3 Types of Financial Analysis and When They Matter
A company’s financial statements contain information that is used in financial analysis to assess its current and past performance.
Financial key performance indicators like liquidity, profitability, and solvency, among others that this process highlights, are used to determine the business entity’s financial strengths and weaknesses.
In order to make it easier for management to make decisions, this analysis can be carried out internally within the organization. Auditors, regulators, financial analysts, investors, and competitors are just a few of the stakeholders and external parties that can use the information at their disposal to conduct their analysis and determine the entity’s financial position. The information is used equally by these stakeholders to make decisions that are in their best interests.
Horizontal analysis, vertical analysis, and ratio analysis are the three types of financial analyses that can be performed on a company’s financial statements.
The assessment and comparison of the relative changes in particular items in a financial statement over specified accounting periods is known as horizontal analysis of financial information. Sales, revenue, etc., could be the issues at hand. Additionally, accounting periods may include months, quarters, years, and so forth.
When attempting to ascertain an item’s dynamic behavior in order to observe its trend over the specified accounting periods, this kind of financial analysis is most useful. This is crucial for figuring out what’s causing the trend, whether it’s positive or negative. A company’s net profit, for instance, can be tracked over five years.
However, a horizontal analysis can be carried out in one of two ways: analysis in percentage and absolute terms.
In percentage analysis, the relative change in the figures is presented in percentages, whereas in absolute analysis, the figures posted in the financial statements are used for the comparisons.
This vertical analysis, which is also known as the common-size analysis, involves comparing individual item figures to a standard figure on the balance sheet over a particular accounting period. If, for instance, an accounting period’s total revenue is assumed to be 100 percent, other expenses, such as debt repayment and employee benefits, can be expressed as percentages of that total revenue.
This type of analysis is most useful for determining the efficiency of business processes by comparing them to common processes like income.
Ratio analysis is a type of financial analysis in which the various items on a balance sheet are compared to the income statement to determine the company’s financial performance. The ratio of assets to liabilities is calculated and presented in a manner that is clearer without using a lot of numbers.
When analysts and stakeholders attempt to ascertain an organization’s long-term and short-term financial strategies’ viability and sustainability, ratio analysis plays a crucial role.