Why are the tools of financial analysis required?

It is important to understand how well a business is doing and where it is headed in the short and the long term while investing in the share market. This is where the tools of financial analysis come handy. It’s not enough to pore over a company’s financial statement. To make sense of the numbers one must employ the methods of financial statement analysis to extract valuable insights into the company’s performance. 

However, these methods have far wider use beyond just the stock market. Here’s a short list of interesting use cases of the tools of financial analysis:

1. They are used by valuation professionals to advise on mergers and acquisitions

2. Banks can make decisions on the solvency of a business and its creditworthiness using these tools

3. Auditors and regulators may use these to sniff out possible discrepancies in a company’s financial statement or business dealings

4. Insurance companies and credit rating agencies could use the techniques of financial analysis to assess various risks  

5. Companies can use these to make business decisions such as where to allocate resources and which unit to shutter.

What are the different types of financial analysis used in the share market?

There are broadly two schools of philosophy with regards to using the tools of financial analysis to invest in a company’s stock. 

a) Fundamental analysis: In this case, information gleaned from the financial statement is used to determine what a business is really worth. This method involves calculating ratios such as price-to-equity, earnings-per-share etc to check how far removed a company’s stock is from its real value.

b) Technical analysis: Here it is believed that the fundamentals of a business are accounted for in the price of its stock. Consequently, the investor works through data on the trading momentum of the stock to get an indication of its movement. 

What are the ingredients of financial analysis?

The financial analysis of a company is done using various data points from its financial statements — namely, the income statement and the balance sheet. The income statement, as the name suggests, speaks about how a company is faring with respect to its topline and bottomline indicators — gross sales, earnings, net income. Meanwhile, the balance sheet provides details of its assets and liabilities.

Techniques of financial analysis

Following is a list of some methods of financial statement analysis that an investor an use to decide whether or not to invest in a company:

1) Trend analysis    

Trend analysis generally involves charting the path of stock prices to make a projection about where they are headed. Trends can be upward or downward and indicate a bull market or a bear market. This is one of the special tools of financial analysis as it can be used to predict the impact of a range of external factors on a stock. 

2) Vertical analysis

In the vertical analysis, all items of a financial statement are expressed as a percentage of a particular header. For example, a company’s net income, various expenses, input costs etc could be written as a percentage of the sales. This tool is generally used to gain an insight regarding the correlation between different factors of production and performance indicators.

3) Horizontal analysis

This is one of the most popular methods of financial statement analysis. You must have noticed that news anchors on television quite often say that XYZ company’s net income has increased by a certain percentage sequentially or annually. Horizontal analysis helps us understand how the various indicators in a financial statement such as income, sales, interest margin (for lenders) etc have grown or faltered over a period of time. 

4) Cash flow analysis

Cash flow analysis means tracking the expenses and income of a business during a specific period. It helps one gauge the working capital requirements of the company and consequently, its speed of expansion in the market and debt requirements.

5) Ratio analysis

Ratio analysis is one of the few techniques of financial analysis that can help an investor evaluate a company with its peers — companies in the same industry and of the same size. A few examples are the earnings to price ratio, the net income to sales ratio and return on assets ratio. This is also a useful method to find the missing links of private companies. 

As an investor, you should ensure that you educate yourself with basic concepts of fundamental and technical investing before you enter the markets.