====== Financial Analysis ======
Financial Analysis is the art and science of deciphering a company's financial story to gauge its health, performance, and future prospects. Think of it as being a financial detective. Instead of a magnifying glass, your primary tools are a company's [[financial statements]]—specifically the [[income statement]], the [[balance sheet]], and the [[statement of cash flows]]. By examining these documents, you can move beyond the daily stock price chatter and market noise to understand the actual business you are considering owning a piece of. For a [[value investor]], this process is non-negotiable. It's the groundwork required to estimate a company’s true [[intrinsic value]] and determine if its stock is being offered at an attractive price. Financial analysis transforms investing from a game of chance into a disciplined pursuit of value, helping you separate rock-solid businesses from those built on shaky foundations.
===== The Analyst's Toolkit: Key Financial Statements =====
At the heart of any financial analysis are three core documents that every publicly traded company must produce. Understanding what each one tells you is the first step toward becoming a savvy investor.
==== The Balance Sheet: A Snapshot in Time ====
The Balance Sheet is a snapshot of a company's financial position at a single point in time. It shows what a company owns ([[assets]]) and what it owes ([[liabilities]]). The difference between these two is the [[shareholders' equity]], which represents the owners' stake in the company.
It all boils down to a simple, unshakable formula: **Assets = Liabilities + Shareholders' Equity**.
A healthy balance sheet typically shows manageable debt levels and assets that can generate future income. A value investor scrutinizes it for signs of financial strength or weakness.
==== The Income Statement: The Performance Story ====
If the balance sheet is a photo, the income statement (also called the Profit and Loss or P&L statement) is a video. It shows how profitable a company was over a specific period, like a quarter or a year. It starts with the company's total sales, or [[Revenue]], at the top. It then subtracts various costs and expenses, such as the [[Cost of Goods Sold (COGS)]] to arrive at [[Gross Profit]], and then operating expenses to find operating income. After deducting interest and taxes, you are left with the famous "bottom line": the [[Net Income]] or profit. Watching a company’s net income trend over several years can tell you a lot about its competitive position and operational efficiency.
==== The Statement of Cash Flows: Following the Money ====
This statement is arguably the most crucial for detecting financial shenanigans because it tracks //actual cash//. While net income on the income statement can be influenced by accounting rules, cash is king. The Statement of Cash Flows reports the cash generated and used during a period, broken down into three activities:
  * **Operating Activities:** Cash from the company's core business operations. Consistently positive cash flow here is a great sign.
  * **Investing Activities:** Cash used for or generated from investments, like buying new equipment or selling old assets.
  * **Financing Activities:** Cash from activities like issuing stock, paying dividends, or taking on or paying off debt.
===== Making Sense of the Numbers: Financial Ratio Analysis =====
Reading the statements is one thing; understanding them is another. This is where [[financial ratio analysis]] comes in. By comparing different numbers from the financial statements, you can create ratios that provide far more insight than the raw numbers alone. For example, knowing a company made $10 million in profit is interesting, but knowing it did so on just $50 million in equity is powerful.
==== Key Categories of Ratios ====
Ratios help you assess a company's performance against its own history, its competitors, and industry benchmarks.
=== Profitability Ratios ===
These ratios tell you how good a company is at turning sales and assets into profits.
  * **[[Return on Equity (ROE)]]:** Measures how much profit a company generates for each dollar of shareholders' equity.
  * **[[Net Profit Margin]]:** Shows what percentage of revenue is left after all expenses have been paid.
=== Liquidity Ratios ===
These measure a company's ability to pay its short-term bills. A low liquidity ratio can be a red flag for financial distress.
  * **[[Current Ratio]]:** Compares current assets to current liabilities. A ratio above 1 is generally considered safe.
=== Solvency Ratios ===
These look at a company's ability to meet its long-term debt obligations. Too much debt can sink an otherwise good company.
  * **[[Debt-to-Equity Ratio]]:** Compares a company's total debt to its shareholders' equity.
=== Valuation Ratios ===
These ratios help you gauge whether a stock is cheap or expensive relative to its own earnings, book value, or sales.
  * **[[Price-to-Earnings (P/E) Ratio]]:** The most famous valuation metric, it compares the company's stock price to its earnings per share.
  * **[[Price-to-Book (P/B) Ratio]]:** Compares the market price to the company's book value of equity. Value investors often hunt for companies with low P/B ratios.
===== The Value Investor's Perspective =====
For a value investor like [[Warren Buffett]], financial analysis is the process of understanding the business. The goal isn't just to find a statistically cheap stock but to find a wonderful business at a fair price. The numbers revealed through analysis are the evidence that supports an investment thesis.
A true value investor uses financial analysis to look for businesses with a durable [[competitive advantage]] (or [[moat]]), a history of consistent profitability, a strong balance sheet with little debt, and shareholder-friendly management. Once you've done the hard work of analysis and are confident in the quality of the business, you can estimate its intrinsic value. If the market is offering you the chance to buy that business for significantly less than your estimate—a discount known as the [[margin of safety]]—you have found a potential investment.