Financial analysis evaluates a company's financial data to understand its performance, profitability, and financial health. It involves reviewing financial statements, calculating key metrics, and using tools to make informed decisions.
1. Basics of Financial Analysis
Key Objectives:
- Performance Evaluation: Assess profitability, efficiency, and liquidity.
- Trend Analysis: Identify patterns in revenue, expenses, and margins.
- Forecasting: Predict future financial outcomes.
- Investment Decisions: Evaluate potential returns and risks.
Core Financial Statements:
- Income Statement:
- Shows profitability (e.g., revenue, expenses, net income).
- Balance Sheet:
- Displays financial position (assets, liabilities, equity).
- Cash Flow Statement:
- Tracks cash inflows and outflows (operating, investing, financing).
Types of Financial Analysis:
- Vertical Analysis:
- Compares line items as a percentage of a base figure (e.g., revenue).
- Horizontal Analysis:
- Tracks changes over time (e.g., YoY growth).
- Ratio Analysis:
- Evaluates financial performance using ratios.
2. Examples of Financial Analysis
Example A: Profitability Analysis
- Scenario: A company wants to evaluate profitability trends.
- Steps:
- Extract revenue, gross profit, operating income, and net income data.
- Calculate Gross Profit Margin:
[
{Gross Profit Margin} = \frac{{Gross Profit}} / {{Revenue}} * 100
]
- Analyze trends in margins over multiple periods.
- Outcome: Identify if margins are improving or declining.
Example B: Liquidity Analysis
- Scenario: Assess if a company can meet short-term obligations.
- Steps:
- Collect current assets and liabilities.
- Calculate the Current Ratio:
[
{Current Ratio} = \frac{{Current Assets}} / {{Current Liabilities}}
]
- Benchmark against industry standards.
- Outcome: Determine if the company has sufficient liquidity.
Example C: Cash Flow Analysis
- Scenario: Analyze the company's ability to generate cash.
- Steps:
- Review the cash flow statement.
- Compare Operating Cash Flow with net income to assess cash quality.
- Calculate Free Cash Flow (FCF):
[
{FCF} = {Operating Cash Flow} - {Capital Expenditures}
]
- Outcome: Ensure the company generates positive free cash flow.
3. Key Formulas in Financial Analysis
A. Profitability Ratios
- Gross Profit Margin:
[
{Gross Profit Margin} = \frac{{Gross Profit}} / {{Revenue}} * 100
]
-
Example: Revenue = $1M, COGS = $600K.
[
{Gross Profit Margin} = \frac{(1M - 600K)}{1M} * 100 = 40\%
]
-
Net Profit Margin:
[
{Net Profit Margin} = \frac{{Net Income}} / {{Revenue}} * 100
]
-
Return on Assets (ROA):
[
{ROA} = \frac{{Net Income}} / {{Total Assets}} * 100
]
-
Return on Equity (ROE):
[
{ROE} = \frac{{Net Income}} / {{Shareholder Equity}} * 100
]
B. Liquidity Ratios
-
Current Ratio:
[
{Current Ratio} = \frac{{Current Assets}} / {{Current Liabilities}}
]
-
Quick Ratio:
[
{Quick Ratio} = \frac{{Current Assets} - {Inventory}} / {{Current Liabilities}}
]
C. Efficiency Ratios
-
Inventory Turnover:
[
{Inventory Turnover} = \frac{{Cost of Goods Sold}} / {{Average Inventory}}
]
-
Accounts Receivable Turnover:
[
{AR Turnover} = \frac{{Revenue}} / {{Average Accounts Receivable}}
]
D. Leverage Ratios
-
Debt-to-Equity Ratio:
[
{Debt-to-Equity} = \frac{{Total Debt}} / {{Shareholder Equity}}
]
-
Interest Coverage Ratio:
[
{Interest Coverage} = \frac{{EBIT}} / {{Interest Expense}}
]
E. Valuation Metrics
-
P/E Ratio:
[
{P/E Ratio} = \frac{{Market Price per Share}} / {{Earnings per Share (EPS)}}
]
-
EV/EBITDA:
[
{EV/EBITDA} = \frac{{Enterprise Value (EV)}} / {{EBITDA}}
]
- EV = Market Cap + Total Debt - Cash.
4. Specific Situations in Financial Analysis
Scenario 1: Break-Even Analysis
- Problem: Calculate the sales volume needed to cover fixed and variable costs.
- Formula:
[
{Break-Even Sales} = \frac{{Fixed Costs}} / {{Price per Unit} - {Variable Cost per Unit}}
]
- Example:
- Fixed Costs = $50,000.
- Price per Unit = $20.
- Variable Cost per Unit = $10.
[
{Break-Even Sales} = \frac{50,000}{20 - 10} = 5,000 \, {units}
]
Scenario 2: Forecasting Revenue Growth
- Problem: Project revenue over the next 5 years.
- Formula:
[
{Revenue}_{t+1} = {Revenue}_t * (1 + {Growth Rate})
]
- Example:
- Year 1 Revenue = $1M, Growth Rate = 10%.
- Year 2 Revenue:
[
1M * (1 + 0.10) = 1.1M
]
Scenario 3: Assessing a Company's Solvency
- Problem: Evaluate if a company can meet its long-term obligations.
- Steps:
- Calculate the Debt-to-Equity Ratio:
[
{D/E} = \frac{{Total Debt}} / {{Equity}}
]
- Analyze the Interest Coverage Ratio:
[
{Interest Coverage} = \frac{{EBIT}} / {{Interest Expense}}
]
Scenario 4: Valuing a Business Using DCF
- Problem: Estimate the intrinsic value of a business.
- Formula:
[
{NPV} = \sum \frac{{FCF}_t}{(1 + {WACC})^t} + \frac{{Terminal Value}}{(1 + {WACC})^t}
]
- Terminal Value:
[
{TV} = \frac{{FCF}_{{last}} * (1 + g)}{{WACC} - g}
]
- Example:
- FCF (Year 1–5): $50K, $60K, $70K, $80K, $90K.
- WACC = 10%, Terminal Growth Rate = 3%.
- Compute Present Value and Terminal Value.
5. Tools for Financial Analysis
Excel Formulas for Financial Analysis
- NPV:
=NPV(rate, range)
- IRR:
=IRR(range)
- ROA:
=Net_Income/Total_Assets
- Debt-to-Equity:
=Total_Debt/Equity
- Growth Rate:
(New Value - Old Value) / Old Value
6. Best Practices in Financial Analysis
- Use Reliable Data:
-
Source data from financial statements, audited reports, or trusted databases.
-
Benchmark Metrics:
-
Compare ratios against industry averages or competitors.
-
Perform Sensitivity Analysis:
-
Test how changes in assumptions affect outcomes (e.g., interest rates, revenue growth).
-
Visualize Results:
- Use charts (bar, line, pie) to present trends and comparisons.
7. Templates for Financial Analysis
Template: Income Statement Vertical Analysis
| Line Item | Value ($) | % of Revenue |
|-------------------------|---------------|------------------|
| Revenue | 1,000,000 | 100% |
| COGS | 600,000 | 60% |
| Gross Profit | 400,000 | 40% |
| Operating Expenses | 200,000 | 20% |
| Net Income | 200,000 | 20% |
Template: Ratio Summary
| Metric | Value | Benchmark |
|-------------------------|---------------|------------------|
| Gross Profit Margin (%)| 40% | 38% |
| Current Ratio | 2.0x | 1.5x |
| Debt-to-Equity Ratio | 0.6x | 0.8x |
To sum it all up:
Financial analysis helps evaluate a company’s performance, profitability, and financial health using tools like ratio analysis, trend analysis, and DCF valuation. Excel formulas, templates, and best practices simplify and enhance the process.