Introduction to Financial Analysis

Financial analysis drives sound business decision-making for governments, companies, and investors when considering plans and budgets for current and future projects. By collecting, organizing, and interpreting financial information and using it to forecast market trends and economic conditions, financial analysts can assess risk and provide advice on financial policies.¹ Their expertise is vital to sound financial management.

Whether they set out to analyze financial data, advise on potential investments, evaluate a company's financial health, or assist in budget planning, financial analysts are a crucial link between raw data and actionable strategies.

Read on to explore several types and applications of financial analysis.

What is financial analysis?

In the corporate world, financial analysis is the systematic process of examining a company's financial statements, budgets, and projects to assess its performance and viability. The primary objective of corporate financial analysis is to determine profitability, liquidity, and solvency.

• Profitability measures how well a company generates earnings and includes metrics such as return on investment (ROI) and net profit margin
• Liquidity focuses on a company's ability to cover short-term obligations, often evaluated through ratios such as the current ratio or quick ratio
• Solvency gauges a company's capacity to meet long-term debts, often analyzed through debt-to-equity ratios or interest coverage ratios

Through financial analysis, stakeholders can determine the financial health and future prospects of a business or investment.²

Types of Financial Analysis

Financial analysis has a broad range of use cases, so analysts employ various methods to draw insight from data based on standardized accounting principles. Two main types of financial analysis used to evaluate a company’s financial performance are vertical analysis and horizontal analysis.

Vertical Analysis

Vertical analysis takes a snapshot of a company's financials at a particular point in time. Here, each item on a financial statement–be it on the income statement, balance sheet, or cash flow statement–is compared to a base item. For example, in an income statement, each expense item might be expressed as a percentage of total revenue. This ratio analysis helps identify correlations and compare companies of different sizes. By turning raw numbers into percentages, comparisons are more meaningful.³

Horizontal Analysis

Horizontal analysis focuses on comparing changes in financial data over a series of reporting periods rather than at a single point in time. Also called trend analysis, it examines how specific financial data points grow or shrink over time. For example, if a company’s revenue increased by 15% from Year 1 to Year 2 and then by 20% from Year 2 to Year 3, horizontal analysis would flag this as a positive trend in revenue growth. Financial analysts use horizontal analysis to identify trends and make projections about future performance.⁴

Financial Ratios

Financial ratios are mathematical calculations that provide valuable insights into various aspects of a company's performance and financial health. Experts looking to utilize key financial ratios may turn to:

Profitability Ratios

Profitability ratios measure a company's ability to generate profit based on its revenue and expenses. Profitability ratios help investors decide if a company is worth investing in. They help business leaders make more informed strategy decisions. Common profitability ratios include:⁵

• Net Profit Margin: Calculates the percentage of revenue that remains as net profit after all expenses are deducted
• Return on Assets (ROA): Assesses how efficiently a company uses its assets to generate profits
• Return on Equity (ROE): Evaluates how much profit a company generates relative to shareholder equity

Liquidity Ratios

Liquidity ratios assess a company's ability to meet its short-term obligations, including debt payments and cash flow. Two main types of liquidity ratios are:⁶

• Current Ratio: Compares a company’s current assets to its current liabilities. A ratio over 1 indicates the company can cover its short-term debts
• Quick Ratio (Acid-Test Ratio): Similar to the current ratio, quick ratio excludes inventory from current assets, offering a stricter measure of liquidity

Solvency Ratios

Solvency ratios gauge a company's ability to meet its long-term debt obligations. Insight gained from this type of ratio can help project future cash flows, monitor long-term liabilities, establish budgets, and predict the company’s future performance. Two of the most important solvency ratios include: ⁷

• Debt-to-Equity Ratio: Measures the amount of debt financing relative to equity financing
• Interest Coverage Ratio: Calculates how easily a company can pay interest expenses on its debt

Market Value Ratios

Market value ratios are often used by investors to gauge a company's stock performance and valuation. They measure and analyze stock prices to understand the financial performance of public companies. Some market value ratios include:⁸

• Price-to-Earnings (P/E) Ratio: Compares a company's stock price to its earnings per share, providing an indication of the stock's valuation
• Earnings Per Share (EPS): Calculates the portion of a company's profit allocated to each outstanding share of common stock

Practical Applications for Financial Analysis

Financial analysts are widely sought after in many industries because of the value they bring to an organization. They’re employed in a range of roles and business activities. Common roles fulfilled by financial analysts include:⁹

• Investment decisions: Investors rely on financial analysis to evaluate the health and potential profitability of companies; metrics such as P/E ratios, liquidity ratios, and debt-to-equity ratios help them choose investment opportunities for both short-term gains and long-term growth
• Business strategy: Company executives depend on financial analysis to make critical business decisions, such as entering new markets, launching products, or acquiring competitors; financial models can simulate different scenarios to predict outcomes and risks
• Performance assessment: Financial analysis enables businesses to evaluate their performance against their direct competitors and industry standards; this can help identify areas for improvement, whether it’s reducing operational inefficiencies or improving product offerings
• Budget planning: Companies use financial analysis to allocate resources more effectively; by using historical data to predict future expenses and revenues, they can create more accurate budgets and forecasts
• Risk management: By analyzing variables that contribute to financial risk, such as market volatility or changes in interest rates, companies can adopt strategies such as diversification or hedging to mitigate these risks

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