What Are The Types Of Financial Analysis?
The financial analysis examines and interprets data of various types according to their suitability. The most common types of financial analysis are vertical analysis, horizontal analysis, leverage analysis, growth rates, profitability analysis, liquidity analysis, efficiency analysis, cash flow, rates of return, valuation analysis, scenario and sensitivity analysis, and variance analysis.
Financial analysis means scrutinizing the financial statement to reach a productive outcome that helps investors and other stakeholders maintain their relationship with the company. There are numerous types that experts and analysts use to analyze financial information.
Table of contents
- Financial analysis is the evaluation method for business and finance-oriented transactions to identify performance and capability.
- The top 10 types of financial analysis are horizontal analysis, vertical analysis, trend analysis, liquidity analysis, solvency analysis, liquidity analysis, scenario & sensitivity analysis, variance analysis, valuation analysis, and FP&A analysis.
- Financial analysis is said to be the essential ingredient in business activity.
- Without financial analysis, running a business may be futile. Therefore, executing economic research and carefully handling it is necessary for every organization.
Types Of Financial Analysis Explained
The types of financial analysis ratios are considered the main ingredient in business activity. With this, running a business successfully is possible. Hence, executing and carefully handling economic research is necessary for every organization. Considerably, they should also duly implement all the analysis findings.
There are many types of financial analysis reports that are very useful and frequently used in the business to achieve its objectives. Trend analysis explains the market trend of the entity over a period of time for which past data and chart patterns are used for interpretation. Similarly, profitability, solvency or liquidity analysis tell the financial condition of the company that is used by analysts and investors for making important investment decisions. Even cash flow and valuation analysis says the inflow and outflow of cash in the business and the current valuation of the company.
In this way, various types of financial analysis in management accounting are used. Studies and evaluations consider the financial data of the past and current year, which the management uses for decisions related to investment in projects, technology, innovation, changes in operation procedures, or any alteration in the products and services. Moreover, the other stakeholders, like lenders and investors, use them to decide their expected return on investment or the company’s creditworthiness.
Different Types Of Financial Analysis
Given below are some of the common types of financial analysis ratios using financial data that companies frequently use during their day-to-day operations.
- 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.
- Vertical Analysis
- 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.
- Liquidity AnalysisLiquidity AnalysisLiquidity is the ease of converting assets or securities into cash.
- Solvency Analysis
- Profitability Analysis
- Scenario & Sensitivity 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.
- Valuation Analysis
- FP&A Analysis
Now, we will discuss the above-described ratios with a detailed explanation.
#1 – Horizontal Analysis
The 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. measures the financial statements line of items with the base year. It compares the figures for a given period with the other period.
- Pros – It helps to analyze the company’s growth from year on year or quarter on quarter with the increase in operations of the company.
- Cons – The company operates in the industrial cycle. Therefore, if the industry is downgrading despite the company’s better performance owing to specified factors that impact the industry, trend analysis will indicate the negative growth in the company
#2 – Vertical Analysis
The vertical analysis measures the line items of the 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. or balance sheet by taking any line item of the financial statement as a base and disclosing the same in percentage form.
For example, the income statement discloses all the line items in percentage form by taking base as net salesNet SalesNet sales is the revenue earned by a company from the sale of its goods or services, and it is calculated by deducting returns, allowances, and other discounts from the company's gross sales.. Similarly, the balance sheet on the asset side reveals all the line items in the percentage form of total assets.
- Pros – The vertical analysis helps compare the entities of different sizes as it presents the 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. in final form.
- Cons – It solely represents a single period’s data, so it avoids comparison across different time phases.
To learn more about vertical financial analysis, we may refer to the following articles: –
- Income Statement Vertical AnalysisIncome Statement Vertical AnalysisVertical 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.
- The Formula of Vertical AnalysisFormula Of Vertical AnalysisVertical 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
- Income statement common size
- Balance Sheet Common SizeBalance Sheet Common SizeThe 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.
#3 – Trend Analysis
Trend analysis means identifying patterns from multiple periods and plotting those in a graphical format to derive actionable information.
#4 – Liquidity Analysis
This method is equally important among various types of financial analysis in management accounting. The short-term research focuses on routine expenses. It analyzes the short-term capability of the company for day-to-day payments of trade creditorsTrade CreditorsThe term "trade credit" refers to credit provided by a supplier to a buyer of goods or services. This makes it is possible to buy goods or services from a supplier on credit rather than paying cash up front., short-term borrowings, statutory payments, salaries, etc. Its main objective is to verify that the appropriate liquidity is maintained thoroughly for the given period and that all liabilities are met without default.
The short-term analysis is carried out using ratio analysis techniqueTechnique Of Ratio AnalysisRatio analysis is the quantitative interpretation of the company's financial performance. It provides valuable information about the organization's profitability, solvency, operational efficiency and liquidity positions as represented by the financial statements. that uses various ratios like liquidity ratio, 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, etc.
#5 – Solvency Analysis
The long-term analysis is also termed solvency analysis. The focus of this analysis is to ensure the good solvency of the company quickly and check whether the company can pay all the long-term liabilitiesLong-term LiabilitiesLong Term Liabilities, also known as Non-Current Liabilities, refer to a Company’s financial obligations that are due for over a year (from its operating cycle or the Balance Sheet Date). and obligations. It gives stakeholders confidence about the entity’s survival with proper financial health.
Solvency ratios like 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. , equity ratioEquity RatioEquity ratio is the solvency ratio which helps in measuring the value of the assets which are financed using the owner’s equity. In simple words, it is a financial ratio that is used to measure the proportion of owner’s investment used to finance the assets of the company and it indicates the proportion of owner’s fund to total fund invested in the business and it is calculated by dividing the total equity of the company by its total assets., debt ratioDebt RatioThe debt ratio is the division of total debt liabilities to the company's total assets. It represents a company's ability to hold and be in a position to repay the debt if necessary on an urgent basis. Formula = total liabilities/total assets, etc., give an accurate picture of the financial solvency and burden on the firm in the form of external debts.
#6 – Profitability Analysis
Profitability financial analysis helps us understand how the company generates revenue.
The decision related to investment is one of the critical decisions of all business people that ensure the maximum profit from the investment made in the project. To verify the decision’s viability, they need to conduct a profitability analysis to check the rate of return in a given period. These will help the investor in obtaining assurance of the safekeeping of funds.
The following tools are used to analyze the same: –
- Profit margin calculationProfit Margin CalculationProfit 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 margin calculationOperating Profit Margin CalculationOperating 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 calculationEBIT Margin CalculationEBIT Margin is a profitability ratio that is used to determine how successfully and efficiently a business can manage its operations. The formula is as follows: Gross Profit/Total Sales*100.
- EBIDTA margin calculationEBIDTA Margin CalculationEBITDA 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 taxes calculationEarnings Before Taxes CalculationPretax 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 – Scenario & Sensitivity Analysis
In business, day in and day out, various changes continue to emerge depending on the economic outlook, varied changes in tax structures, banking rates, duties, etc. Each of these determinants highly affects the financials. Therefore, the treasury department must conduct a sensitivity analysisSensitivity AnalysisSensitivity analysis is a type of analysis that is based on what-if analysis, which examines how independent factors influence the dependent aspect and predicts the outcome when an analysis is performed under certain conditions. concerning each factor and analyze their effects on the company’s financials.
Among various types of financial analysis we can use the following to do sensitivity analysis: –
- Sensitivity Analysis
- Data table using excelData Table Using 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 using ExcelTwo-Variable Data Table Using 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 using ExcelOne Variable Data Table Using 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.
#8 – Variance Analysis
The business operates on estimates and budgets after completing transactions. It is also crucial to check the variance between the budget and assessments with the actual one. This variance analysis will prevent any loopholes in the process and help an entity take corrective actions to avoid the same. Variance analysis can be carried out by standard costingStandard CostingStandard cost is an estimated cost determined by the company for the production of the goods and services or for performing an operation under normal circumstances and are derived by the company from the historical analysis of the data or from the time and the motion studies. technique comparing estimated, standard, and actual costs.
#9 – Valuation
Valuation analysis means deriving the company’s fair valuation. We may employ one of the following valuation financial analysis tools: –
- Dividend discount modelDividend Discount ModelThe 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.
- DCF formulaDCF 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.
- Relative valuation multiples
- Transaction multiplesTransaction MultiplesTransaction 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.
- SOTP valuationSOTP 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.
#10 – FP&A Analysis
Every company has its Financial Planning and AnalysisFinancial Planning And AnalysisFinancial planning and analysis (FP&A) is budgeting, analyzing, and forecasting the financial data to align with its financial objectives and support its strategic decisions. It helps investors to know if the company is stable and profitable for investment. (FP&A) department to analyze the internal organization’s various data points and construct the Management Information System (MIS) to report to the top management. The MIS is vital for the company and shall be published and unpublished. Furthermore, among various types of financial analysis, such analysis helps top management adopt preventive strategies that can help avoid any major setbacks.
Let us take a simple example to understand the concept.
We assume ABC Ltd plans pharmaceutical sector, plans to invest money into expansion. It wants to open more retail stores in a few prominent parts of the city and in rural areas. But to achieve this aim, the company has to do a solvency analysis to check the debt-bearing capacity, make a robust cash flow analysis to track whether its collection methods are research, conduct horizontal and vertical analysis to study its overall performance, etc.
Thus, companies do various types of financial analysis reports with their financial data during different decision-making processes.
Frequently Asked Questions (FAQs)
The basic types of financial analysis are horizontal, vertical, leverage, profitability, growth, liquidity, cash flow, and efficiency. The two main types of financial analysis are fundamental analysis and technical analysis.
A financial analysis’s main objective is to determine whether a given organisation is secure, solvent, liquid, or profitable enough to justify a financial investment. It is employed to assess financial trends, establish monetary policy, create long-term corporate activity plans, and choose investments in projects or businesses.
The three tools of financial analysis are ratios analysis, vertical analysis, and horizontal analysis.
The primary type of financial analysis models are accounting models and quantitative models.
This article is a guide to what are Types Of Financial Analysis. We explain different types of it along with example. You may learn more about financial analysis from the following articles: –