you may be asking yourself, “Why should I do financial analysis when I have my own stock research strategy that works great and I don’t need to calculate ratios or spend time looking at financial statements?”
For those of you who have found success in the market without prioritizing a deep dive into a company’s financial statements before investing, this may seem like an unnecessary step, but there’s a reason why some of the world’s most successful investors include analysis of a company’s financial statements before by investing:
Financial analysis is the key to identifying relationships between the various elements of a company’s financial statements.
For example, knowing that a company’s inventory is increasing significantly from year to year can provide a better understanding of why the accounts payable balance is also increasing. Or finding a company with steady sales growth but declining profitability may tell you that the company is unable to scale because of difficulties controlling costs or finding raw materials.
By the same token, knowing that a company is building inventory but sales are declining can be a prime indicator that the company may be writing down inventory in the not-too-distant future.
Information that is obviously good to know before investing in a company!
We delve deep into analysis of financial reporting ratioswhich examines this concept in much more detail, but in general, financial ratio analysis can provide insight into a company’s operating results and be useful in measuring how well a company’s performance compares to other companies in its peer group.
Types of financial analysis
When someone talks about financial analysis, they usually mean:
(1) Fundamental analysis, or
(2) Technical analysis.
While fundamental analysis and technical analysis are generally considered opposite methods of stock analysis, both methods involve financial data and are completed to analyze real-time or historical financial data to assign a company value or predict future stock price. .
Fundamental Analysis: A Roadmap for Value Investors
Fundamental analysis focuses on a company’s financial statements and typically uses key financial performance measures, including revenue, profit, return on equity, profit margin, etc., to determine a company’s underlying value and potential for future growth.
The ultimate goal of fundamental analysis is to determine the actual fair value of a stock, which an investor can use against the current price of the security to determine whether the stock is undervalued or overvalued.
You may have recognized the name of one famous fundamental analyst, Warren Buffett, the Oracle of Omaha, who is recognized as one of the most successful investors who use fundamental analysis to pick winners in the stock market.
But Warren Buffett isn’t the only investor who uses fundamental analysis as a key component of his investment strategy. Value investors around the world understand the importance of studying a company’s fundamentals and using that information to make investment decisions.
Because we believe that using fundamental analysis is one of the most important steps you should take before investing in a company, we have reviewed almost everything you need to know about fundamental analysis more details in a separate article.
Unlike fundamental analysis, which assesses the intrinsic value of a stock, technical analysis focuses on price action charts and various analytical tools to assess a stock’s strengths and weaknesses.
The general view among technical analysts is that past trading activity and changes in a security’s price are better indicators of future stock price movement than the intrinsic value of the stock. One of the key assumptions underlying technical analysis is that market price movements are not purely random, but follow identifiable patterns and trends that repeat themselves over time.
An example of financial analysis
Okay, now that we know more about the “who, what and why” of financial analysis, it’s time to dive into how to research and analyze a company’s financial statements.
At DiscoverCI, we use the fundamental analysis method in our stock research. Our view of the market is that there can be patterns in market price movements, but the best strategy for making money in the stock market is to invest in undervalued companies with excellent fundamentals.
For this reason, our example of analyzing a company’s financial data will focus on performing fundamental analysis.
Step 1: Defining the company’s key performance indicators
Think before you start analyzing.
Key Performance Indicators, or “KPIs,” are different for every company. Before starting the analysis, your task is to determine which financial indicators and financial ratios are important for the company you are analyzing.
KPIs can be financial statement items (such as revenue, cost of goods sold, and net income) or financial ratios (such as profit margin, current ratio, inventory turnover, or earnings per share).
Step 2: Collect the financial statements of the company and calculate the financial indicators
Once you have determined which KPIs are important to your analysis, you can begin to collect the company’s reported financial results and analyze the company’s key performance indicators.
Let’s say you analyzed Apple, Inc. (ticker: AAPL) and measured revenue growth, EBITDA, price to book value (P/BV), price to earnings (P/E), dividend yield and return on equity (ROE). ) as a KPI.
First, gather the information you need to calculate these ratios.
DiscoverCI has all the data you need to complete your financial analysis, or if you prefer, you can also find company financial statements using SEC Company Finder and collect and calculate information manually.
Second, assess trends in these metrics and how they stack up against key competitors.
For example, if you were looking at revenue growth:
You can see from the chart above that Apple’s revenue growth today isn’t as high as it was in 2008-2012 (when they were really growing sales), but overall there is steady growth!
It’s also important to know how the company is doing compared to its peers. In this case, it might be useful to examine how Apple’s revenue growth compares to that of Amazon and Google:
Interesting… Apple’s growth was huge from 2008 to 2012 and has slowed compared to peers since 2013.
Step 3: Analysis of operating results and financial indicators
As you may have guessed, further evaluation of the metrics from step 2 will require additional analysis. This can take several forms, but the goal is to keep an eye on the data and use the information you have in front of you to get a better idea of where the company may see growth or decline in the future.
Remember that you are working to determine the fair value of a company, which requires the use of multiple data points.
A single financial ratio, or KPI, is of limited value if other important factors are not included in your analysis.
For example, one company’s 10% growth may seem high at first, but when you compare it to a competitor’s 15% growth over the same period, your view of 10% growth may seem average.
You can also gain insights by viewing KPIs for different periods. Knowing that Apple’s sales growth has been 7.9% over the past five years, which represents a decline in sales growth over a 10-year period, can provide a deeper insight into the company’s future strength.
After defining and calculating key financial indicators and financial ratios, comparing these data points to other key drivers can reveal trends in the financial data.
What industry does the company operate in? What are the main indicators and financial results of competing companies? Is the company innovative and do customers have strong brand loyalty?
The most challenging aspect that separates good investors from great ones is the ability to interpret financial results and ratios and use those interpretations to properly value a company.
Getting it is a right
An in-depth and comprehensive financial analysis will lead to a better understanding of the company’s position and lead to smarter investment decisions.
Identifying key trends and insights in a company’s financial data is an important step in evaluating and valuing a company, and ultimately using that information to make money in the stock market.