The Basics of Financial Analysis
In most of my individual stock outlook or forecast articles, the second and third sections are two forms of analysis. The first being fundamental analysis, and the second being technical analysis. These sections require some basic financial analysis, though quite different from the kind implemented in corporate finance. To aid in your own financial literacy, today we’ll be going over the basics of financial analysis.
Necessary Documents and Tools
The basics of financial analysis begin with a few key documents and tools. The key documents are the company’s 10-K or 10-Q. This is the required annual and quarterly reports filed with the SEC. The key tools you need are a calculator, the company stock chart and an Excel or Google spreadsheet. The two most important sections within either document will be the balance sheet and the income statement. The two sections will cover company assets, liabilities, revenue, net income, shares outstanding, etc. All the things we need. Thankfully, once you have some practice reading these documents, plugging in the necessary information will be almost reflexive. Looking at the company stock chart, you’ll focus on perceived patterns. And also indicators that we’ll cover later.
Keep reading for more on the basics of financial analysis.
Basics of Fundamental Analysis
Our fundamental analysis varies based on whether we are taking a top-down or bottom-up approach. Top-down approaches focus on the broader economy or sector first, and then focuses on a specific company. If concerns about the economy are stated first, odds are it’s an article which utilized a top-down approach. A bottom-up approach looks first at a specific company. This type of approach emphasizes microeconomic factors. Bottom-up financial analysis will more closely resemble corporate financial analysis in terms of complexity.
There is no correct answer in determining which approach you want to take. A top-down approach will generally focus on high growth opportunities. This is in regards to an economy with high inflation. Keep in mind that growth companies generally do not have the most appealing fundamentals. They will generally have low/no profitability, no dividends and high P/E ratios. Profitability is fairly easy to gauge. Net income can either be positive or negative. Dividends are also fairly easy to spot.
You can find the P/E ratio by dividing the stock price by the earnings per share. You would generally hope for a low(er) ratio. P/E ratios also vary by industry, so be sure to take that into account as well. ROA and ROE are measures of profitability. These measures are taken by dividing net income by either assets or shareholder equity. If a company has a high level of leverage, the ROE will generally be higher than the ROA. Value companies will generally also have solid ROA and ROEs.
Recognizing that much of fundamental analysis seems to focus on ratios and acronyms, I understand how it may seem confusing. However, with continued exposure and practice, it should become significantly less so. With that, we’ve rounded out the “fundamental” portion of our basics of financial analysis. Now, on to technical analysis.
Basics of Technical Analysis
When examining the basics of financial analysis, it’s important to note that technical analysis is quite distinct from fundamental analysis. Whereas fundamental analysis required calculations and company documentation, technical analysis requires a trained eye. Technical analysis focuses first on stock price movement. As well as perceived patterns or trends. Some patterns and trends are bullish, others are bearish, while some are a combination of both. In general, technical analysis has been reserved for short term investors, day and swing traders. Given the reliance on short term data, building long term projections is rather unreasonable an ask. Stock patterns can be quite hit and miss. And the best will have accuracy rates around 83%.
Beyond the chart, and the patterns or trends you see on it, what are other things technical analysts look for? Increase volume, relative to the average volume of the stock. The RSI, which is a momentum indicator, is used as an indicator for a reversal or pullback. An RSI above 70 is considered overbought. And an RSI below 30 is considered oversold. Other indicators include moving averages. This measures the average stock price at different periods of time. Technical analysts combine these, and other, technical indicators with perceived stock patterns to illustrate an investment opportunity.
In covering the basics of financial analysis, I’d like to make clear that I am not arguing for an either-or approach. As I do in my articles, I believe that using fundamental and technical analysis together has benefits. If the two forms lead you to the same conclusion, would you not feel stronger in your decision(s)? Allowing both to work in your favor is a benefit I don’t think you should quickly turn down.
Basics of Financial Analysis: Conclusions
While different, the two forms of financial analysis have the same goal. To help you find good investment opportunities. Whereas one focuses more heavily on financial data and ratios, the other focuses more on consumer actions and sentiment. Honing and understanding both should be the goal of any investor. Once you have, your ability to deploy both forms to your advantage becomes significantly easier. From there, finding better investment opportunities should also become easier.
About Gabriel Shabat
Gabriel Shabat is a writer who focuses on financial literacy and investing topics. He has been studying and talking about the markets for over seven years. Last year he became a part of the instructional staff at Boston University, teaching graduate finance courses as part of their Masters degree programs. When he isn’t working, he enjoys playing the guitar, working out and spending time with his loved ones.