Understanding Financial Analysis
Financial analysis is the practice of evaluating a company’s financial performance based on financial data. The information gathered in these analyses can help companies make important business decisions and identify potential areas of growth. Financial analysis is important for both short-term and long-term business success.
There are many different types of financial analysis, which often rely on a company’s financial statements and certain financial ratios. This information helps companies compare their data points to others in the industry, as well as observe their progress over time.
Why is Financial Analysis Useful?
Financial analysis is critical for businesses, since it helps them gauge their financial success and make important business decisions moving forward. The various types of analyses and ratios we’ve discussed give company leaders important information about the company, its profitability, its cash flow, and more.
While financial analysis is critical for businesses, it’s also useful for investors. Much of the information that companies rely on during financial analysis is also available to individuals using the financial statements companies must file with the Securities and Exchange Commission. As a result, individual investors can use financial analysis to make important investment decisions.
The 12 Types of Financial Analysis
There are a dozen key types of financial analysis, each of which is used for a different purpose and gives companies different information to help them in their decision-making.
Vertical analysis involves studying the relationship between different information on a company’s income statement. Companies can divide different data points by their revenue to find important percentages such as the gross profit ratio, operating profit ratio, net profit ratio, and more.
Vertical analysis generally looks at a single financial period, which companies can then compare to the same ratios for previous financial periods or to the same ratios from other companies in the industry.
While vertical analysis only looks at information from a single financial period, horizontal analysis looks at information over many financial periods to compare changes in a company’s finances. Horizontal analysis uses much of the same information as vertical analysis, including a company’s revenue, profit, operating income, and more from its financial statement.
Horizontal analysis generally takes into account information from at least three years of financial statements to look at changes over time. Companies can also compare these ratios with other companies in the industry for the same periods.
Leverage refers to a company’s use of borrowing to facilitate financial growth. During leverage analysis, a company evaluates certain leverage ratios, including debt to equity, debt to EBITDA, EBIT to interest, and more. These ratios are helpful because they can help a company determine how well they’re using debt, their ability to repay their debts, and whether they are over-leveraged. Leverage ratios are often more helpful than simply looking at the amount of debt a company has since they take other factors into account as well.
A company’s growth rates describe the change over time of a specific financial variable. When companies do growth rate analysis, they generally look at factors such as their revenue, earnings, and more. Analysis can then use these growth rates to project future growth.
Some of the common growth rates that companies look at include:
- Year-over-year (YOY) simply measures the growth of a particular metric, such as revenue, from one year to the next.
- Regression analysis studies the relationship between a dependent variable and one or more independent variables, which can be useful in determining how certain factors affect revenue.
- Bottom-up analysis involves the use of microeconomic factors to determine how they affect a company’s revenue.
- Top-down analysis involves the use of macroeconomic factors to determine how they affect a company’s revenue.
Profitability is perhaps the most important objective of a company, making profitability analysis critical. This type of analysis uses a company’s income statement to calculate certain ratios that show its rate of return.
Some of the ratios that can be found using profitability analysis include gross profit margin, operating profit margin, net profit margin, return on investment, return on equity, and more. When a company does profitability analysis, it may compare its ratios to other companies for the same period or to previous financial periods of its own financial statements.
Liquidity generally refers to access to cash. And for a company, liquidity analysis can help it measure its ability to access the cash needed to meet its short-term obligations, which are those due within the next year.
The simplest way to do liquidity analysis is to find a company’s current ratio, which is its current assets divided by its current liabilities. Other examples of liquidity analysis may include the acid test, cash ratio, and net working capital. Each of these helps a company determine whether it can meet its financial obligations.
Efficiency for a company generally refers to how well it uses its assets to generate revenue and cash flow. One of the ways efficiency analysis is done is by calculating the asset turnover ratio, which measures how efficiently a company turns its assets into sales. The higher a company’s asset turnover ratio, the more efficiently it operates.
Other ratios used in efficiency analysis include the fixed asset turnover ratio, cash conversion ratio, and inventory turnover ratio. Companies can compare these ratios to those of other companies to measure how efficiently they use their assets compared to their competitors.
A company’s cash flow is the money transferred in and out of the business. Being able to generate cash flow is an important sign of a company’s financial health. Using cash analysis, companies can get an idea of their cash flow, including their operating cash flow, free cash flow, and more.
Cash flow analysis is generally done using a company’s statement of cash flow, which summarizes its operating activities, investing activities, and financing activities. Using this information, companies can learn where their money is coming in from, as well as where it’s going to.
Rates of Return
Rates of return analysis involves determining the return on investment of various parties. Rate of return is important for investors, because it shows them whether they’ve made a good investment in a particular company. Rate of return analysis also helps the company to see how well they’ve used money from various sources. A few types of rate of return analysis include return on equity, return on assets, return on invested capital, internal rate of return, and more.
Valuation analysis is the process of determining what a company is worth. It’s important in many situations, including when a company is trying to raise capital or is being acquired by another company. There are many approaches to valuation, each of which uses a different set of information and calculations to determine the value of a company.
Some of the most popular methods of valuation include the cost approach; the relative value approach, which uses comparable company analysis; and the intrinsic value, which uses discounted cash flow analysis.
Scenario & Sensitivity
Scenario and sensitivity analysis is a way for companies to measure risk by measuring the likely outcome of different best-case and worst-case scenarios. These calculations allow a company to determine how certain independent variables may affect certain dependent variables, and to measure how sensitive those dependent variables are.
Scenario and sensitivity analysis is an important forecasting tool for businesses. They can use it to make future business decisions based on what they believe the ultimate outcome will be.
Variance analysis involves comparing budgeted or forecasted numbers with actual results. For example, a company might use variable analysis to determine whether it was on track with its spending, or whether it needs to change its forecast for future financial periods.
Not only is variance analysis important for learning what happened, but also why it happened. When a company’s results are different from its forecast, it can look at different variables and determine why to ensure it’s more accurate moving forward.
Author is not a client of Personal Capital Advisors Corporation and is compensated as a freelance writer.
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