Economics for Financial Analysts

Financial analysts provide valuable guidance to CEOs, project managers, and other company leaders on everything from when to go public to the risk level of developing and launching new products. Economics offers context for these decisions.¹ For example, if you’re working as a financial analyst and your research and development manager approaches you about a potential new product, economics helps you look beyond the company’s current cash flow to assess the risk.

Read on to learn more about important economics principles you need to complete financial analysis successfully.

Microeconomics Fundamentals

Microeconomics focuses on individual behaviors within the market that could affect your business.² This includes fundamentals such as:

• Supply and demand: A means to assess how changing prices on products and services will have an impact on consumer needs;³ In most cases, demand drops as the price rises and vice versa
• Pricing strategies: These involve assessing factors that influence how your products and services should be priced, including competitor pricing and market conditions
• Consumer behavior: An understanding of which mental and physical activities customers engage in before making a purchase⁴
• Utility maximization: A strategy by which you or your company seeks the highest value from every dollar you spend⁵

Understanding microeconomics will help you assess past consumer behavior to predict how the market will react when you set various price points for products and services.

Macroeconomics Fundamentals

Macroeconomics involves assessing the economy as a whole, including facets of it such as gross domestic product (GDP), fiscal policy, and economic conditions.⁶

• GDP refers to a country’s economy in terms of total output over a certain period;⁷ knowledge of it helps you assess whether a country’s financial conditions are healthy
• Fiscal policy refers to how a country’s government uses taxes and spending to influence the economy⁸
• Economic conditions and financial decisions go hand in hand, as a weak economy can make certain endeavors riskier

As a financial analyst, the ability to understand macroeconomics helps you guide multiple decisions regarding hiring, pricing, and research and development. If you know the economy is weak, for example, you may recommend hiring freezes to help stabilize your company’s profits.

Understanding the economics of financial systems can also help you determine whether a foreign market is desirable. Your company may want to enter an emerging market, but you might look at its GDP and determine that the economy is too volatile at the moment.

Economic Indicators and Financial Markets

A career in financial analysis is not limited to guiding corporate finance. You may also recommend how to borrow and invest, and a keen understanding of economic indicators and financial markets plays a key role in this aspect of analysis.

You may look at the yield curve, which showcases interest rates of similar bonds with different maturity dates.⁹ You may also look at interest rates themselves and how they have fluctuated in a given period. These two data points can help you assess whether the economy is healthy or if it’s headed toward a recession. They can also guide investment decisions and help you determine whether your company should take on debt to finance new projects.

Economic Forecasting Techniques

In your career as a financial analyst, you will be asked to make projections. You might need to estimate corporate earnings to help allocate project management budgets, or you might be involved in scenario planning: visualizing multiple situations and creating plans for each possible outcome. Common forecasting techniques include:¹⁰

• Trend identification, which involves assessing a large volume of historical data to identify patterns
• Time series analysis, which involves analyzing data from a set period, such as quarterly or every six months, and noting any economic trends that appear

Leading and lagging indicators are key in assessing a company’s potential future performance. Leading indicators help you predict success and lagging indicators measure how past performance affects a business.¹¹ They include customer satisfaction and churn rate—the rate at which customers are leaving your company. If your company has a high customer satisfaction rating, it could indicate future success. Coincident indicators, including the unemployment rate, wages, and average hours worked by people across industries in an area, help you assess the economy as a whole.¹²

Knowing how to forecast economic variables helps you make data-driven recommendations that can lead your company to perform well financially.

Common Applications of Economic Theory in Financial Analysis

Valuation Modeling

Valuation modeling is used to assess the present or expected value of a company.¹³ You may use valuation models to assess your company’s position in the market or to help recommend potential investments to your company or your clients.

Risk Assessment

Economics is commonly used to assess risks associated with various business decisions. For example, suppose that your research and development team wants to explore a new product launch. Developing and launching new products is often costly, and these ventures frequently fail. Knowing this, you would assess the market to determine how well your business can absorb the financial risk involved in a launch. If your company is already in a precarious financial position, launching a new product could be considered overly risky.

Strategic Decision-Making

As a financial analyst, you also guide business decisions such as hiring, setting salaries for multiple positions, and implementing changes. For example, if your organization is interested in adopting new software to streamline operations, you may analyze the potential financial impacts of choosing each vendor.

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