What is Financial Analysis

Financial analysis involves using financial data to assess a company’s performance and make
recommendations about how it can improve going forward. Financial Analysts primarily carry out
their work in Excel, using a spreadsheet to analyze historical data and make projections of how
they think the company will perform in the future.

Financial analysis is the process of examining a company’s performance in the context of its
industry and economic environment in order to arrive at a decision or recommendation. Often, the
decisions and recommendations addressed by financial analysts pertain to providing capital to
companies—specifically, whether to invest in the company’s debt or equity securities and at what
price. An investor in debt securities is concerned about the company’s ability to pay interest and to
repay the principal lent. An investor in equity securities is an owner with a residual interest in the
company and is concerned about the company’s ability to pay dividends and the likelihood that its
share price will increase.

Overall, a central focus of financial analysis is evaluating the company’s ability to earn a return
on its capital that is at least equal to the cost of that capital, to profitably grow its operations, and to
generate enough cash to meet obligations and pursue opportunities.

Fundamental financial analysis starts with the information found in a company’s financial reports.
These financial reports include audited financial statements, additional disclosures required by
regulatory authorities, and any accompanying (unaudited) commentary by management. Basic
financial statement analysis—as presented in this reading—provides a foundation that enables the
analyst to better understand other information gathered from research beyond the financial
reports.

Learning Outcomes

The member should be able to:

Describe the roles of financial reporting and financial statement analysis;

Describe the roles of the statement of financial position, statement of comprehensive income,
statement of changes in equity, and statement of cash flows in evaluating a company’s
performance and financial position;

Describe the importance of financial statement notes and supplementary information—including

Describe the objective of audits of financial statements, the types of audit reports, and the
importance of effective internal controls;

Identify and describe information sources that analysts use in financial statement analysis besides
annual financial statements and supplementary information;

Describe the steps in the financial statement analysis framework.

Summary
The information presented in financial and other reports, including the financial statements, notes,
and management’s commentary, help the financial analyst to assess a company’s performance
and financial position. An analyst may be called on to perform a financial analysis for a variety of
reasons, including the valuation of equity securities, the assessment of credit risk, the
performance of due diligence on an acquisition, and the evaluation of a subsidiary’s performance
relative to other business units. Major considerations in both equity analysis and credit analysis
are evaluating a company’s financial position, its ability to generate profits and cash flow, and its
potential to generate future growth in profits and cash flow.

The primary purpose of financial reports is to provide information and data about a company’s
financial position and performance, including profitability and cash flows. The information
presented in the reports —including the financial statements and notes and management’s
commentary or management’s discussion and analysis—allows the financial analyst to assess a
company’s financial position and performance and trends in that performance.

The primary financial statements are the statement of financial position (i.e., the balance sheet),
the statement of comprehensive income (or two statements consisting of an income statement
and a statement of comprehensive income), the statement of changes in equity, and the
statement of cash flows.

The balance sheet discloses what resources a company controls (assets) and what it owes
(liabilities) at a specific point in time. Owners’ equity represents the net assets of the company; it
is the owners’ residual interest in, or residual claim on, the company’s assets after deducting its
liabilities. The relationship among the three parts of the balance sheet (assets, liabilities, and
owners’ equity) may be shown in equation form as follows: Assets = Liabilities + Owners’ equity.

The income statement presents information on the financial results of a company’s business
activities over a period of time. The income statement communicates how much revenue and
other income the company generated during a period and what expenses, including losses, it
incurred in connection with generating that revenue and other income. The basic equation
underlying the income statement is Revenue + Other income – Expenses = Net income.

The statement of comprehensive income includes all items that change owners’ equity except
transactions with owners. Some of these items are included as part of net income, and some are
reported as other comprehensive income (OCI).

The statement of changes in equity provides information about increases or decreases in the
various components of owners’ equity.

Although the income statement and balance sheet provide measures of a company’s success,
cash and cash flow are also vital to a company’s long-term success. Disclosing the sources and
uses of cash helps creditors, investors, and other statement users evaluate the company’s
liquidity, solvency, and financial flexibility.

The notes (also referred to as footnotes) that accompany the financial statements are an integral
part of those statements and provide information that is essential to understanding the statements.
Analysts should evaluate note disclosures regarding the use of alternative accounting methods,
estimates, and assumption.
In addition to the financial statements, a company provides other sources of information that are
useful to the financial analyst. As part of his or her analysis, the financial analyst should read and
assess this additional information, particularly that presented in the management commentary
(also called management report[ing], operating and financial review, and management’s
discussion and analysis [MD&A]).

A publicly traded company must have an independent audit performed on its annual financial
statements. The auditor’s report expresses an opinion on the financial statements and provides
some assurance about whether the financial statements fairly present a company’s financial
position, performance, and cash flows. In addition, for US publicly traded companies, auditors
must also express an opinion on the company’s internal control systems.

Information on the economy, industry, and peer companies is useful in putting the company’s
financial performance and position in perspective and in assessing the company’s future. In most
cases, information from sources apart from the company are crucial to an analyst’s effectiveness.

The financial statement analysis framework provides steps that can be followed in any financial
statement analysis project. These steps are:

Articulate the purpose and context of the analysis;

Collect input data;

Process data;

Analyze/interpret the processed data;

Develop and communicate conclusions and recommendations; and

Follow up.