Financial analysis is used by investors to better understand a company's current operating position, it's likelihood for growth, and whether a company is over or undervalued based on its operating metrics.
Unfortunately for some investors, financial analysis can feel like a daunting task, that may lead to side effects such as: feelings of nausea, boredom, or low energy (hopefully this doesn't apply to any of you)!
But for those who can stomach, and for maybe a few crazy investors out there, maybe even enjoy, incorporating a disciplined analysis of financial data in their stock research, the result can be better investment decisions and more money in your pocket.
In this article we’ll cover a few main 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 enhance your investment strategy.
In the end, hopefully this post will help you avoid all of the potentially negative side effects of analyzing financial statements and financial statement ratios, and lead to better investment analysis going forward.
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 is focused 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 an investment of your hard earned cash.
To organizations, the goal is to identify strengths and weaknesses, which leads to better business decisions and accelerated growth.
Analyzing financial data can also be used at a more macro level to evaluate economic trends, establish financial benchmarks, and compare key financial ratios to industry or sector best practices.
Why is Financial Analysis Important?
At this point you may be asking yourself, “why would I need to perform financial analysis when I have my own stock research strategy that works just fine and I don’t have to calculate ratios or spend time looking at financial statements?”
For those of you who experience success in the market without prioritizing a deep dive into the financial statements of a company before investing, it may seem like an unnecessary step, but there is a reason some of the most successful investors in the world incorporate an analysis of a company's financial statements before investing:
Financial analysis is the key to identifying relationships between various elements of a company’s financial statements.
For example, knowing that a company's inventory is increasing significantly year-over-year, can lead to a better understanding of why their accounts payable balance is growing as well. Or, identifying a company that is experiencing steady sales growth, but margins are decreasing, could tell you that the company isn't able to scale their operations due to difficulty in controlling their costs, or sourcing raw materials.
Along these same lines, knowing that a company is building inventory, but sales are decreasing, could be a leading indicator that the Company may be taking an inventory write-down in the not-so-distant future.
Information that is obviously good to know before investing in a company!
We take a deep dive into analyzing financial statement ratios, which goes into this concept in much greater detail, but overall, financial ratio analysis can lead to insights into a company's operating results, and be useful in measuring how a company's metrics measure up to other companies within their peer group.
Types of Financial Analysis
When someone says financial analysis they are usually referring to either:
(1) Fundamental analysis, or
(2) Technical analysis.
While fundamental analysis and technical analysis are generally considered opposite methods for analyzing stocks, both methods incorporate financial data, and are completed to analyze real-time, or historical financial data in order to assign a value to a company, or predict future stock price performance.
Fundamental Analysis: The Value Investors Road Map
Fundamental analysis focuses on the reported financial statements of a company, and generally utilizes key financial performance metrics, including revenues, earnings, return on equity, profit margins, etc… to determine a company’s underlying value and potential for future growth.
The end goal of fundamental analysis is to determine a stock’s actual fair value, which a value investor can use in comparison to a security’s current price to determine whether the stock is undervalued or overvalued.
You may recognized the name of one famous fundamental analyst, Warren Buffett, the Oracle of Omaha, who is recognized as one of the most successful investors to utilize fundamental analysis to pick stock market winners.
But Warren Buffett isn't the only investor using fundamental analysis as a key component of their investing strategy. Value investors around the world understand the importance of digging into a company's fundamentals and using this information to direct their investment decisions.
Since we think using fundamental analysis is one of the more important steps you should take before making an investment into a company, we covered almost everything you should know on fundamental analysis in greater detail in a separate article.
Unlike fundamental analysis, which evaluates a stock’s intrinsic value, technical analysis focuses on charts of price movement and various analytical tools to evaluate a stock’s strengths and weaknesses.
The general belief among technical analysts is that past trading activity and price changes of a security are better indicators of the stock’s future price movements than the intrinsic value of the stock. One key assumption, which forms the basis for technical analysis, is that market price movements are not purely random, but move in identifiable patterns and trends that repeat over time.
Financial Analysis Example
Alright, now that we know more about the “who, what and why” of financial analysis, it’s time to dive into how to go about researching and analyzing the financial statements of a company.
At DiscoverCI we employ the fundamental analysis method in our stock research. Our view of the market is that there may be patterns in market price movements, but the best strategy for making money in the stock market is investing in undervalued companies with great fundamentals.
For this reason, our example of analyzing the financial data of a company will will focus on performing fundamental analysis.
Step 1: Determine a Company’s Key Performance Indicators
Think before you start analyzing.
Key Performance Indicators, or “KPI’s”, are different for each company. Before starting your analysis, your job is to identify what financial metrics and financial ratios are important to the Company you are analyzing.
KPI’s can be financial statement line items (i.e., revenue, cost of goods sold, and net income), or financial ratios, (i.e., profit margin, current ratio, inventory turnover, or earnings per share).
Step 2: Collect Company Financial Statements and Calculate Financial Ratios
Once you have identified what KPI’s are important to your analysis, you can begin gathering the Company’s reported financial results and analyze the Company’s key metrics.
Let’s say you were analyzing Apple, Inc. (ticker: AAPL) and you identified Revenue Growth, EBITDA, Price to Book Value (P/BV), Price to Earnings (P/E), Dividend Yield, and Return on Equity (ROE) as KPI’s.
First, gather the information necessary to calculate these ratios.
DiscoverCI has all of the data you need to complete your financial analysis, or if you prefer, you can also find Company Financial Statements using the SEC’s Company Search Tool and compile and calculate the information manually.
Second, evaluate trends in these metrics, and how they stack up to key competitors.
For example, if you were looking at revenue growth:
You can see from the chart above that Apple's revenue growth isn't as high today as it was back in 2008 through 2012 (when they were really ramping up sales), but overall, there has been steady growth!
It is also important to know how the company is performing relative to its peers. In this case, it may be beneficial to investigate how Apple's revenue growth compares to Amazon and Google:
Interesting... Apple's growth was huge in 2008 through 2012, and has slowed compared to its peers since 2013.
Step 3: Analyze Operating Results and Financial Ratios
As you probably guessed, more analysis would be required to further evaluate the metrics from Step 2. This can take several forms, but the goal is to follow the data and use the information you have in front of you to become better informed about where a company could see growth, or declines going forward.
Remember, you're working towards determining a company's fair value, which requires the use of several data points.
A single financial ratio, or KPI has limited usefulness if other relevant factors aren’t incorporated into your analysis.
For example, one company’s 10% growth may initially seem high, but when you compare it to a competitor’s 15% growth over the same period, your view of 10% growth may start to seem average.
You may also gain information by looking at KPI’s over different periods. Knowing that Apple’s sales growth is 7.9% over the last five years, which shows decreasing sales growth when compared to the 10-Year period, may provide deeper insight into the Company’s future strength.
After determining and calculating key financial metrics and financial ratios, benchmarking these data points to other key factors can unlock trends within the financial data.
What industry does the Company operate in? What are the key metrics and financial results of company competitors? Is the company innovative and do customers show strong brand loyalty?
The most difficult aspect, and one that separates good investors from great investors, is being able to interpret financial results and ratios, and use those interpretations to correctly value a company.
Getting it Right
In depth and comprehensive Financial Analysis will result in a better understanding of a company’s positioning, and lead to smarter investment decisions.
Spotting key trends and insights within a company’s financial data is a crucial step in evaluating and valuing a company, and ultimately using this information to make money in the stock market.