Financial Analysis (Definition, Guide)

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 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 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 sheet. The assets, liabilities, and shareholder’s 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 –

#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.

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#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 –

#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 affects the sensitivity of the 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

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.

#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 –

#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 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 –

#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 in Excel
MIRR in Excel
NPV in Excel
Payback Period & Discounted Payback Period

Advantages

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 future market trends and able to make future planning.

Disadvantages

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 different 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 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.

Conclusion

It 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.

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 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.

Financial Analysis