Financial Analysis – Definition
Financial Analysis is the systematic process of analyzing or examination of financial information of the company to reach a business decision. People in the company examine how stable, solvent and profitable business or any project of the company and these assessments are carried out by examining the income statement, balance statement and cash flow statement of the company. A person after assessing the company’s performance by using financial data present findings to top management of a company with the recommendations about how it can improve in the future.
Top 15 Most commonly used financial analysis techniques are listed below –
- #1 – Vertical Analysis
- #2 – Horizontal Analysis
- #3 – Trend Analysis
- #4 – Liquidity Analysis
- #5 – Turnover Ratio Analysis
- #6 – Profitability Analysis
- #7 – Business Risk Analysis
- #8 – Financial Risk Analysis
- #9 – Stability Ratios
- #10 – Coverage Analysis
- #11 – Control Analysis
- #12 – Valuation Analysis
- #13 – Variance Analysis
- #14 – Scenario & Sensitivity Analysis
- #15 – Rate of Return Analysis
Let us discuss each one of them in detail –
Top 15 Financial Analysis Techniques
There are many ways one can perform Financial analysis, the most popular types and tools are listed below –
#1 – Vertical Analysis
Vertical Analysis is a technique to identify how the company has applied its resources and in what proportion its resources are distributed across the income statement and the balance sheet. The assets, liabilities and shareholders equity is represented as a percentage of total assets. In the case of Income Statement, each element of income and expenditure is defined as a percentage of the total sales.
To learn more on Vertical Financial Analysis, you can refer to the following articles –
- Vertical Analysis of Income Statement
- Vertical Analysis Formula
- Common Size Income Statement
- Common Size Balance Sheet
#2 – Horizontal Analysis
In Horizontal Analysis financial statements of the company is made to review for a number of years and it is also called a long term analysis. It is useful for long term planning, and it compares figures of two or more years. Here we find out the growth rate of the current year as compared to the previous year in order to identify opportunities and problems.
#3 – Trend Analysis
Trend analysis involves collecting the information from multiple time periods and plotting the collected information on the horizontal line with the objective to find actionable patterns from the given information.
#4 – Liquidity Analysis
Liquidity Analysis determines the company’s ability to meet its short term financial obligations and how it plans to maintain its short-term debt repayment ability. Ratios used for Liquidity Financial analysis are as follows
#5 – Turnover Ratio Analysis
Turnover Ratio primarily identifies how efficiently the company’s resources are utilized. Following Ratios are used to do Turnover Analysis –
- Accounts Receivable Turnover
- Inventory Turnover Ratio
- Working Capital Turnover
- Asset Turnover Ratio
- Equity Turnover Ratio
- Days Payable Outstanding (DPO)
#6 – Profitability Analysis
Profitability financial analysis helps us understand how the company generates its profit from its business activities. Following tools are used to analyze the same –
#7 – Business Risk Analysis
Business Risk Analysis measures how investment in fixed assets affect the sensitivity of company’s earnings and the debt on the balance sheet. Top ways to analyze Business Risk is as follows –
#8 – Financial Risk Analysis
Here we measure how leveraged is the company and how it is placed with respect to its debt repayment capacity. Tools used to do leverage financial analysis –
#9 – Stability Ratios
Stability ratio is used with a vision of long-term. It uses to check whether the company is stable in the long run or not.
#10 – Coverage Analysis
This type of coverage financial analysis is used to calculate dividend which needs to be paid to investors or interest to be paid to the lender.
#11 – Control Analysis
Control ratio from the name itself it is clear that its use to control things by management. This type of ratio analysis helps management to check favorable or unfavorable performance.
There are mainly three types of ratios used here – Capacity Ratio, Activity Ratio, and Efficiency Ratio
- Capacity Ratio Formula = Actual Hour Worked / Budgeted Hour * 100
- Activity Ratio Formula = Standard Hours for Actual Production / Budgeted Standard Hour * 100
- Efficiency Ratio Formula = Standard Hours for Actual Production / Actual Hour Worked * 100
#12 – Valuation Analysis
Valuation Analysis helps us identify the fair value of the business, investment or a company. While valuing a business, choosing the correct valuation methodology is very important. You may use one of the following valuation financial analysis tools –
- Dividend Discount Model (DDM)
- DCF Formula (Discounted Cash Flow)
- Trading Multiples
- Transaction Multiples Valuation
- Sum of the Parts Valuation
#13 – Variance Analysis
Variance analysis in budgeting is the study of deviation of the actual outcome against the forecasted behavior in finance. This is essentially concerned with how the difference between actual and planned behavior indicate and how business performance is being impacted.
#14 – Scenario & Sensitivity Analysis
Scenario analysis takes account of all the scenarios and then analyze them to find out the best scenario and the worst scenario. You can use the following to do sensitivity analysis –
- Sensitivity Analysis in Excel
- Data Table in Excel
- Two-Variable Data Table in Excel
- One Variable Data Table in Excel
#15 – Rate of Return Analysis
The internal rate of return is a metric employed in capital budgeting which is used to measure the extent of profitability of potential investments. It is also known as ERR or economic rate of return. IRR is defined as the discount rate that sets the NPV of a project to zero is the project’s IRR. Following tools can be used to rate of return analysis –
- Incremental IRR
- XIRR Excel Function
- MIRR Function
- NPV in Excel
- Payback Period & Discounted Payback Period
- With the help of financial analysis, method management can examine the company’s health and stability.
- It provides investors an idea about deciding whether to invest a fund or not in a particular company and it gives the answer to a question such as whether to invest?, How much to invest? And what time to invest?
- It simplifies the financial statements which help in comparing companies of different sizes with one another.
- With the help of a financial analysis company can predict the future of the company and can forecast the future market trends and able to make future planning.
- One of the disadvantages of financial analysis is that it uses facts and figures that are as per current market conditions which may fluctuate.
- False data in the statement will give you false analysis and data may be manipulated companies and it may not be accurate.
- Comparison between different companies is not possible if they adopt different accounting policy.
- If any company is working in a rapidly changing and highly competitive environment, its past results shown in the financial statement may or may not be indicators of future results.
Limitations of Financial Analysis
- When companies do financial analysis, most of the time they fail to consider the price changes and due to this they unable to show inflation impact.
- It only considers the monetary aspects of companies financial statements and does not take into consideration the non-monetary aspects of financial statements.
- It is totally based on past data in financial statement and future results can’t be like a past.
- Many Intangible assets not recorded in the statement, due to this Intangible assets don’t consider while doing financial analysis.
- This is limited to a specific time period and not always comparable with different company’s statement due to different accounting policies.
- Sometimes financial analysis is the influence of personal judgment, and it doesn’t necessarily mean that strong financial statements analysis of companies have a strong financial future.
Analysis and examination of Financial statements are an important tool in assessing the company’s health and it provides information to company management and then it is used by them for future planning and decision making. It helps the company to raise capital in domestic as well as overseas. With the help of various Financial Analysis methods as mentioned above the company can predict the future of a company or individual projects and it helps company management to take decision by examine the recommendations made in a report. It helps investors whether to invest funds in a company or not by assessing the company’s financial reports.
This has been a guide to what is Financial Analysis and its definition. Here we discuss the top 15 most common financial analysis techniques including its advantages, disadvantages, and limitations. You can learn more about financing from the following articles –
- What is Sensitivity Analysis?
- Meaning of Incremental Revenue
- Nominal Rate of Return | Meaning
- 10 Best Importance of Capital Budgeting
- Top 5 Capital Budgeting Techniques
- Financial Ratios with Formulas
- Financial Statements Objectives
- Job Description of a Financial Analyst
- WallStreetMojo Financial Analyst Course