Financial analysis is the process of assessing the company’s performance and making recommendations about how it will perform in the future.
Financial analysts, for this purpose, use excel in carrying out their work to analyze historical data and make projections on future performances.
There are twelve types of financial analysis, which are extremely important and very useful for an organization.
Common types of financial analysis are:
1) Vertical Analysis
In vertical analysis, the analyst takes each line item in the income statement and divide it by revenue to reach a percentage.
These results are then benchmarked against other companies in the same industry to assess the company’s performance.
This process is sometimes referred to as a common-sized income statement as it allows comparison between companies of different sizes by evaluating their profits.
2) Horizontal Analysis
Another type of analysis is horizontal. Instead of moving vertically in the income statement, we compare year over year performance by moving across in the income statement.
Financial data is analyzed from year to year by dividing with each other to arrive at a growth rate. This analysis is also commonly referred to as trend analysis. Data of eight-plus years is taken to carry out meaningful trend analysis.
Mostly, historical data of at least three years or forecasted data of five years is required to build financial models.
3) Leverage Analysis
Leverage ratios are critical to an organization. It tells the analysts how much debt or equity a business has relative to its assets or cash. Four leverage ratios are commonly used.
- Debt-to-equity ratio: This indicates the proportion of equity and debt used by a company to finance its liabilities.
- Interest coverage ratio: It determines the ability of a company to repay the interest on outstanding debts.
- Debt-to-EBITDA ratio: This evaluates the ability of a company to repay its debt that has been incurred.
- Equity Multiplier: This ratio evaluates the company’s ability to use its debt to finance its assets.
4) Growth Rate Analysis
Another necessary type of financial analysis is the Growth Rate Analysis. Based on historical results, an analyst can forecast how it expects the company to grow in the future.
This can be done by analyzing year to year growth rates, regression analysis, top to down or bottom to up analysis, and more.
5) Profitability Analysis
This analysis looks at how much income a business earns relative to its revenue. It is a way to measure the organization’s performance.
Investors may use this ratio to pursue assurance of the security of their funds. To check profitability, we may use the following ratios.
- Gross Profit Margin (GPM): Used to assess the profitability of products and services.
- Operating Margin (OM): Used to evaluate the indirect cost of producing products and services like admin and overhead expenses.
- Return on Assets (ROA): This measures the company’s effectiveness to produce a return from assets.
- Return on Equity (ROE): This measures the Return the company is earning for each dollar invested into the company.
6) Liquidity Analysis
Liquidity analysis is also critical for any organization. It looks at the short-term ability of the company to meet its obligations or ability to pay the bills promptly.
These ratios include cash ratio, quick ratio, current ratio, and more. Liquidity ratios are essential for the lenders and borrowers to analyze the financial situation of the company.
7) Efficiency Analysis
Efficiency analysis looks at the company’s balance sheet as well as its ability to generate revenue.
This ratio takes the company’s value of assets and sales and assesses how efficiently a company is using its assets to generate revenue.
8) Cash Flow Analysis
The company needs to perform cash flow analysis in addition to profitability analysis since cash is an important asset.
By looking at the cash flow statement, we get a clear picture of how much cash a company is generating.
9) Rates of Return Analysis
This analysis is of great value for investors. Before investing, they need to analyze the Return they may get from the Investment. Return on Investment can be measured using various ways.
Some common ratios include Return on equity (ROE), Return on invested capital (ROIC), Return on assets (ROA), Capital gain, Dividend yield, and Internal Rate of return (IRR).
10) Valuation Analysis
It is when an analyst attempts to value a company based on cash flow or other methods. This process estimates the worth of a business. The primary purposes of assessing a business or assets are described below.
- Cost approach
- The market approach or relative value approach
- Discounted cashflow or intrinsic value approach
11) Scenario and sensitivity Analysis
This analysis can be layered on top of valuation work. It shows how sensitive the data of a company is relative to changes in operating assumptions.
The external assumptions of tax rates, duties, bank rates may profoundly affect the financials. Thus, carrying out sensitivity analysis is of great importance.
Scenarios can be used to demonstrate how a business might perform in various future economic environments. It measures the risk that a company may have. This analysis may form the basis of budgets and forecasts.
This analysis assesses the performance of a company relative to its budget or forecast. It seeks to understand using root cause analysis, what were the lead, or cause of over and underperformance.
It helps to maintain control over the business. Detailed variance analysis will highlight why fluctuations occurred in business and how the situation can be handled in the future.
A flexed budget may be produced while calculating variances. This budget is a bridge between the original budget and actual results.
Variance analysis may be carried out using standard costing techniques, i.e., comparing standard, budgeted, and actual costs.
All these financial analyses must be carried out using the accountants’ best practices to get a clear picture of the organization.
This way, an organization may carry out better planning, set more realistic standards and benchmarks, have a better control mechanism and responsibility control.