Investment analysis involves the use of relevant ratios, trend analysis, and the opinions of researchers to decide how to allocate funds in various investment vehicles. The following factors are important in investment analysis:
- A review of the economic and regulatory factors influencing the industry in which the investor is interested.
- An examination of a company’s balance sheet to see if it is maintaining a sufficient level of liquidity, has a conservative capital structure, and is making efficient use of its assets.
- An examination of a firm’s income statement to see if it is generating adequate gross margins and net profits, and is experiencing a reasonable and sustainable rate of sales growth.
- An examination of a firm’s statement of cash flows to see if it is generating adequate cash flows.
- A review of the disclosures that accompany the financial statements to see if the company is using conservative accounting practices or is using “gray area” accounting to fudge its reported results and financial position.
After the evaluating the preceding information, one must determine the risk level of the investment. This includes the risk that dividends will change from current expectations, as well as that the sale price of the investment may decline from the original purchase price. This risk is based on many factors, such as the possibility of new competition in the market, changes in technology, changes in government regulations, and changes in tax rates.
The investor must consider the probability of not being able to sell the investment for more than the original purchase price. This may be a major concern when a security is thinly traded. It is possible that a decline in investor interest could trigger a sell-off of the asset in question, resulting in the investor incurring major losses at some later date.
The outcome of an investment analysis also depends on the investment preferences of the investor. For example, someone nearing retirement might not be interested in investing in a startup company for which there are reasonable prospects of significant growth several years in the future, since there is also a risk of losing the entire investment.