Skillmart International
College
Part 2
Financial Analysis
Fisseha M. (PhD Candidate)
KEY TAKEAWAYS
• If conducted internally, financial analysis can help managers make future
business decisions or review historical trends for past successes.
• If conducted externally, financial analysis can help investors choose the
best possible investment opportunities.
• Fundamental analysis and technical analysis are the two main types of
financial analysis.
• Fundamental analysis uses ratios and financial statement data to
determine the intrinsic value of a security.
• Technical analysis assumes a security's value is already determined by its
price, and it focuses instead on trends in value over time.
Types of Financial Analysis
• Corporate Financial Analysis
• In corporate finance, the analysis is conducted internally by the accounting department
and shared with management in order to improve business decision making.
• This type of internal analysis may include ratios such as net present value (NPV) and
internal rate of return (IRR) to find projects worth executing.
• Many companies extend credit to their customers. As a result, the cash receipt from
sales may be delayed for a period of time. For companies with large receivable
balances, it is useful to track days sales outstanding (DSO), which helps the company
identify the length of time it takes to turn a credit sale into cash.
• The average collection period is an important aspect of a company's overall cash
conversion cycle.
• A key area of corporate financial analysis involves extrapolating a company's past
performance, such as net earnings or profit margin, into an estimate of the company's
future performance. This type of historical trend analysis is beneficial to identify
seasonal trends.
Investment Financial Analysis
• In investment finance, an analyst external to the company conducts an analysis for
investment purposes. Analysts can either conduct a top-down or bottom-up
investment approach.
• A top-down approach first looks for macroeconomic opportunities, such as high-
performing sectors, and then drills down to find the best companies within that sector.
• A bottom-up approach, on the other hand, looks at a specific company and conducts a
similar ratio analysis to the ones used in corporate financial analysis, looking at past
performance and expected future performance as investment indicators.
• Bottom-up investing forces investors to consider microeconomic factors first and
foremost.
• These factors include a company's overall financial health, analysis of financial
statements, the products and services offered, supply and demand, and other
individual indicators of corporate performance over time.
Fundamental Analysis
• Fundamental analysis uses ratios gathered from data within the financial statements,
such as a company's earnings per share (EPS), in order to determine the business's value.
• Using ratio analysis in addition to a thorough review of economic and financial situations
surrounding the company, the analyst is able to arrive at an intrinsic value for the
security.
• The end goal is to arrive at a number that an investor can compare with a security's
current price in order to see whether the security is undervalued or overvalued.
• Technical Analysis
• Technical analysis uses statistical trends gathered from trading activity, such as moving
averages (MA).
• Essentially, technical analysis assumes that a security’s price already reflects all publicly
available information and instead focuses on the statistical analysis of price movements.
• Technical analysis attempts to understand the market sentiment behind price trends by
looking for patterns and trends rather than analyzing a security’s fundamental attributes.
Examples of Financial Analysis
• As an example of fundamental analysis, Discover Financial Services
reported its fourth-quarter 2020 earnings per share (EPS) at $2.59.
That was up from the third quarter 2019 EPS of $2.25.
• A financial analyst using fundamental analysis would take this as a
positive sign of increasing the intrinsic value of the security.
• With that, future EPS projections may also be forecast to rise. For
example, according to Nasdaq.com, the estimated first-quarter 2021
EPS is forecast to come in at $2.78, up from the first quarter 2020 EPS
of $1.36.
Other Types of Financial Analysis
The most common types of financial analysis are:
1. Vertical
2. Horizontal
3. Leverage
4. Growth
5. Profitability
6. Liquidity
7. Efficiency
8. Cash Flow
9. Rates of Return
10.Valuation
11.Scenario & Sensitivity
12.Variance
Vertical Analysis
• This type of financial analysis involves looking at various components of the income statement and
dividing them by revenue to express them as a percentage.
• For this exercise to be most effective, the results should be benchmarked against other companies in
the same industry to see how well the company is performing.
• This process is also sometimes called a common-sized income statement, as it allows an analyst to
compare companies of different sizes by evaluating their margins instead of their dollars.
Horizontal Analysis
• Horizontal analysis involves taking several years of financial data and comparing them to each other to
determine a growth rate.
• This will help an analyst determine if a company is growing or declining, and identify important trends.
• When building financial models, there will typically be at least three years of historical financial
information and five years of forecasted information.
• This provides 8+ years of data to perform a meaningful trend analysis, which can be benchmarked
against other companies in the same industry.
Leverage Analysis
• Leverage ratios are one of the most common methods analysts use to
evaluate company performance.
• A single financial metric, like total debt, may not be that insightful on
its own, so it’s helpful to compare it to a company’s total equity to get
a full picture of the capital structure.
• The result is the debt/equity ratio.
Profitability Analysis
Profitability is a type of income statement analysis where an analyst
assesses how attractive the economics of a business are.
Liquidity Analysis
This is a type of financial analysis that focuses on the balance sheet, particularly, a
company’s ability to meet short-term obligations (those due in less than a year).
Efficiency Analysis
Efficiency ratios are an essential part of any robust financial analysis. These ratios look at how well a
company manages its assets and uses them to generate revenue and cash flow.
Cash Flow
As they say in finance, cash is king, and, thus, a big emphasis is placed on a company’s ability to generate cash flow. Analysts across a wide
range of finance careers spend a great deal of time looking at companies’ cash flow profiles.
The Statement of Cash Flows is a great place to get started ,
including looking at each of the three main sections: operating
activities, investing activities, and financing activities.
Rates of Return
At the end of the day, investors, lenders, and finance professionals, in general, are focused on what type
of risk-adjusted rate of return they can earn on their money. As such, assessing rates of return on
investment (ROI) is critical in the industry.
Valuation Analysis
• The process of estimating what a business is worth is a major component of financial analysis, and
professionals in the industry spend a great deal of time building financial models in Excel. The value
of a business can be assessed in many different ways, and analysts need to use a combination of
methods to arrive at a reasonable estimation.
Approaches to valuation include:
• Cost Approach
O The cost to build/replace
• Relative Value (market approach)
O Comparable company analysis
O Precedent transactions
• Intrinsic Value
O Discounted cash flow analysis
Scenario & Sensitivity Analysis
• Another component of financial modeling and valuation is performing
scenario and sensitivity analysis as a way of measuring risk.
• Since the task of building a model to value a company is an attempt to
predict the future, it is inherently very uncertain.
• Building scenarios and performing sensitivity analysis can help determine
what the worst-case or best-case future for a company could look like.
• Managers of businesses working in financial planning and analysis (FP&A)
will often prepare these scenarios to help a company prepare its budgets and
forecasts.
• Investment analysts will look at how sensitive the value of a company is as
changes in assumptions flow through the model using Goal Seek and Data
Tables.
Variance Analysis
• Variance analysis is the process of comparing actual results to a budget or forecast.
• It is a very important part of the internal planning and budgeting process at an
operating company, particularly for professionals working in the accounting and
finance departments.
• The process typically involves looking at whether a variance was favorable or
unfavorable and then breaking it down to determine what the root cause of it was.
• For example, a company had a budget of $2.5 million of revenue and had actual
results of $2.6 million.
• This results in a $0.1 million favorable variance, which was due to higher than
expected volumes (as opposed to higher prices).
Financial Analysis Best Practices
• All of the above methods are commonly performed in Excel using a wide range of formulas,
functions, and keyboard shortcuts.
• Analysts need to be sure they are using best practices when performing their work, given the
enormous value that’s at stake and the propensity of large data sets to have errors.
Best practices include:
• Being extremely organized with data
• Keeping all formulas and calculations as simple as possible
• Making notes and comments in cells
• Auditing and stress testing spreadsheets
• Having several individuals review the work
• Building in redundancy checks
• Using data tables and charts/graphs to present data
• Making sound, data-based assumptions
• Extreme attention to detail, while keeping the big picture in mind
