Financial analysis and financial modeling are two very different tools in finance. Financial analysis examines past data to evaluate the previous performance and health of a company. Conversely, financial modeling involves making certain assumptions to predict future financial results , which can aid in making strategic decisions. This distinction is important for providing proper financial insights.
Financial Analysis
Financial analysis is an evaluation of financial statements and other available data to determine the financial health and performance of an entity. Commonly, this includes analyzing a firm’s income statement, balance sheet, and cash flow statement regarding profitability, liquidity, solvency, and general financial position. The right tools and techniques for analyzing data will enable you to make informed investment or business decisions and provide insights into predicting and improving the performance of a business or investment.
Types of Financial Analysis
There are two main types of financial analyses related to equity investment.
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Fundamental Analysis: Financial statements contain data compilations that yield various ratios . In fundamental analysis, the collected ratios determine the value of the business being analyzed, including the company’s earnings per share. Using ratio analysis alongside an exhaustive study of the economic and financial conditions of the company, the analyst can derive an intrinsic value for the security. The ultimate goal is to produce a number that investors can compare with the current price of a security to determine whether it is under- or over-valued.
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Technical Analysis: Technical analysis relies on statistical trends obtained from trading activity, which includes moving averages (MA). From a technical standpoint, the intrinsic philosophy of technical analysis is that the price of any security already incorporates all known information; instead, it focuses on statistical information regarding price movements . It attempts to predict market direction by identifying patterns and trends in stock prices and volumes rather than analyzing a security’s fundamental attributes.
Key Elements of Financial Analysis
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Data review: The search through historical financial statements, for example, an income statement, balance sheet, and cash flow statement, would present an effort to gain an accurate picture of past company performance.
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Ratio analysis: Analysts calculate the financial ratios for understanding various aspects of business health through profitability ratios, liquidity ratios, and efficiency ratios.
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Trend analysis: How the key performance indicators have evolved over time to find the pattern of growth in revenue, expenses, profit margin, and in debt level.
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Benchmarking: Comparative analysis to compare and contrast the performance of a company in its industry and its peers or set up some benchmarks to assess competitive position.
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Risk assessment: Evaluate financial risks including leverage, interest cover, and cash generation capability to measure the threat a company faces.
Financial Modelling
Financial modeling involves designing an ideal or representative model of a real-world financial situation . It refers to a mathematical model that represents, in the simplest manner possible, the performance of a financial asset or portfolio related to any kind of investment: business, project, or others .
Thus, financial modeling is typically interpreted in one of two ways : as asset pricing or corporate finance modeling , which has a numerical flavor . Specifically , it amounts to an exercise that translates a set of hypotheses about how markets or agents behave into numerical predictions of certain outcomes . ” Financial modeling” is a rather vague term with different meanings in various contexts ; generally speaking, it connects to accounting/corporate finance applications or certain applications in quantitative finance.
Financial Model Used For
The result of a financial model is used to support decision-making and perform financial analysis, either internally or externally to the company. Decisions based on financial models include:
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Raising capital (debt and/or equity)
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Acquiring businesses and/or assets
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Organic business growth activity – for example, opening new stores or entering new markets
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Selling/divesting assets and business units
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Budgeting and forecasting (gaining a sense of what to expect in future years)
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Capital allocation (which projects to fund)
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Business valuation
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Analysis of financial statements/ratio analysis
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Management accounting
Key Elements of Financial Modelling
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Forecasting: Preparing projections of revenue, expenses, and cash flows as a function of hypotheses regarding future performance.
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Assumption Setting: Establish realistic assumptions about growth rates, cost, and market conditions to use as a basis on which projections are constructed.
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Three-Statement Model: The income statement, the balance sheet, and the cash flow statement are integrated in such a way that changes in one statement are reflected through others.
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Scenario Analysis: Testing different assumptions-for example, best-case and worst-case-scenarios to understand the sensitivity of changes in assumptions on outcomes.
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Valuation Technique: Valuation of companies using techniques such as DCF, Comparable Company Analysis, etc.
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Sensitivity Analysis: Testing adjustments for critical assumptions to understand the sensitivity of the model to different variables-aids in building risk factors.
Conclusion
financial analysis and financial modeling complement each other concerning decisions over business and investments. Financial modeling focuses on future projections . Both aspects help organizations make more valid, data-driven decisions for potential stability in the present and growth in the future.