Financial Analysis

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 –

Financial-Analysis

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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 of Colgate Income Statement

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.read more. 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.read more, 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 –

#2 – Horizontal Analysis

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

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 - Current Ratio

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

Accounts Receivables Turnover Ratio

The turnover Ratio primarily identifies how efficiently the company’s resources are utilized. The following Ratios are used to do Turnover 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.read more Analysis

Gross Profit

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 –

#7 – Business Risk Analysis

Operating Leverage

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.read more 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.read more 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.read more is as follows –

#8 – Financial Risk Analysis

Seadrill DSCR calculation - 4

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 –

#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.

fixed asset ratio

#10 – Coverage Analysis

interest-coverage-ratio

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

#12 – Valuation Analysis

Valuation Methods

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 Analysis2

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.read more 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

Alibaba Valuation Summary - manual 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

IRR example 1

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.read more, 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 –

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 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.

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 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

Conclusion

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.read more 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.read more 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.read more 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.

Recommended Articles

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 –

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