What is financial analysis?

The process uses a range of techniques to analyze financial statements and other reports to help investors and internal management evaluate the company’s stability.

The central focus of financial analysis is to evaluate all available financial information, including income statements, cash flow statements, balance sheets and any other disclosures or financial reports. Financial analysts on financial planning and analysis (FP&A) teams then use that data to assess the company’s overall financial position.

It is now common practice for organizations to use tools and techniques powered by artificial intelligence (AI) and machine learning (ML) to analyze data and inform decision-making. 

Key components of financial analysis include ratio analysis and reviewing historical data to inform future financial management projections and better understand the company’s health and potential. Some of the common types of financial analysis include vertical analysis, horizontal analysis, leverage analysis, liquidity analysis and profitability analysis.

Financial analysis is built on several types of financial statements and three core statements are worth noting:

• An income statement (also called profit and loss statement) details a company’s revenue, expenses, net income and overall profit or loss over a period.

• A balance sheet is a snapshot of a company’s assets, liabilities and shareholders’ equity at a certain point in time.

• A cash flow statement is a financial document that tracks cash inflows and outflows, a company’s liquidity and its ability to pay down debts.

Generally speaking, a company’s success depends on its financial health. This is why it’s important to take a company’s financial statements and turn those figures into actionable insights through financial analysis. The findings from thorough financial analysis can drive better budgeting and forecasting decisions and help inform future performance metrics. Typically, financial ratios are used to analyze relationships among financial data.

The role of a financial analyst is to use the tools at their disposal to build models and forecast outcomes. A financial analysis is the steward for evaluating financial performance and driving future decision-making.

Conducting a thorough financial analysis also allows organizations to accomplish the following important tasks:

• Assess health and performance: By evaluating a company’s overall financial condition, internal stakeholders and external investors can get a full picture of its viability and profitability.

• Inform strategic decisions: Financial analysis provides data-driven insights for internal management to set more effective benchmarks and goals.

• Identify strengths and weaknesses: Thorough financial statement analysis, a company can pinpoint areas where it excels and where it might need improvement.

• Guide investment decisions: A financial analysis helps investors determine whether to buy stock and where to invest.

• Mitigate risk: Financial analysis also considers external investment trends and economic factors to reduce financial risks.

Many financial analysis techniques exist and each are crucial to the success of a company in their own way.

A ratio analysis approach calculates standardized metrics to compare financial statements. Examples of metrics include the current ratio, turnover ratio and quick ratio. Financial analysts will convert raw data into important indicators, enabling direct comparisons against historical performance, competitors or industry benchmarks.

Analysts can isolate specific variables, such as asset turnover, inventory turnover and rate of return, to identify trends and assess overall corporate health.

This method compares each line item as a percentage of a base figure within a single reporting period, such as total assets or net sales. Revenue is typically the base figure on the income statement, while the base on the balance sheet includes total assets, total liabilities and equity.

Management uses this perspective to identify shifts in resource allocation and cost concentration.

A company borrows money to finance operations and growth. A leverage analysis examines the extent to which a company uses those borrowed funds and measures the relationship between debt and equity to evaluate financial risk.

By assessing fixed-charge coverage, stakeholders determine the company’s ability to meet long-term obligations and sustain its capital structure.

A liquidity analysis measures a company’s ability to convert assets into cash to meet immediate and short-term obligations. Financial analysts focus on the availability of liquid resources relative to current liabilities and working capital.

Maintaining optimal liquidity helps ensure that organizations can navigate unexpected financial disruptions and sustain daily operations without exhausting credit capacity.

A company uses profitability analysis to measure the profit it’s able to generate relative to its sales, assets and equity. This method quantifies the efficiency of value creation across different business segments.

Common profitability analysis tools include return on invested capital and profit margins. These tools help guide strategic decisions on pricing and investment to maximize shareholder returns and the company’s long-term viability.

A successful company aims to have the best outcomes with the smallest footprint (inputs). Efficiency analysis, also called activity analysis, evaluates a company’s asset utilization and its management of liabilities.

This method tracks turnover rates for inventory (inventory turnover ratio), receivables and payables. By optimizing the operational cycle, companies minimize wasted resources and increase the velocity of revenue generation.

Cash flow analysis examines the actual movement of money into and out of a company across operations, investments and financial activities. Unlike accrual-based accounting, it reveals the organization’s power to generate cash and true solvency.

The method can ensure that the company maintains sufficient cash and is assessed by using techniques such as free cash flow, operating cash flow and the coverage ratio.

There are a range of stakeholders interested in financial analysis, including investors, investment analysts, lenders and auditors.

A company seeking investors or analysts will need to have its financials in line.

Investors and lenders will use ratio analysis, examine profitability ratios, liquidity and gross profit to assess the company’s health. These stakeholders will use this data to compare with past performance and competitors. They will also want to know a company’s valuation and if it’s being fairly evaluated.

Key analysis types for these users:

• Profitability analysis
• Valuation analysis
• Growth analysis
• Risk assessment

A company’s accountants, C-suite executives, operations managers and internal auditors analyze financial data to improve overall decision-making.

A company’s financial performance can lead to better internal business decisions and strategic planning for future resource allocation.

Key analysis types for these users:

• Efficiency analysis
• Variance analysis
• Cash flow analysis
• Budget analysis

Regulators and government agency stakeholders use financial analysis for compliance and overall financial stability. They assess a company’s ability to manage its total assets and help ensure that its financial system remains stable.

Tax regulators monitor a company’s compliance with regulations and detect potential violations.

Key analysis types for these users:

• Liquidity analysis
• Capital adequacy
• Risk assessment
• Compliance metrics

Competing companies will use financial analysis to benchmark performance and identify competitive advantages.

Competitors can analyze a company’s profitability and liquidity through trend analysis, financial modeling and other fundamental analysis practices. These insights can drive strategic planning decisions and help competitors set performance targets.

Key analysis types for these users:

• Market share analysis
• Efficiency metrics
• Profitability analysis
• Growth analysis

A company must first define the objective of the financial analysis. A purpose is necessary for deciding which data and metrics to use.

A company might consider an objective like evaluating liquidity for short-term obligations or analyzing long-term solvency.

The next step is to collect all relevant and necessary financial statements. These statements serve as the foundation for the analysis. Therefore, the data must be clean and up to date.

Modern financial planning software can help integrate Excel spreadsheets and web data from across departments to create financial reports.

Ratio analysis is a vital part of evaluating a company’s financial health. Some key ratios to calculate include current ratios, leverage ratios, coverage ratios and efficiency ratios. These figures provide a company with valuable insights into how well its operating, how financially stable it is and if it’s capable of meeting its obligations.

To go even deeper into profitability, some companies will use DuPont analysis to further break down return on equity (ROE).

Financial analysts examine historical data over varying periods to identify patterns and directional shifts in performance. Finance teams can use horizontal analysis to quantify year-over-year growth, evaluate revenue consistency and identify the drivers of expenses.

Comparative analysis can go a step further by benchmarking internal metrics against industry peers and market leaders. A dual approach can help teams get a clear view of current performance through the lens of both historical trends and fundamental structural changes.

In this step, analysts will scrutinize the statement of cash flows to determine whether net income converts effectively into usable cash. Analysts will focus on liquidity flows by calculating free cash flow to better understand the company’s ability to make financial moves.

Evaluating cash flow quality uncovers discrepancies between accounting profits and the realities of the operation.

The next step in achieving financial analysis is to project future financial outcomes by integrating historical performance with anticipated market conditions and company initiatives. Financial analysts build dynamic models that simulate multiple scenarios, such as changes in interest rates or shifts in consumer demand.

This step is a forward-looking process enabling management to proactively allocate resources and set realistic performance targets. Accurate financial forecasting is key to identifying potential capital shortfalls or surpluses before they occur, helping companies pivot their strategy in the most strategic way possible.

In this final step, financial analysts turn the quantitative data into actionable business intelligence. Finance teams have the numbers and now it’s time to identify the why behind them.

This step links financial results to specific operational decisions or external headwinds beyond the company’s control. Based on the insights, analysts can make recommendations for intervention, such as cost-reduction programs or divestitures.

The data must be effectively interpreted so that financial analysis catalyzes change and informed decision-making.

Finance teams are undergoing a massive restructuring due to advances in AI and automation. In financial analysis and financial reporting, specifically, the shift is both operational and structural. Analysts are shifting from tediously entering data to interpreting it as routine tasks are automated and AI drives finance insights.

AI-driven tools enable powerful budgeting, forecasting and financial reporting automation. These types of AI in FP&A tools can empower teams to collaborate and make informed business decisions.

However, with these technological advancements come notable challenges. Human judgment is and will remain a critical part of deploying these AI capabilities. A company must keep humans at every step of the process and have the final say on any report or analysis shared, both internally and externally.

Separately, data privacy and security should be top priorities for organizations as they rely more on digital systems. IT teams and financial professionals must remain steadfast in cybersecurity measures and compliance.

Finance professionals must be strategic when choosing an AI-driven FP&A tool. Technology can’t just be bolted onto existing finance operations; it needs to be rebuilt to integrate tools effectively across the enterprise.