A financial analysis comprises the set of tools, frameworks, and methodologies to analyze the primary financial statements of companies to make internal (to make managerial decisions) and external (to determine the firm’s value or context) assessments. Financial analysis helps determine the state of a company’s valuation based on its main financial statements: balance sheet, income statement, and cash flow statement.
|1. Financial Statements (FS)||Review financial statements, including the income statement, balance sheet, and cash flow statement.||– Examine financial statements to assess the company’s financial performance and health. – Analyze income statements for revenue, expenses, and profitability. – Evaluate the balance sheet for assets, liabilities, and equity. – Assess the cash flow statement for cash flows from operations, investments, and financing activities.||– Provides an overview of a company’s financial position, performance, and liquidity. – Highlights trends in revenue, expenses, and profitability. – Indicates the company’s ability to generate cash and manage debts.||– Assessing the financial health of a company before making investment decisions. – Analyzing financial statements for credit risk assessment in lending.||Financial Statements Example: Reviewing a company’s income statement to determine its net profit margin and operating income.|
|2. Ratio Analysis (RA)||Calculate and interpret financial ratios to assess various aspects of a company’s performance.||– Calculate key financial ratios such as liquidity ratios (e.g., current ratio), profitability ratios (e.g., return on equity), leverage ratios (e.g., debt-to-equity ratio), and efficiency ratios (e.g., inventory turnover). – Interpret the ratios to gain insights into the company’s liquidity, profitability, solvency, and operational efficiency.||– Offers a quantitative assessment of a company’s financial health and performance. – Helps in comparing the company’s performance to industry benchmarks. – Identifies strengths and weaknesses in various financial aspects.||– Evaluating a company’s liquidity using the current ratio. – Assessing profitability through return on assets (ROA) and return on equity (ROE) ratios.||Ratio Analysis Example: Calculating the debt-to-equity ratio to assess a company’s financial leverage and solvency.|
|3. Trend Analysis (TA)||Analyze financial data over time to identify trends, patterns, and changes in performance.||– Review historical financial data for multiple periods (e.g., years or quarters). – Identify trends in revenue growth, expense management, profitability, and financial stability. – Evaluate the consistency and direction of financial performance indicators.||– Helps in understanding the company’s financial performance dynamics over time. – Aids in forecasting future financial trends and challenges. – Indicates whether the company’s financial health is improving or deteriorating.||– Analyzing annual financial reports to track revenue and profit trends. – Identifying patterns in quarterly cash flow fluctuations.||Trend Analysis Example: Examining a retailer’s revenue trends over the past five years to identify seasonality and growth patterns.|
|4. Budget Analysis (BA)||Compare actual financial performance to budgeted expectations to assess variance and cost control.||– Analyze the company’s actual financial results in comparison to the budgeted figures. – Identify variances (positive or negative) between actual and budgeted revenue, expenses, and profits. – Evaluate the reasons behind budget variances, such as cost overruns or revenue shortfalls.||– Assesses the effectiveness of budgeting and cost control measures. – Identifies areas where cost management and resource allocation can be improved. – Helps in aligning financial goals with actual outcomes.||– Comparing actual revenue and expense figures to the budget for cost control. – Analyzing budget variances to optimize spending and resource allocation.||Budget Analysis Example: Assessing the variance between the budgeted and actual operating expenses for a fiscal year.|
|5. Investment Analysis (IA)||Evaluate the financial viability and potential returns of investment opportunities or projects.||– Assess investment opportunities using techniques such as Net Present Value (NPV), Internal Rate of Return (IRR), and Payback Period. – Analyze cash flow projections, investment costs, and expected returns. – Consider risk factors and market conditions when making investment decisions.||– Determines whether an investment is financially sound and generates positive returns. – Helps in selecting projects or assets that align with financial goals and risk tolerance. – Evaluates the impact of investments on cash flow and profitability.||– Evaluating the financial feasibility of a new product launch project. – Assessing the potential return on investment (ROI) for a real estate development.||Investment Analysis Example: Calculating the NPV and IRR of a capital investment project in a manufacturing facility.|
Analysis set up
We are going to perform this analysis up by taking three simple steps. But before we do that we have to have all the information needed available. Where do we find this information? Easy, we look at the target company’s website.
Analysis Overview – make a very few assumptions
In many financial analyses (especially those based on forecasts and financial models), the starting point is to make assumptions. In our analysis, instead, we want to make as few assumptions as possible.
In fact, we are going to let the financials speak for themselves. How? Through three simple steps: in step number one, we are going to select a set of that we will use as analytical tools to understand our target company.
In step number two, we are going to perform a DuPont analysis to understand how the evolved over time. Indeed, since we want to make very few assumptions, we are going to drill-down into the ROE and see what influenced it.
Let’s proceed with order:
Step-One:set-up & two-year comparison
In this step, we are going to select a set of ratios that will guide us toward our analysis. are metrics that help us in comprehending the main financial statements. To have a more detailed account of how they work check out our previous article on ratio analysis here.
In this phase, we have to select some ratios to assess few main aspects of the that we will divide into four main categories: profitability, liquidity, leverage and efficiency. In this phase, we are going to leave valuation out, which we are going to include in the third step of our analysis.
Once selected these ratios we have to run them for the current and previous year. This is because we want to understand how the company’s trend evolved over time. In this specific case, I decided to do an analysis for 2014 and 2015 for simplicity sake.
As you can see from the above table I picked ten different ratios and run them to understand how Apple Inc. performance changed from 2014 to 2015. The table shows increased profitability, liquidity, leverage and efficiency.
The only negative number that you see in this table is a good sign. This is because the receivable in days ratio tells us how long it takes for the company to collect the money from the customers that buy on credit.
In short, the shortest the time it takes for a company to collect money from its customers the more it becomes liquid over time. In Apple Inc. specific case, the receivable in days decreased by 12%, from 30.5 days to 26.8 days.
This is definitely a good sign. In fact, usually a number, which goes below 60 days, is positive, and in this case below 30 days is an extremely positive result.
After completing step one, we can move forward to our second step.
Step number two: DuPont analysis
In fact, as you can see from the previous table our ROE increased from 33% to 46%.
As you can see from this table, although the ROE increased substantially it did so due to leverage and profitability. In short, the company was able to improve itsbut also to contract more debt.
These two factors combined made the company ROE skyrocket. We are ready to move to our third and last step.
Step three: select comparable set-up and comparative analysis completion
In this phase here we have to select some comparable. In short, we want to select companies, which present the same features as our target firm. Afterward, we can relate the main financial ratios of our target company against those of the comparable.
The objective here is to understand the competitive context. In short, although we can make a first assessment of the company’s financials through the first and second step, we are still missing some pieces to complete our puzzle.
Consequently, we are going to use two criteria to select our comparable companies: business model and financial profile. These two profiles will be our guidelines.
- Sector – in what sector does the target company operate?
- Product and services – what are the core products and services the target company offers?
- Distribution channel – how does the target company get to its end customers?
- Geography – what is the main market where our target company operates?
For instance, Apple Inc. operates in the consumer goods category and electronic equipment category. Its main products are iPhone, iPod, MAC (which make up most of its).
Apple Inc. distributes its products mainly through its own retails stores, and the primary market is the U.S. (although the company operates worldwide and currently Greater China makes up for 25% of the company’s sales).
The financial profile attains to quantitative aspects of the. We are going to consider five main aspects:
- Size – Market cap, , net income
- Profitability – Average net margin, or last three or five years
- Growth profile – Where does the revenue growth come from? Geography and product analysis
- Return on investment
- Credit profile – What rating was the company assigned lately? Or what level of the company has?
For instance, Apple Inc. 2015 market cap surpassed $500 billion dollars, with over $230 billion dollars in and over $50 billion in .
In addition, as for the growth came mainly from one product, the iPhone and one market, Greater China., the company showed an average net margin ( /sales) of 23% in the last 5 years. Its revenue
It is time to select Apple’s main comparable.
For simplicity sake, here I want to highlight the fact that when selected Apple comparable I gave more importance to criteria such as geography, products and services, size, and profitability.
In fact, Apple has been able to achieve a powerful position in so many different industries in the tech world and therefore it has also several direct competitors. For instance, in the smartphone industry, Apple’s direct competitors are Samsung, Sony, Lenovo and so on.
In the personal computer industry, Apple’s main competitors are Microsoft, Dell, HP, and Lenovo. We could go on forever.
Although, my assumption here is that de facto Apple’s success was mainly due to its ability to integrate several products through a very intuitive interface that differentiated it from its competitors.
In short, I am assuming (sometimes we have to use assumptions) that the future battle in the tech industry will be played on the software side, rather than the hardware. Therefore, the two biggest players, which are competing against Apple in this respect, are Microsoft and Google.
Perform comparative analysis
In this table is summarized the financial performance of Apple Inc. in comparison with Microsoft and Google for 2015. As you can see from the date Apple has better valuation ratios.and efficiency ratios but also worse liquidity, leverage and market
Wrap-up and Conclusions
In this article, we saw how to set up a financial analysis in three steps. In the first step we selected a set of financial data useful to comprehend the performance of our target company.
In step-two, we went further and analyzed how the ROE evolved over time.
Eventually in step-three, we sleeted comparable companies, and performed a comparative analysis to determine how our target company performed in comparison to the group of company, which operate in the same context.
From the above analysis, you can already be able to draw some conclusions but also investigate further what is going on with our target company. But I hope this article wasn’t too long. Therefore, we will remand our further investigations to another future occasion.
- Structured Analysis Approach: The article introduces a systematic approach to conducting financial analysis, which can be followed step by step. This structured approach ensures that all relevant aspects of the company’s financial performance are evaluated comprehensively.
- Step One – Financial Ratios Set-Up & Comparison:
- Relevance of Financial Ratios: Financial ratios are crucial tools that help in assessing a company’s performance from various angles. They provide insights into its profitability, liquidity, operational efficiency, and leverage.
- Trend Analysis: By comparing these ratios for the current year and the previous year (or multiple years), analysts can identify trends and changes in the company’s financial health over time.
- Interpretation of Ratios: The article highlights the importance of understanding the meaning and implications of each selected financial ratio. For example, a decrease in receivable days could indicate improved liquidity and faster collection of customer payments.
- Step Two – DuPont Analysis:
- ROE Deconstruction: The DuPont analysis is used to deconstruct the Return on Equity (ROE) metric into its key components, such as net profit margin, asset turnover, and financial leverage. This provides a deeper understanding of the factors driving changes in ROE.
- Factors Influencing ROE: By examining each component’s impact on ROE, analysts can identify whether increased profitability is driven by operational efficiency, improved margins, or financial leverage.
- Step Three – Comparable Set-Up and Comparative Analysis:
- Comparable Selection: The article emphasizes the importance of selecting comparable companies that share similar business models and financial profiles. These comparables should be chosen based on criteria such as sector, products/services, size, profitability, growth, and financial health.
- Competitive Context: Comparative analysis enables analysts to evaluate how the target company’s financial performance stacks up against that of its peers. This assessment provides insights into the company’s competitive position within its industry.
- Holistic Insight: By combining financial ratios, DuPont analysis, and comparative analysis, the article’s approach provides a well-rounded view of the company’s financial health, strengths, weaknesses, and competitive landscape.
- Data-Driven Decision-Making: This structured approach enables decision-makers to base their strategies on concrete financial data and trends rather than assumptions or limited perspectives.
- Investor and Managerial Use: The insights generated from this analysis can be valuable for both external stakeholders (investors, lenders) and internal stakeholders (managers, executives) for making informed decisions.
Resources for your business:
- Successful Types of Business Models You Need to Know
- What Is a Business Model Canvas? Business Model Canvas Explained
- Marketing vs. Sales: How to Use Sales Processes to Grow Your Business
- What Is a Value Proposition? Value Proposition Canvas Explained
- What Is Business Development? The Complete Guide To Business Development
- The Three Most Important Financial Ratios for the Manager
- Financial Ratios Formulas To Analyse Any Business
- What Is a Financial Ratio? The Complete Beginner’s Guide to Financial Ratios
- What Is a Financial Option? The Complete Beginner’s Guide to Financial Options
Popular case studies from the blog:
- The Power of Google Business Model in a Nutshell
- How Does Google Make Money? It’s Not Just Advertising!
- How Does DuckDuckGo Make Money? DuckDuckGo Business Model Explained
- How Amazon Makes Money: Amazon Business Model in a Nutshell
- How Does Netflix Make Money? Netflix Business Model Explained
- How Does Spotify Make Money? Spotify Business Model In A Nutshell
- The Trillion Dollar Company: Apple Business Model In A Nutshell
- DuckDuckGo: The [Former] Solopreneur That Is Beating Google at Its Game
Connected Financial Concepts
- Accounting Equation
- Financial Statements In A Nutshell
- Cash Flow Statement In A Nutshell
- How To Read A Balance Sheet Like An Expert
- Income Statement In A Nutshell
- What is a Moat?
- Gross Margin In A Nutshell
- Profit Margin In A Nutshell