Financial analysis

From Wikipedia, the free encyclopedia

Financial analysis entails examining the accounts and economic prospects of a firm or project.

1 Goals
2 Methods
3 See also
- 3.1 Ratios
4 Notes
5 External links

[edit] Goals

Financial analysts often assess the firm's:

performance, for the management to improve operations,

solvency, so a bank or a supplier can safely grant credit,

potential value to decide an investment or divestment. Then it is called fundamental analysis and is linked to business valuation and stock valuation

[edit] Methods

Financial analysts often compare financial ratios (of solvency, profitability, growth...):

Across historical time periods for the same firm (the last 5 years for example)
In forecasts of the firm's anticipated future performance
And among similar firms.

These ratios are calculated by dividing a (group of) account balance(s), taken from the balance sheet and / or the income statement, by another, for example :

Net profit / equity = return on equity

Gross profit / balance sheet total = return on assets

Stock price / earnings per share = P/E-ratio

Comparing financial ratios merely one way of conducting financial analysis. Financial ratios face several theoretical challenges:

They say little about the firm's prospects in an absolute sense. Their insights about relative performance require a reference point from other time periods or similar firms.
One ratio holds little meaning. As indicators, ratios can be logically interpreted in at least two ways. One can partially overcome this problem by combining several related ratios to paint a more comprehensive picture of the firm's performance.
Seasonal factors may prevent year-end values from being representative. A ratio's values may be distorted as account balances change from the beginning to the end of an accounting period. Use average values for such accounts whenever possible.
Financial ratios are no more objective than the accounting methods employed. Changes in accounting policies or choices can yield drastically different ratio values.
They fail to account for exogenous factors like investor behavior that are not based upon economic fundamentals of the firm or the general economy (fundamental analysis) ^[1].