Types of Financial Analysis

Types of Financial Analysis

The financial analysis examines and interprets data by 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.

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Source: Types of Financial Analysis (wallstreetmojo.com)

List of Top 10 Types of Financial Analysis

1. 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.read more
2. Vertical Analysis
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.read more
4. Liquidity AnalysisLiquidity AnalysisLiquidity shows the ease of converting the assets or the securities of the company into the cash. Liquidity is the ability of the firm to pay off the current liabilities with the current assets it possesses.read more
5. Solvency Analysis
6. Profitability Analysis
7. Scenario & Sensitivity Analysis
8. 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
9. Valuation Analysis
10. 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.read more measures the financial statements line of items with the base year. That means 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 statement 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.read more. 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 statements in final form.

• Cons – It solely represents a single period’s data, so it avoids comparison across different time phases.

To learn more on vertical financial analysis, you 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. read more
• 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 100read more
• 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.read more

#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

The short-term analysis 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.read more, 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.read more 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 read more, 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). read more 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. read more, 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.read more,  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 assetsread more, 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 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. read more
• 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.read more
• 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.read more
• 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 Salesread more
• 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.read more

#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  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.read more concerning each factor and analyze their effects on the company financials.

You 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.read more
• 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.read more
• 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.read more

#8 –  Variance Analysis

The business operates on estimates and budgets after completing transactions. Not to forget, it is also crucial to check the variance between 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 in the future. 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.read more technique comparing with estimated, standard, and actual costs.

#9 – Valuation

Valuation analysis means deriving the company’s fair valuation. You 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.read more
• 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.read more
• 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.read more
• 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. read more

#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.read more (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 it shall be published and unpublished. Furthermore, such analysis helps top management adopt preventive strategies that can help avoid any major setback.

Conclusion

Nowadays, financial analysis is considered the main ingredient in business activity. Without this, running a business may be futile. Hence, executing economic research and carefully handling it is necessary for every organization. Considerably, they should also duly implement all the analysis findings.

Recommended Articles

This article has been a guide to Types of Financial Analysis. Here, we discuss the top 10 types of financial analysis with their advantages and disadvantages. You may learn more about financial analysis from the following articles: –

• Financial Ratios Types
• Financial Ratios Overview
• Importance of Ratio Analysis
• Advantages of Ratio Analysis