Companies use various forms of financial analysis to measure their performance and value. These analyses are an excellent way for businesses to evaluate their financial stability and for investors to evaluate whether a company is a worthy investment. Knowing what financial analysis is and reviewing examples can help you manage a company’s finances efficiently.
In this article, we define financial analysis, describe how companies use it, list the various types, and provide examples to further your knowledge of the various processes.
What is financial analysis?
Financial analysis is the process of analyzing a company’s finances to evaluate its financial stability and future. It involves concrete evaluations of financial data and making recommendations to help business owners determine necessary actions to make a profit or avoid bankruptcy. It also allows investors to decide whether to invest in a business.
During this process, you analyze a company’s financial statements, such as its income, balance and cash flow statements. For example, analysts in many fields of finance often devote considerable effort to studying the cash flow characteristics of various businesses. The cash flow statement shows cash from operating, investing and borrowing activities.
How companies use financial analysis
Companies use financial analysis both internally and externally. Internally, they analyze their financial status to improve future decisions that could be beneficial or adjust their budgets accordingly. Externally, a company uses various types of financial analyses for investment, where analysts evaluate a company’s finances to determine whether they’d make a worthwhile investment. For example, investors can analyze a company’s past performance to predict future performance using a bottom-up approach.
Most companies use financial analysis as a monitoring tool to assess progress periodically. They can choose a method based on the cost involved or the suitability of the analytical approach to the business. For example, an analyst may assess the income statement for a certain period and use various financial ratios, such as gross profit margin, to determine how a company efficiently generates profits. A higher gross profit margin may appeal to investors.
7 types of financial analysis
Within the general scope of financial analysis, there are several types to consider. Here are seven types of financial analysis:
In vertical financial analysis, you analyze the relationship between various items on a financial statement. For example, during one accounting period, you might measure one item against another item considered the base and express the relationship as a percentage. It only accounts for one time period, but it can help you recognize changes over time and compare various entities.
Horizontal analysis refers to the evaluation of how financial statement figures change over a certain period. It compares one item to another in a different period and can help you analyze a business’ finances from one year to the next. You can also refer to horizontal analysis as dynamic or trend analysis because this form of analysis can help spot trends over time.
The financial liquidity of any business or company means its ability to pay back a loan or debt after a given period. Regular financial audits provide information that’s helpful to creditors before they give out any loan or credit, as they gain insight into the company’s financial health. Liquidity information is also helpful in giving the company insights on future investment if it plans to expand, as it shows its ability to repay loans. You can use various ratios, such as the current and cash ratios, to determine the liquidity ratio.
In a profitability analysis, you evaluate a company’s rate of return. Every business operates mainly to make a profit, so using profitability analysis to measure its cost and revenue in a given period is beneficial. If the cost of operating a business or company is higher than revenue, the company sustains a loss, whereas if revenue outweighs its costs, it’s profitable.
In this analysis, you use profitability ratios, including margin and return ratios. Examples of margin ratios are gross profit margin, operating profit margin, net profit margin and cash flow margin. Examples of return ratios include return on investment or assets, equity and cash return on assets.
5. Scenario and sensitivity
The initial investment value of any startup is subject to changes over time, requiring a routine evaluation to determine the value of the investment. You measure an investment’s value based on current scenarios and changes during this analysis. For example, it analyzes the effect on one variable based on changes and sensitivities in other variables. Scenario and sensitivity analysis can help analysts predict specific outcomes based on different variables, where they study the various variable effects based on prior data and make informed decisions based on their findings.
Variance is the difference or variation in the stipulated budget and the actual cost of running a business. The expected budget may be higher or lower in different scenarios than the actual business cost. For example, if you budget your sales at $1,000 but sell at $250, the variance analysis is the difference at $750.
Once you find a variance, you can use it to determine the cause and implement strategies to mitigate negative variance occurrences. Variance analysis encompasses various types of variances, including purchase price variance, labor rate variance, fixed overhead spending variance, and material yield variance. It can help you cut costs, improve your spending and determine the suitability of business operations.
Through financial valuation analysis, you can evaluate a business’ present value. You can use this analysis for various instances, such as mergers and acquisitions or taxable events. There are different types of valuation ratios, including price-to-earnings and price sales. Once you determine a company’s ratios, you can compare them to its past ratios, competitor’s ratios, or the particular industry of its operation.
Examples of financial analysis
Here are some examples of financial analysis:
Current ratio example
A company has current assets of $150,000 and current liabilities of $100,000. A second company has current assets of $500,000 and current liabilities of $350,000. An investor uses the current ratio, a liquidity ratio, to determine if the first company’s current ratio is better than the second company’s. The current ratio formula is:
Current ratio = current assets / current liabilities
Here are the investor’s calculations for the first company:
Current ratio = 150,000 / 100,000 = 1.5
Here are their calculations for the second company:
Current ratio = 500,000 / 350,000 = 1.43
The investor determines that the first company has a current ratio of 1.5 and the second company has a current ratio of 1.43. This means that the first company is better financially and can repay any current debts or obligations.
Profitability ratios example
A shoe company has an operating profit of 50,000 and net sales of 200,000, while a sportswear company has an operating profit of 25,000 and net sales of 100,000. The operating profit ratio equals earnings before interest and tax divided by sales. An investor calculates the following for the shoe company:
Operating profit ratio = 50,000 / 200,000 = 25%
Then, the investor calculates the ratio for the sportswear company:
Operating profit ratio = 25,000 / 100,000 = 25%
Based on this information, the investor finds that the shoe company and the sportswear company have the same operating ratio.
Revenue change example
A marketing company had revenue of $5,000 in 2020 and $4,000 in 2021. The change in revenue for the year is 25%. Using horizontal analysis, the company divides $5,000 by $4,000, then subtracts the result by one to get 0.25. The company then multiplies 0.25 by 100 to get its percentage form, which is 25%.
I hope you find this article helpful.