Financial Analysis Definition
Financial analysis refers to an analysis of finance-related projects/activities or company’s financial statements which includes a balance sheet, income statement, and notes to accounts or financial ratios to evaluate company’s results, performance and its trend which will be useful for taking significant decisions like investment and planning projects and financing activities. 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 AnalysisHorizontal AnalysisHorizontal analysis interprets the change in financial statements over two or more accounting periods based on the historical data. It denotes the percentage change in the same line item of the next accounting period compared to the value of the baseline accounting period.
- #3 – Trend AnalysisTrend AnalysisTrend analysis is an analysis of the company's trend by comparing its financial statements to analyze the market trend or analysis of the future based on past performance results, and it is an attempt to make the best decisions based on the results of the analysis done.
- #4 – Liquidity Analysis
- #5 – Turnover Ratio Analysis
- #6 – ProfitabilityProfitabilityProfitability refers to a company's ability to generate revenue and maximize profit above its expenditure and operational costs. It is measured using specific ratios such as gross profit margin, EBITDA, and net profit margin. It aids investors in analyzing the company's performance. 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 Financials 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 sheetBalance SheetA balance sheet is one of the financial statements of a company that presents the shareholders' equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner's capital equals the total assets of the company.. The assets, liabilities, and shareholder’s equity is represented as a percentage of total assets. In the case of Income StatementIncome StatementThe income statement is one of the company's financial reports that summarizes all of the company's revenues and expenses over time in order to determine the company's profit or loss and measure its business activity over time based on user requirements., each element of income and expenditure is defined as a percentage of total sales.
To learn more on Vertical Financial Analysis, you can refer to the following articles –
- Vertical Analysis of Income StatementVertical Analysis Of Income StatementVertical Analysis of Income Statement is a proportional analysis wherein every line item present in a Company’s income statement is listed as a percentage of gross sales. It helps analyze the performance of a business by highlighting where it is displaying an upward or downward trend.
- Vertical Analysis FormulaVertical Analysis FormulaVertical analysis is a kind of financial statement analysis wherein each item in the financial statement is shown in percentage of the base figure. The formula is: (Statement line item / Total base figure) X 100
- Common Size Income StatementCommon Size Income StatementCommon Size Income Statement is a Company’s financial statement that presents every listed line item as a percentage of total revenue or sales. Moreover, it helps analyze the contribution of every item towards the profitability of the Company.
- Common Size Balance SheetCommon Size Balance SheetThe term "common size balance sheet" refers to a percentage analysis of balance sheet items based on a common figure, with each item presented as an easy-to-compare percentage. For example, each asset is expressed as a percentage of total assets, and each liability is expressed as a percentage of total liabilities.
#2 – Horizontal Analysis
In Horizontal Analysis, financial statements of the company are made to review for several 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 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 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
- Current RatioCurrent RatioThe current ratio is a liquidity ratio that measures how efficiently a company can repay it' short-term loans within a year. Current ratio = current assets/current liabilities
- Quick Ratio
- Cash RatioCash RatioCash Ratio is calculated by dividing the total cash and the cash equivalents of the company by total current liabilities. It indicates how quickly a business can pay off its short term liabilities using the non-current assets.
#5 – Turnover Ratio Analysis
The turnover Ratio primarily identifies how efficiently the company’s resources are utilized. The following Ratios are used to do Turnover Analysis –
- Accounts Receivable TurnoverAccounts Receivable TurnoverAccounts Receivable turnover, also known as debtors turnover, estimates how many times a business collects the average accounts receivable per year and is used to evaluate the company's effectiveness in providing a credit facility to its customers and timely collection. Accounts Receivable Turnover Ratio Formula = (Net Credit Sales) / (Average Accounts Receivable)
- Inventory Turnover RatioInventory Turnover RatioInventory Turnover Ratio measures how fast the company replaces a current batch of inventories and transforms them into sales. Higher ratio indicates that the company’s product is in high demand and sells quickly, resulting in lower inventory management costs and more earnings.
- Working Capital Turnover RatioWorking Capital Turnover RatioWorking Capital Turnover Ratio helps in determining that how efficiently the company is using its working capital (current assets – current liabilities) in the business and is calculated by diving the net sales of the company during the period with the average working capital during the same period.
- Asset Turnover RatioAsset Turnover RatioThe asset turnover ratio is the ratio of a company's net sales to total average assets, and it helps determine whether the company generates enough revenue to justify holding a large amount of assets under the company’s balance sheet.
- Equity Turnover RatioEquity Turnover RatioThe equity turnover ratio depicts the organization's efficiency to utilized the shareholders' equity to generate revenue. It is evaluated by dividing the total sales from the average shareholders' equity.
- Days Payable Outstanding DPODPODays Payable Outstanding (DPO) is the average number of days taken by a business to settle their payable accounts. DPO basically indicates the credit terms of a business with its creditors.
#6 – ProfitabilityProfitabilityProfitability refers to a company's ability to generate revenue and maximize profit above its expenditure and operational costs. It is measured using specific ratios such as gross profit margin, EBITDA, and net profit margin. It aids investors in analyzing the company's performance. Analysis
Profitability financial analysis helps us understand how the company generates its profit from its business activities. The following tools are used to analyze the same –
- Profit MarginProfit MarginProfit Margin is a metric that the management, financial analysts, & investors use to measure the profitability of a business relative to its sales. It is determined as the ratio of Generated Profit Amount to the Generated Revenue Amount.
- Operating Profit MarginOperating Profit MarginOperating Profit Margin is the profitability ratio which is used to determine the percentage of the profit which the company generates from its operations before deducting the taxes and the interest and is calculated by dividing the operating profit of the company by its net sales.
- EBIT Margin
- EBIDTA MarginEBIDTA MarginEBITDA Margin is an operating profitability ratio that helps all stakeholders of the company get a clear picture of the company's operating profitability and cash flow position. It is calculated by dividing the company's earnings before interest, taxes, depreciation, and amortization (EBITDA) by its net revenue. EBITDA Margin = EBITDA / Net Sales
- Earnings Before TaxesEarnings Before TaxesPretax income is a company's net earnings calculated after deducting all the expenses, including cash expenses like salary expense, interest expense, and non-cash expenses like depreciation and other charges from the total revenue generated before deducting the income tax expense.
#7 – Business Risk Analysis
Business Risk AnalysisRisk AnalysisRisk analysis refers to the process of identifying, measuring, and mitigating the uncertainties involved in a project, investment, or business. There are two types of risk analysis - quantitative and qualitative risk analysis. measures how investment in fixed assetsFixed AssetsFixed assets are assets that are held for the long term and are not expected to be converted into cash in a short period of time. Plant and machinery, land and buildings, furniture, computers, copyright, and vehicles are all examples. affects the sensitivity of the company’s earnings and the debt on the balance sheet. The top ways to analyze Business RiskAnalyze Business RiskBusiness risk is associated with running a business. The risk can be higher or lower from time to time. But it will be there as long as you run a business or want to operate and expand. is as follows –
- Operating LeverageOperating LeverageOperating Leverage is an accounting metric that helps the analyst in analyzing how a company’s operations are related to the company’s revenues. The ratio gives details about how much of a revenue increase will the company have with a specific percentage of sales increase – which puts the predictability of sales into the forefront.
- Degree of Operating LeverageDegree Of Operating LeverageThe Degree of Operating Leverage (DOL) of a company measures how a change in sales affects its operating income. A higher DOL indicates a higher proportion of fixed costs in business operations, whereas a lower DOL indicates a lower proportion of fixed costs in business operations.
- Financial LeverageFinancial LeverageFinancial Leverage Ratio measures the impact of debt on the Company’s overall profitability. Moreover, high & low ratio implies high & low fixed business investment cost, respectively.
- Degree of Financial LeverageDegree Of Financial LeverageThe degree of financial leverage formula computes the change in net income caused by a change in the company's earnings before interest and taxes. It aids in determining how sensitive the company's profit is to changes in capital structure.
#8 – Financial Risk Analysis
Here we measure how leveraged the company is and how it is placed with respect to its debt repayment capacity. Tools used to do leverage financial analysis –
- Debt to Equity RatioDebt To Equity RatioThe debt to equity ratio is a representation of the company's capital structure that determines the proportion of external liabilities to the shareholders' equity. It helps the investors determine the organization's leverage position and risk level.
- DSCR RatioDSCR RatioDebt service coverage (DSCR) is the ratio of net operating income to total debt service that determines whether a company's net income is sufficient to cover its debt obligations. It is used to calculate the loanable amount to a corporation during commercial real estate lending.
#9 – Stability Ratios
The stability ratio is used with a vision of the 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.
- Coverage Ratio FormulaCoverage Ratio FormulaThe coverage ratio is the company's ability to cover its obligations, including debt, lease obligations, and dividend in any time frame. Fixed Charge Coverage Ratio = (EBIT+ Lease payments)/ (Interest payments+ Lease payments), Interest coverage ratio = EBIT/ Interest payments, Debt coverage ratio = Cash Flow From Operations/ Total Debt.
- Interest Coverage RatioInterest Coverage RatioThe interest coverage ratio indicates how many times a company's current earnings before interest and taxes can be used to pay interest on its outstanding debt. It can be used to determine a company's liquidity position by evaluating how easily it can pay interest on its outstanding debt.
#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 FormulaEfficiency Ratio FormulaEfficiency ratios are a measure of how effectively a company manages its assets and liabilities and include formulas like asset turnover, inventory turnover, receivables turnover, and accounts payable turnover. = 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 –
- DDMDDMThe Dividend Discount Model (DDM) is a method of calculating the stock price based on the likely dividends that will be paid and discounting them at the expected yearly rate. In other words, it is used to value stocks based on the future dividends' net present value.
- Discounted Cash Flow FormulaDiscounted Cash Flow FormulaDiscounted Cash Flow (DCF) formula is an Income-based valuation approach and helps in determining the fair value of a business or security by discounting the future expected cash flows. Under this method, the expected future cash flows are projected up to the life of the business or asset in question, and the said cash flows are discounted by a rate called the Discount Rate to arrive at the Present Value.
- Trading Multiples
- Transaction Multiples ValuationTransaction Multiples ValuationTransaction multiples or Acquisition Multiple is a method where we look at the past Merger & Acquisition transactions and value a comparable company using precedents. The method assumes that a company's value can be estimated by analyzing the price paid by the acquirer company's incomparable acquisitions.
- Sum of the Parts ValuationSum Of The Parts ValuationSum of the Parts Valuation is a valuation method wherein each of the subsidiary or segment of a Company is separately valued & then all of them are added together to estimate the business’s total value.
#13 – Variance Analysis
Variance analysisVariance AnalysisVariance analysis is the process of identifying and analyzing the difference between the standard numbers that a company expects to accomplish and the actual numbers that they achieve, in order to help the firm analyze positive or negative consequences. in budgeting is the study of deviation of the actual outcome against the forecasted behavior in finance. It is essentially concerned with how the difference between actual and planned behavior indicates 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 ExcelSensitivity Analysis In ExcelSensitivity analysis in excel helps us study the uncertainty in the output of the model with the changes in the input variables. It primarily does stress testing of our modeled assumptions and leads to value-added insights. In the context of DCF valuation, Sensitivity Analysis in excel is especially useful in finance for modeling share price or valuation sensitivity to assumptions like growth rates or cost of capital.
- Data Table in ExcelData Table In ExcelA data table in excel is a type of what-if analysis tool that allows you to compare variables and see how they impact the result and overall data. It can be found under the data tab in the what-if analysis section.
- Two-Variable Data Table in ExcelTwo-Variable Data Table In ExcelA two-variable data table helps analyze how two different variables impact the overall data table. In simple terms, it helps determine what effect does changing the two variables have on the result.
- One Variable Data Table in ExcelOne Variable Data Table In ExcelOne variable data table in excel means changing one variable with multiple options and getting the results for multiple scenarios. The data inputs in one variable data table are either in a single column or across a row.
#15 – Rate of Return Analysis
The internal rate of return is a metric employed in capital budgetingCapital BudgetingCapital budgeting is the planning process for the long-term investment that determines whether the projects are fruitful for the business and will provide the required returns in the future years or not. It is essential because capital expenditure requires a considerable amount of funds., 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. The following tools can be used to rate of return analysis –
- Incremental IRRIncremental IRRIncremental IRR or Incremental internal rate of return is an analysis of the return over investment done with an aim to find the best investment opportunity among two competing investment opportunities that involve different cost structures. As the costs of two investments are different, an analysis is done on the difference amount.
- XIRR in ExcelXIRR In ExcelThe XIRR function, also known as the Extended Internal Rate of Return function in Excel, is used to calculate returns based on multiple investments made for a series of non-periodic cash flows.
- MIRR in ExcelMIRR In ExcelMIRR or (modified internal rate of return) in excel is an in-build financial function to calculate the MIRR for the cash flows supplied with a period. It takes the initial investment, interest rate and the interest earned from the earned amount and returns the MIRR.
- NPV in ExcelNPV In ExcelThe NPV (Net Present Value) of an investment is calculated as the difference between the present cash inflow and cash outflow. It is an Excel function and a financial formula that takes rate value for inflow and outflow as input.
- Payback Period & Discounted Payback PeriodDiscounted Payback PeriodThe discounted payback period is when the investment cash flow paybacks the initial investment, based on the time value of money. It determines the expected return from a proposed capital investment opportunity. It adds discounting to the primary payback period determination, significantly enhancing the result accuracy.
- 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 answers 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 financial analysis, the company can predict the future of the company and can forecast future market trends and able to do 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.
- A comparison between different companies is not possible if they adopt other accounting policies.
- 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 statementsFinancial StatementsFinancial statements are written reports prepared by a company's management to present the company's financial affairs over a given period (quarter, six monthly or yearly). These statements, which include the Balance Sheet, Income Statement, Cash Flows, and Shareholders Equity Statement, must be prepared in accordance with prescribed and standardized accounting standards to ensure uniformity in reporting at all levels. and does not take into consideration the non-monetary aspects of financial statements.
- It is based on past data in financial statements,s and future results can’t be like a past.
- Many Intangible assetsIntangible AssetsIntangible Assets are the identifiable assets which do not have a physical existence, i.e., you can't touch them, like goodwill, patents, copyrights, & franchise etc. They are considered as long-term or long-living assets as the Company utilizes them for over a year. are not recorded in the statement, due to Intangible assets don’t consider while doing financial analysis.
- It is limited to a specific time period and not always comparable with different company’s statement due to different accounting policiesAccounting PoliciesAccounting policies refer to the framework or procedure followed by the management for bookkeeping and preparation of the financial statements. It involves accounting methods and practices determined at the corporate level..
- 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.
It is the systematic process of analyzing or examination of financial informationFinancial InformationFinancial Information refers to the summarized data of monetary transactions that is helpful to investors in understanding company’s profitability, their assets, and growth prospects. Financial Data about individuals like past Months Bank Statement, Tax return receipts helps banks to understand customer’s credit quality, repayment capacity etc. 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 statementCash Flow StatementA Statement of Cash Flow is an accounting document that tracks the incoming and outgoing cash and cash equivalents from a business. of the company.
Analysis and examination of Financial statements are essential tools in assessing the company’s health, and it provides information to company management. 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 methodsFinancial Analysis MethodsFinancial analysis tools are different ways or methods of evaluating and interpreting a company’s financial statements for various purposes like planning, investment and performance. as mentioned above, the company can predict the future of a company or individual projects, and it helps company management to make decisions 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 article 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 –