What is Financial Analysis

Financial Analysis

Financial analysis is the use of financial data and information to evaluate the performance of a company and come up with strategies and recommendations as to how to improve its operations.

Financial analysts are people who study and help analyse the historical data of a company and make predictions about its future performances.

Types of Financial Analysis

There are various kinds of financial analysis, which are:

  • Vertical Analysis
    This is a form of analysis where different components of an income statement are taken into consideration and then segregated on the basis of revenue to express them as a percentage. Results obtained are often compared with that of other companies in a similar industry to get a better overview of the company performance.
  • Horizontal Analysis
    This form of financial analysis involves the study of extensive financial data gathered over a couple of years which are then compared with each other to determine their rate of growth over time. This helps in understanding whether a certain organisation is growing or falling.
  • Leverage Analysis
    Highly popular among financial analysts, leverage ratios are used in the evaluation of an organisation’s performance. While complete debt is considered as a single financial metric and may not be completely helpful on its own, it can be evaluated against the total equity of a company to understand its complete capital structure.
  • Growth Rates
    Another big aspect of financial analysis is understanding growth rates and making predictions or projections regarding the same. Here are a couple of examples of how growth rate analysis is conducted:

    ● Regression analysis
    ● Year on year
    ● Bottom-up analysis
    ● Top-down analysis

  • Profitability Analysis
    This is a variation of an income statement analysis to understand if the economics of any business is in place or not. Here is how profitability analysis is conducted:

    ● Net profit margin
    ● Gross margin
    ● EBIT margin
    ● EBITDA margin

  • Liquidity Analysis
    This kind of financial analysis depends on the balance sheet of an organisation, mostly to understand if the short term obligations of a company have been met or not. Common methods of liquidity analysis are:

    ● Acid test
    ● Cash ratio
    ● Current ratio
    ● Net working capital

  • Efficiency Analysis
    Efficiency ratios are analysed to understand if an organisation can manage its assets well and effectively use them in cash flow and revenue generation. Most efficiency ratios are:

    ● Cash conversion ratio
    ● Inventory turnover ratio
    ● Asset turnover ratio
    ● Fixed asset turnover ratio

  • Cash Flow Analysis
    Any organisation’s ability to generate cash flow is one of the most crucial factors in the field of finance. Analysts usually start from the cash flow statement to understand the operating procedure of any company including their investing histories and finance activities. Common cash flow analysis methods are:

    ● Free cash flow
    ● Operating cash flow
    ● Free cash flow to the equity
    ● Free cash flow to the firm

  • Return Rates
    Analysing return on investment (ROI) is very crucial in the finance sector since investors are always concerned about the rate of return they can earn on the money they have invested. Common rates of return analysis include:

    ● Return on assets
    ● Return on equity
    ● Return on invested capital
    ● Capital gain
    ● Dividend yield
    ● Internal rate of return
    ● Accounting rate of return

  • Valuation Analysis
    The valuation of a business is an important part of financial analysis; financial analysts often spend time building financial models to understand this. There are quite a few approaches for valuation analysis, which can be:
    ● Market approach of relative value
    ❖ Precedent transactions
    ❖ Comparable company analysis
    ● Cost approach
    ❖ The cost of building or replacing
    ● Intrinsic value
    ❖ Discounted cash flow analysis
  • Sensitivity and Scenario Analysis
    Risk measurement of any business is conducted by the method of sensitivity and scenario analysis during financial modeling. This procedure is to value and predict the future of a company. Performing a sensitivity test could help understand if the future of a company might be at stake, which is why financial planning and analysis is essential. This also helps an organisation prepare budgets and make future predictions.
  • Variance Analysis
    A form of financial analysis, it is the method of comparing the budget or a forecast to the actual projections or results. Variance analysis is important for the finance and accounts departments of a company since it helps in budgeting, internal planning, and operations.

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