Types of Financial Analysis

What Are the Types of Financial Analysis?

Financial analysis ratios of various kinds are regarded as the key component of corporate activity. This makes it feasible to run a firm successfully. Therefore, doing and processing economic research with care is essential for every organization. They should carefully execute all of the analysis's findings.

Financial analysis comes in a wide variety of forms, all of which are extremely helpful and regularly utilized in the company to accomplish goals. A trend analysis interprets an entity's market trend over a period of time using historical data and chart patterns.

Similarly, this profitability, solvency, or liquidity analysis provides information about a company's financial health that analysts and investors use to make critical investment decisions.

Even cash flow and valuation analyses reveal the influx and outflow of cash within the company as well as its current market value.

The types of financial analysis discussed in the article are as follows:

1. Vertical Analysis
2. Horizontal Analysis
3. Ratio Analysis
4. Valuation Analysis
5. Variance Analysis
6. Cash Flow Analysis
7. FP&A Analysis
8. Sensitivity & Scenario Analysis

What Is Financial Analysis?

Financial Analysis is the study involving the assessment of financial information for making business and investment decisions. It involves the scrutiny of financial statements to assess company health and create well-informed decisions.

Financial analysis, also known as financial statement analysis or accounting analysis. It refers to an assessment of the feasibility, steadiness, and profitability of a business, strategic business units, or projects.

It is performed by professionals who prepare reports using ratios and other techniques that make use of information taken from financial statements and other reports.

It's the process of financially assessing businesses, projects, budgets, and other finance-related decisions. The financial data is used for the following

• Assess a company's performance

• Project the statements

• Make recommendations.

The financial statements include the Income Statement, Balance Sheet, and Statement of Cash Flows.

Analysts use historical information and data from financial statements so that value can be projected over multiple years. These values can identify trends, project profitability, value cash flows, and solvency. 

A deep understanding of the 3 Financial Statements is crucial to making an analysis and recommendation on them.

There are multiple ways to value and analyze a company depending on what is needed, ranging from a company's value compared to others in its sector or an analysis of how well a company utilizes its equity.

We have discussed some methods above. And some below. Let us see different ways of Financial Analysis.

Types of Financial Analysis

The different types of financial analysis are discussed below.

1. Vertical Analysis

A comparative analysis of various elements on the Income Statement and Balance Sheet to a base. When looking at the income statement, it’s important to focus on net sales. While looking at the balance sheet, total assets are the primary element for this analysis. The result is represented as a percentage of the base.

For this reason, it is also known as the Common Size Statement, as analysts may use it to compare results within the company and industry.

Vertical analysis is most beneficial when appropriate benchmarks are used.

Vertical analysis lags in the context that it limits the view of comparison for one accounting period only. Yet, it assists in comparing companies of different sizes within the same industry.

The percentages should be proportionate over the years. Any changes that affect the consistency should be investigated.

Vertical Analysis of Income Statement

One of the most common uses of vertical analysis in the income statement is observing the behavior of various expense line items as a percentage of sales.

Let's say the COGS to sales ratio is 0.4 or 40%, and it stays the same for the coming four years. But, in the year 5, it jumps up to 49%. This is an alarming sign.

With this, we also understand that vertical analysis aids in identifying trends over time for various line items like the variation in COGS as a percentage of sales.  

Consider the following scenario, The sales from year 1 to year two have increased from $1,000,000 to $1,400,000. The COGS remained the same, $400,000. The gross profit margin remained the same too. But, the net income shrank from 18% to 11.42%.

This points toward the increase in non-cogs expenses that are to be controlled so that they can contribute towards overall profitability.

Vertical Analysis in Balance Sheet

The primary issue with vertical analysis in the balance sheet is the selection of the base item for comparison. Total assets are the most commonly used but using total liabilities is also acceptable.

With the help of vertical analysis on the balance sheet, we can view the pattern of investments in current assets and the existence of current liabilities with their proportions over time. This is the company's ability to pay short-term obligations with current assets.

Following the trends, an analyst can also point out that the ability to pay such obligations will increase or decrease.

Picture this, in year one, current assets stood at 25% of total assets. Put in dollar amounts, $250,000 out of $1,000,000 assets and the current liabilities were 18% ($180,000). The current ratio was 1.38.

Later, in year 2, assume the sales were $1,200,000. The current assets grew to $280,000, and current liabilities increased to $200,000. The new current ratio would be 1.4 ( $280,000/$200,000).

Indicating that an increase in sales with an increase in current assets and liabilities will improve the current ratio slightly every passing year.

2. Horizontal Analysis

The horizontal analysis includes the elements of financial statements over the years and the changes in upcoming years. It takes certain items and compares them to another in a different period.

It's calculated as:

Horizontal Analysis = Base Year (-) Current Period / Base Year

One item is compared to another within a different period.

Analysts use horizontal analysis to identify trends and discern the variations in finance and expenditures over time. Any growth, spike, or even decline could be easily understood.

This kind of analysis involves using the determined information, plotting it on a graph, and deriving actionable information.

For the reason above, it's also known as Dynamic Analysis and Trend Analysis.

Calculation of Horizontal/Trend Analysis

Horizontal analysis can also be used for the income statement, balance sheet, and cash flow statement. The calculation can result in dollar amount (absolute) terms and percentage terms depending on the formula and use decided.

For absolute terms, as mentioned earlier:

= Amount of comparison year (-) amount of base year

For percentage terms:

= amount of comparison year (-) amount of base year/ amount of base year * 100%

In absolute terms, the sales increased and look favorable when compared to the base year. The real picture is highlighted when we convert the absolute terms into percentage terms. Real growth is in percentage terms, and trends are highlighted here.

The outcome can be calculated as: 

$130,000 - $125,000 = $5000

In percentage terms, the calculation is as follows:

($130,000 - $125,000)/125,000 x 100 = 4%

Horizontal analysis is important because it helps in determining trends year over year (YoY). Any deviation from the normal can be easily observed. Performance can be judged over a period of time.

Ratio Analysis

A quantitative and measurable analysis of a firm's financial information incorporates learning about:

• Liquidity
• Solvency
• Operational efficiency
• Operational profitability
• Turnover
• Business/Financial Risk Of An Organization

It discloses the relationships, inter-dependencies, and points of comparison between the financial data. Both present and historical values and outcomes.

The financial data, with the help of RA, can aid in viewing it from various angles.

Providing a comprehensive look at the financial statements and highlighting potential areas of concern.

The financial data could be arranged in various combinations to arrive at insights aiding future decision-making for external and internal stakeholders.

The results are in percentages/decimals/times, each of them explaining what currency figures won't.

Liquidity Analysis

The term liquidity here refers to how easily an asset can be converted into ready cash. The faster an asset can be converted into cash, the more liquid the asset is.

Cash is often referred to as the most liquid kind of asset. An asset can also be a physical or a financial instrument such as bonds and futures.

Liquidity is the degree to which an asset/security is converted into liquid cash without a decrease in the current value. It is defined as the ease and hassle-free reworking of an asset into its market value.

Liquidity analysis helps in analyzing the financial position of firms limited to paying obligations with cash and cash equivalents.

The general understanding of determining a company's liquidity is finding out if it were to end its operations today and how much cash is readily available to meet its near obligations.

Liquidity analysis is used in ratio analysis with liquidity ratios.

It includes:

1. Current Ratio
2. Quick Ratio
3. Cash Ratio

The calculations include cash, marketable securities, inventory, and accounts receivables depending upon the ratio being calculated, which is predominantly divided by Current Liabilities.

Here are the formulas and further information for the Current Ratio, Quick/Acid-Test Ratio, and Cash Ratio.

Solvency Analysis

Financial competence of a company to pay off the debt. It's the freedom from the

obligation to pay the long-term debts and obligations of the firm.

It's the firm's evaluation to see if its assets are more than its debt obligations. Solvency analysis provides the view to look at an organization to pay its obligation in the long term.

In solvency analysis, debts are compared to assets, equity, and earnings. It's most beneficial to governments, banks, employees, and investors. Solvency analysis is conducted with the help of solvency ratios.

Solvency ratios include:

• Debt to Equity Ratio
• Debt Ratio
• Proprietary Ratio
• Interest Coverage Ratio

Profitability Analysis

To assess a company's growth, a careful analysis of profits is necessary. The main goal of a company, beginning on day one, is to generate profits, decrease costs, and expand. 

The expansion of businesses depends upon the excess of revenues over expenses. The leftover amount is the profits. Minimizing expenses and maximizing profits is what every organization seeks to achieve.

Profitability analysis helps analysts and investors to:

• Identify chances to make profits
• Generate revenues
• Identify growth opportunities
• Slow-moving stock items
• Market trends, etc

These items ultimately contribute to decision-makers taking informed action toward profits and expansion opportunities.

Profitability analysis provides a 360-degree view to the owners and investors of a company's performance. Different ratios can be used to understand different aspects of profitability.

This analysis is facilitated by profitability analysis. which sub-categorized into

A. Margin Ratios: Margin ratios tend to explain different profitability measures and the proportion of costs involved in relation to the profits. 

• Gross Profit Ratio
• Operating Profit Ratio
• Net Profit Ratio
• Cash Flow Ratio
• EBITDA Ratio

B.  Return Ratios: Return ratios explain the economic return an organization will be able to generate with the given amount of assets and invested equity resources.

• Return on Asset
• Return on Invested Capital
• Return on Equity

Efficiency Analysis

Also referred to as activity analysis/turnover analysis, assesses a company's ability to manage its assets in the short term efficiently.

Here, efficiency refers to how well a company is using its assets to generate income. Efficiency/Activity analysis looks at various aspects of the current performance of the company, such as:

• Ability to collect cash from customers
• Conversion of Inventory to Cash
• Time is taken to Pay for Credit Purchases
• Efficient use of Fixed Assets to generate income
• The quantity and usage of Equity

Efficiency analysis is done using efficiency/activity ratios, which highlight how effectively and efficiently the firm has been leveraging its assets to make profits and cash.

Efficiency Ratio Analysis includes:

1. Accounts Receivable Turnover Ratio
2. Inventory Turnover Ratio
3. Accounts Payable Turnover Ratio
4. Total Assets Turnover Ratio
5. Return on Equity

Leverage Analysis

Leverage is the use of borrowed capital (debt) for investment, expecting the profits made to be greater than the interest arising from the debt payable.

It involves arranging the fixed assets in a way that fixed return is ensured. 

Leverage is used for:

• maximizing return on investment
• acquisition of assets, or
• to raise funds

If a company is termed as "highly leveraged," it means that the presence of debt is more prominent than equity. This requires investors to understand a company's debt obligations to make the right call when making an investment

Leverage ratios are one of the most common methods analysts use to check company performance related to debt, equity, and earnings.

Common Leverage Ratios include:

• Debt to Equity
• Debt to EBITDA
• Interest Coverage Ratio
• DuPont Analysis

Here is a detailed explanation of every topic related to Ratio Analysis.

Valuation Analysis

The process of estimating the total worth of an asset or business is the primary purpose of a valuation. The process may include many different techniques resulting in many different valuations.

Discounted Cash Flows Valuations:

1. Comparative Prices at which Competitors have sold
2. Valuation of Subsidiaries
3. Individual Asset Valuation

It facilitates the organization to identify the fair value of the business, investment, or company.

Analysts use different valuation models and analytic techniques to arrive at the most detailed and informational results.

Valuation analysis is a vast concept in finance, but if you would like to learn more in-depth aspects of each valuation technique, here is our comprehensive course on Valuation and Modeling. 

There are three main valuation methods:

1. Market Approach
2. Cost Approach
3. Income Approach

The market approach values public companies and their competitors' comparables based on prior transactions.

The cost approach focuses on the replacement principle.

The income approach is based on the current cash flow value and projected cash flow value of a company.

Some of the most well-known and most utilized valuation techniques are DCF analysis, comparable analysis, and precedent transactions. 

These mentioned methods are the most common valuation processes used in:

• Investment Banking (IB)
• Leveraged Buyouts (LBO)
• Mergers & Acquisitions (M&A)
• Equity Research
• Private Equity
• and many more areas of finance.

The DCF analysis is based on an assumption from an analyst who forecasts Free Cash Flows (Free from Leverage or Debt) into the future and discounts that value to the present value using the Weighted Average Cost of Capital.

The DCF model is based primarily on the intrinsic value of the company versus its external.

DCF modeling is one of the most in-demand skills that IB and consulting firms look for in a candidate. Here is WSO’s detailed course on DCF Analysis & Intrinsic Value Mastery. 

The comparable analysis, or comparable company analysis, is based on the premise of comparing the current value of a company with another company of similar traits within its sectors. 

Precedent transaction analysis is a method in which past M&A transactions are used to value present-day comparable businesses. This technique is the least common to occur because most transactions occur off-market, limiting the amount of credible information and values analysts have access to.

Variance Analysis

Variance can be defined as the fact or quality of being different, divergent, or inconsistent. This particular analysis in finance and budgeting is the difference between expected and actual outcomes. These expected outcomes are set through budgets, forecasts, and standards.

The primary reason someone would conduct variance analysis is to notify management about the occurrence of an unusual event. 

The actual results are compared to the standard/budgeted results to see variances.

These variances enable management to evaluate performances and understand the causes of variance and possible departments and personnel.

There are two types of variances. Controllable and Uncontrollable. Controllable Variances can further be classified into. Favorable and Unfavorable variances.

Revenue Variance Analysis

Favorable variance when actual revenue is more than standard/budgeted revenue

= AR > SR

Unfavorable variance when actual revenue is less than standard/budgeted revenue.

= AR < SR 

Revenue Variance includes sales variances:

• Sales Price Variance
• Sales Quantity Variance
• Sales Mix Variance

Cost Variance Analysis

Favorable variances occur when actual costs expended are less than standard/budgeted costs planned.

= AC < SC

Unfavorable variances occur when actual costs incurred are more than standard/budgeted costs planned.

= AC > SC

The significance of variances depends upon the amount, direction, frequency, and trend.

Cost variances include direct material variances, direct labor variances, and overhead variances.

Direct material variances are again divided into:

• Direct Material Price Variance
• Direct Material Quantity Variance
• DM Mix and Yield Variance ( In the presence of more than One Input)

Direct labor variances are classified into:

• Direct Labor Rate Variance
• Direct Labor Efficiency Variances
• DL Mix and Yield Variance ( When are more than 1 type of Labor)

Overhead variance includes:

• Variable OH Spending Variance
• Variable OH Efficiency Variance
• Fixed OH Spending Variance
• Fixed OH Production Volume Variance

Some of the advantages to the list are:

1. Promoting accountability
2. Identifies actual results differing from budgeted actions
3. A basis for the investigation is provided
4. Promotes understanding of operations
5. Evaluation of personnel's performance
6. Identifies budgeted estimates that require revision.

Variance analysis is limited because of:

1. Time-Consuming Investigation
2. Investigations are carried out after the events have occurred
3. Historical Focus

Cash Flow Analysis

In finance, there is a phrase that says, "Cash Is King," and it certainly is. The number of cash flows determined the liquid flexibility of the organization and its ability to meet short-term deadlines.

Thus, a big emphasis is placed on the cash, and analysts spend a considerable amount of time assessing the cash position of the firm, whether it be for investing in the firm or lending short-term credit.

For this purpose, the statement of cash flows is a great place to analyze the position of the firm. The statement of cash flows aids the user in understanding all the sources of cash and its expenditures.

There are three types of activities, and the cash from them should be evaluated.

1. Operating Activities
2. Investing Activities
3. Financing Activities

Operating Activities

Activities are related to activities in the normal course of business. Transactions recorded on the income statement are included in operating activities. 

In the cash flows, transactions recorded using accrual accounting are converted into cash accounting.

NI on the income statement includes non-cash revenue like uncollected credit sales and non-cash expenses like unpaid expenses (depreciation, depletion, and amortization).

These items reduce the net income but do not affect the cash flows for the current period.

These items are added back when determining cash flows from operating activities.

Cash inflows under operating cash flows:

• Cash Receipts from sales of goods and services
• Collection of accounts receivables
• Cash Receipts from royalties, fees, commissions, and other revenues.

Cash outflows under operating cash flows:

• Cash Payments to suppliers for employees and goods and services
• Cash payments towards government taxes, duties, fines, penalties, interest on debt, and other fees.

There are two acceptable methods to present net cash flows from operating activities.

1. Direct Method, aka Income Statement Method, is where net cash flows of operating activities are calculated by converting revenues and expenses from an accrual basis to a cash basis. It’s a preferred method but rarely used.
2. The indirect Method, aka the Reconciliation Method, is the most popular. It starts by converting NI to net cash flows from operating activities by adjustments. Adjustments include adding back non-cash expenses and paper losses and deducting non-cash revenues and paper gains.

Investing Activities

Activities related to the expenditure are intended to generate future incomes and cash flows. Most of the transactions in the investing activities come from changes in long-term assets accounts.

Cash inflows under investing activities from the receipt:

• Receipt from the sale of PPE
• Receipt from the sale of intangible assets
• Receipt from the sale of other long-lived assets
• Sale of investments in other company's equity or securities
• Collections of principals on loans to another entity

Cash Outflows include:

• Purchase of PPE
• Purchase of intangible assets
• Purchase of other company's debt or equity securities
• Granting loans to another company

Financing Activities

Activities are related to changes in long-term liability and equity accounts. Financing activities are related to the transactions that involve the issuance, settlement, or reacquisition of an entity's debt and equity instruments.

Financing Cash Inflows:

• Sale of the entity's equity security
• Issuance of debt (Bonds/Notes)
• Obtaining resources from owners

Financing cash outflows:

• Payment to stockholders for dividends
• Payment made to reacquire capital stock
• Redeem the company's outstanding debt
• Payments for a reduction in outstanding liability (by lessee) of operating or finance lease.

Here is a link to a 13-week program for learning Cash Flow Modeling to understand better the planning and execution of the most useful statement of the organization.

FP&A Analysis

Computation in finance and planning is a set of four activities that support an organization's financial health. 

There are a few common analysis techniques related to financial planning. 

• Planning & Budgeting
• Integrated Financial Reporting
• Management & Performance Reporting
• Forecasting & Modeling

FP&A increases the organization's ability for planning, budgeting, management, and performance by linking them to the organization's strategy to execution.

With the help of a sound FP&A system, analysts can combine data from financial, operational, and external sources.

Analysts can analyze the data, uncover insights, and determine plans and projects, which all allow for more confident and profitable decisions. With the help of strong and well-developed FP&A tools, analysts may provide a great deal of aid. 

Providing facts and number-based information for making intelligent business decisions:

• Assess and evaluate a business's cash flows and investments, and monitor its performance.
• Build and maintain strong financial modeling techniques and forecasts.
• Alignment with corporate strategy
• Execution and monitoring the performance.
• Identifying, assessing, and recommending business opportunities and threats and many more.

Steps involved with the FP&A:

1. The first step in the Data Collection is from financial, operational, and external sources, ERP systems, and data warehouses.
2. The data collected is supposed to be Consolidated.
3. Verification of the data collected and consolidated to ensure the accuracy and legitimacy of the financial and non-financial data/information
4. Planning and Forecasting is the stage in which the data collected and verified is used so that it can be projected over time to see the future expected performances. EDA, predictive analysis, and AI can help a great deal in this step.
5. Budgeting is the formal process of executing a budget, expenses are estimated, and corporate plans are put to execution based on the sales forecasts and mission and vision statement. Based on these forecasts, the budget is formulated, and resources are committed.
6. Budgets are supposed to act as a Performance Evaluation and Monitoring Tool for the organization. Since the budgeted figures are taken as standard, it may also facilitate variance analysis.

Financial Planning & Analysis is a field that is vast and respected, and this brief explanation does no justice to the course or profession itself. So, provided in this link is a complete Financial Modeling and Valuation Package from The WSO.

Sensitivity Analysis & Scenario Analysis

Sensitivity Analysis

This analysis uses the trial & error method to determine the effects of changes on variables and assumptions on the final result.

It helps decide whether expending extra resources to get better results is justified.

Trial and error are inherent to the sensitivity analysis and are greatly facilitated with the use of certain computer software. A major use of sensitivity analysis in finance is found in capital budgeting.

Example: Calculation of interest rates and profitability index.

Sensitivity analysis, in other words, assesses how sources of uncertainty affect a model's total uncertainty given the changes made in the independent variable under a given set of assumptions.

The analysis determines the effects of a variable on the outcome in the quantitative model.

It's used in business, finance, and economics for various purposes. Some purposes are to predict the interest rates for bonds, effects on cash flow through the changes in inflation rates, and predict the share prices of public enterprises.

Sensitivity analysis facilitates the decision-making process, making improvements where necessary, and offers a great deal of knowledge on variables.

Yet, it's limited because of the excessive use of assumptions instead of facts, and these models are based on historical figures.

Scenario Analysis

In simple words, a scenario means one way that things or events may unfold in the future. Precisely, it's a specific possibility.

Scenario analysis is the analytic method for predicting/forecasting the possible occurrence of an event. The happening of such an event and its consequences are evaluated, with the assumption that the same pattern or trend will be repeated in the coming periods.

With scenario analysis, an analyst has a complete picture of all the scenarios that can happen in the future. The exploration of alternate scenarios allows an analyst to identify possible threats/problems and plan how to mitigate the risk involved.

Scenario analysis can be used with the following steps below:

Define the issue, the purpose of the analysis, and the decisions to achieve the goal set. A timeline of events is to be planned for the timely execution of activities.

Identify the key factors, trends, uncertainties, and assumptions encompassing the analysis.

The next step is separating and listing the uncertainties from the certainties. And rank them in order of magnitude, the largest and the most significant ones.

Develop scenarios starting from the most significant one. Develop them in order of one moderately good outcome and one moderately bad outcome. Repeat the same with the second most significant scenario.

Finally, use the scenarios in the planning process, eyeing the risks and rewards.

Sensitivity analysis and scenario analysis are quite similar to each other. However, differs in the context that sensitivity analysis uses only one variable at a time to see its effect on the possible outcome.

Whereas it's not the same case in scenario analysis. Multiple variables are taken into the picture before arriving at the simulated outcome.

Scenario analysis requires analysts to prepare scenarios of three types. 

1. Base-Case Scenario: situations under normal conditions.
   • Ex: Industry operating under the prevailing circumstances.
2. Best-case scenario: situations under the most favorable conditions.
   • Ex: Amendments in industrial regulations may facilitate acquiring material at lower prices with reduced expenses in COGS.
3. Worst-case scenario: situations under the most unfavorable conditions.
   • Ex: Changes in Industrial Regulations banning the usage of a particular ingredient crucial for producing the product. Leading to increased expenses in acquiring the substitute.

Researched and authored by Farooq Azam Khan, CMA | LinkedIn

Edited by Colt DiGiovanni | LinkedIn

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Analysis of Financial Statements

• Financial Analysis Ratios Glossary

• Financial Controls

• Financial Plan

• Financial Ratios