As one of the essential tools in business activity, financial analysis helps companies to identify performance and capability. There are many types of financial analysis reports that guide businesses to achieve their objectives and help investors make important investment decisions. Join us as we explore the 12 types of financial analysis, how they provide key financial information, and what purpose they serve.
What Is Financial Analysis?
Financial analysis is essential for evaluating an organization's financial information, like financial statements, ratios, and other data, to make informed business decisions. It can also be used for evaluating economic trends, building long-term plans for business activity, setting financial policy, and identifying projects or companies for investment.
The primary goals of financial analysis include:
- Liquidity: A primary objective of financial analysis is to assess a company's ability to meet short-term obligations like routine expenses.
- Solvency: Another primary goal of financial analysis is a long-term analysis of a company's overall financial stability. Solvency analysis is also valuable to ensure the company meets its long-term obligation.
- Profitability: Financial analysis also serves to examine the company's capacity to generate revenue over a specific period, be it short-term or long-term.
- Stability: Another goal of financial analysis is to show the company's ability to maintain its overall financial health in the long run.
It also aids companies in assessing their financial performance, making informed decisions, planning for the future, and ensuring compliance with regulations. Financial analysis can be crucial in various instances, such as investment decisions, credit approval, mergers and acquisitions, internal management decisions, stakeholder communication, forecasting and planning, and investor relations.
12 Types of Financial Analysis
Here are the various types of financial analysis:
1. Vertical
Vertical analysis involves looking at various income statement components and then dividing them by total revenue or assets to create a percentage. They are most commonly used on income statements, balance sheets, or cash flow statements. It allows businesses to see the correlation between single items and the bottom line and to analyze operational differences at the same base. Moreover, it helps them understand how expenses affect their overall net profit.
2. Horizontal
On the other hand, horizontal analysis interprets the changes in financial statements over two accounting periods like Year over Year (YoY) or Quarter over Quarter (QoQ). Horizontal analysis helps companies to compare financial data over time, highlighting trends, patterns, and changes in performance. This way, they can make informed decisions as they can evaluate financial stability, identify risks and opportunities, and track progress. Making accurate horizontal analysis requires selecting several years of financial data, with the oldest year serving as a baseline. Each year is then compared to the baseline, creating a percentage to easily identify which accounts are growing and which are shrinking.
3. Liquidity
Liquidity analysis is an important type of financial analysis that focuses on short-term research of routine expenses like short-term borrowings, salaries, statutory payments, etc. It analyzes the availability of liquid assets to cover current liabilities. This ensures the company can operate smoothly without failing cash flow problems and maintain its day-to-day operations. Examples of liquidity analysis are net working capital, cash ratio, acid test, current ratio, etc.
4. Profitability
The profitability analysis shines a light on how companies generate revenue. This type of income statement analysis is helpful for investors, as it helps check the rate of return in a given period and assures them of the safekeeping of funds. The analysis can be broken down into profits by product, geographic region, individual store, product line, subsidiary, etc. Examples of profitability measures include the EBIT margin, net profit margin, gross margin, and EBITDA margin.
5. Scenario and Sensitivity
Another type of financial analysis is scenario and sensitivity analysis. The treasury department conducts this type of analysis, and it helps companies understand the effects of factors like banking rates, changes in tax structures, economic outlook, etc. Moreover, they can help companies to prepare budgets and forecasts. Scenario and sensitivity analysis are ways to measure risk, so building scenarios and performing sensitivity analysis can aid companies in determining what their best-case and worst-case future can look like.
6. Variance
The variance analysis is a helpful type of financial analysis that studies the deviations of the actual behavior versus the forecasted or planned behavior in budgeting to understand the impact on the business performance. This makes variance analysis a critical tool to identify where the business succeeded or fell short. It can be broken down into two steps: calculating and recording individual variances and understanding the cause of each variance. Some causes of variances can be changes in market conditions, idealistic budgeting standards, certain activities that cannot be planned accurately, etc. By understanding the causes and reasons behind variances, management is able to make informed decisions and adjust strategies to increase efficiency.
7. Valuation
Valuation analysis is also a helpful process to estimate the approximate value of an asset, be it real estate, business, commodity, equity, or other assets. The value of an asset represents the present value (PV) of all future cash the asset is forecasted to produce. The valuation process involves a series of assumptions regarding financing costs, tax rates, capital expenditures, sales growth, etc. There are different ways financial analysts can approach the assessment of the value of an asset, which can be the cost approach, intrinsic value, and relative value. Or they can combine them to derive a range of possible valuations.
8. Leverage
Leverage analysis is another tool financial analysts utilize to evaluate a company's performance. The leverage ratio measures how much capital comes in the form of debt. Or it assesses the company's ability to meet its financial obligations. As companies rely on a mix of equity and debt to finance their operations, leverage ratios can give the company an idea of how changes in output will affect the operating income. Examples of leverage ratios include Dupont analysis, EBIT/interest (interest coverage), Debt/EBITDA, and Debt/equity.
9. Growth
Growth analysis is an important tool for informing investors on how a company performs and pinpointing undervalued companies. Financial analysts spend considerable time analyzing historical growth rates and projecting future ones to understand how things can change over time.
Examples of growth analysis include regression analysis, YoY, bottom-up analysis (starting from the individual drivers of revenue), top-down analysis (starting with market size and share), and others.
10. Efficiency
Efficiency analysis is an essential type of financial analysis to inspect how well an organization manages its assets and utilizes them to generate revenue and cash flow. An efficiency ratio analysis includes the asset turnover ratio, inventory turnover ratio, and receivables turnover ratio. The asset turnover ratio measures an organization's ability to generate revenues from its assets efficiently. Simply said, it shows how many sales are generated from each dollar of assets.
The inventory turnover ratio measures an organization's ability to manage its inventory efficiently and provides insight into sales. This ratio helps financial analysts determine if enough sales are generated to utilize the inventory.
Lastly, the receivables turnover ratio measures how efficiently an organization can collect its debt and extend its credits. Financial analysts divide the organization's net credit sales by its average accounts receivable to calculate this ratio.
11. Cash Flow
An integral part of a business’s success is the ability to generate cash flow. So, financial analysts across a wide range of industries spend a great deal of time and effort looking at cash flow profiles. Cash flow analysis also provides insights into its liquidity position, working capital management, and overall financial health. Moreover, it showcases the businesses' ability to meet their financial obligations and to invest in growth opportunities. Simply said, a cash flow statement shows how much money a business has after taking care of expenses.
A cash flow statement includes sections like operating activities, investing activities, and financing activities. Although the details and format of cash flow statements are different for every business, they include the same general information like expenses and business income.
Examples of cash flow analysis include free cash flow (FCF), operating cash flow (OCF), free cash flow to equity (FCFE), and free cash flow to the firm (FCFF).
12. Rates of Return
Lastly, an important type of financial analysis is the rate of return (RoR), which helps investors, financial professionals, and lenders measure an investment's profit or loss over a set period of time. The RoR can be used for any kind of investment, dealing with any kind of asset like stocks, bonds, art, and real estate. Common examples of RoR measures can be capital gain, return on invested capital (ROIC), return on assets (ROA), return on equity (ROE), internal rate of return (IRR), etc.
The Bottom Line
Financial analysis helps review a company's performance over time, assess the current position and operational efficiency, predict growth and profitability prospects, identify weaknesses and strengths, and help companies make informed decisions about financing activities, business operations, and investments.
Different types of financial analysis include valuation, variance, horizontal analysis, vertical analysis, liquidity, profitability, cash flow analysis, and more, which serve various purposes for analyzing a company's overall financial health.
As we've explored all these types of financial analysis and more, we've shown how a career as a financial analyst can be intriguing and exciting. If you're considering a career in finance, check out our online MS Financial Analysis program.
Frequently Asked Questions (FAQs):
What are the five goals of financial analysis?
Financial analysis is a crucial tool that serves many purposes and is essential to a company's financial success. That said, the main goals of financial analysis include liquidity, profitability, solvency, stability, and aiding companies, investors, or interested parties to make informed financial decisions.
What are the four major financial statements?
Financial statements are informative documents that convey an organization's business activity and financial performance. The four major financial statements of an organization are the balance sheet, which presents an organization's assets, liabilities, and shareholder's equity at a given time; the income statement, which summarizes an organization's revenues, net income or loss, and expenses over a specific time; cash flow statement, which monitors the inflows and outflows of cash; and the statement of shareholders' equity, which outlines the shareholders' equity changes over a period.
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