Types of Financial Analysis
Types of financial analysis is analyzing and interpreting data by various types according to their suitability and 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 the analysis of the financial statement to reach up to the productive conclusion, which will help the investors and other stakeholders to maintain their relationship with the company, and there are various types that experts and analysts use to do a post-mortem of financial statements.
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.
- #2 – Vertical Analysis
- #3 – Trend Analysis
- #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.
- #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.
- #9 – Valuation Analysis
- #10 – FP&A Analysis
Further, 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. That means it compares the figures for a given period with the other period.
- Pros – It helps to analyze the growth of the company from year on year or quarter on quarter with the increase in operations of the company.
- Cons – The company operates in the industrial cycle, and if the industry is downgrading in spite of the company is performing better, due to specified factors that affect the industry, trend analysis will show negative growth in the company.
#2 – Vertical Analysis
The vertical analysis measures the line item of the income statement or balance sheet by taking any line item of financial statement as a base and will disclose the same in percentage form.
For example, in Income Statement, to disclose 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.. Likewise, in the Balance sheet on the asset side to disclose all the line items in the percentage form of total assets.
- Pros – The vertical analysis helps in comparing the entities of different sizes, as it presents the financial statements in absolute form.
- Cons – It represents the data of a single period only, so miss comparison across different time phase
To learn more on Vertical Financial Analysis, you can 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.
- 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 time periods and plotting those in a graphical format such that actionable information could be derived.
#4 – Liquidity Analysis
The short-term analysis focus on routine expenses. It analyses the short-term capability of the company with respect to 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 intent is to verify the appropriate liquidity being maintained thoroughly for the given period, and all the liabilities are being met without any default.
The short-term analysis is carried out using the technique of ratio analysisTechnique 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., which 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 as Solvency analysis. The focus under this analysis is to ensure the proper solvency of the company in the near future and to check whether the company is able to 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 survival of the entity 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 Ratio, 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 a correct 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
The investment decision is one of the most important decisions to be taken by all the businessperson. The main aim of all the investment decisions is to ensure the maximum profit out of the investment made in the project. In order to verify the viability of the decision, they carry out profitability analysis, which will check the rate of return in a given period. This 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 keep on coming. In addition, based on the economic outlook, different kinds of changes in tax structures, banking rates, duties, etc. Each of these determinants highly affects the financials; hence it is of utmost importance that the treasury department does such 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. with respect to each factor and try to analyze the effect of the same with the company financials.
You can use the following to do sensitivity analysis –
- Sensitivity Analysis
- Data Table using Excel
- Two-Variable Data Table using Excel
- 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
Business runs on estimates and budgets; after the completion of transactions, it is of utmost importance to check the variance in between budget and estimates with the actuals one. Such variance analysis will help in checking any loopholes in the process, and hence it will help an entity to take corrective actions for avoidance of 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. technique, comparing budgeted, standard, and actual costs.
#9 – Valuation
Valuation analysis means deriving the company’s fair valuation. You may use one of the following valuation financial analysis tools –
- Dividend Discount Model
- 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 will have its own 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 whose main work is to analyze the internal organization’s various data points and to construct the Management Information System (MIS), which will be reported to top management. Such MIS circulated by the FP&A department is of the highest importance for the company as there will be both published as well as unpublished information. Such analysis helps top management to adopt strategies which will be preventive in nature and can help in avoiding any major setback.
Financial analysis is nowadays considered as the main ingredient in business activity; without this, to run a business will turn out to be futile. Hence for every organization, to do financial analysis is not only necessary but to handle the same diligently, and all the findings of the analysis should get duly implemented.
This article has been a guide to Types of Financial Analysis. Here we discuss the top 10 types of financial analysis along with its advantages and disadvantages. You can learn more about financial analysis from the following articles –