3 types of financial analysis and when they matter
Financial analysis is carried out using the information published in a company’s financial statements to assess the current financial position and past performance.
Key financial performance indicators, such as liquidity, profitability, and solvency, among others, highlighted by this process, are used to determine the financial strengths and weaknesses of the business entity.
This analysis can be done internally within the organization to facilitate decision making by management. External parties and interested parties, such as auditors, regulators, financial analysts, investors, and competitors, may also perform their analysis using available data to determine the financial position of the entity. These actors also use the information to make decisions appropriate to their respective interests.
Three types of financial analysis can be performed with the financial statements of companies: horizontal analysis, vertical analysis, and ratio analysis.
- horizontal analysis
Horizontal analysis of financial information involves the evaluation and comparison of the relative changes in specific elements of a financial statement during stipulated accounting periods. The items in question may be sales, revenue, etc., and the accounting periods may be months, quarters, years, etc.
This type of financial analysis is best applied when seeking to determine the dynamic behavior of an item to observe the trend of the item over specified accounting periods. This is important to determine the factors behind the trend, whether positive or negative. For example, a company’s net profit can be tracked over a five-year period.
However, there are two ways to perform a horizontal analysis, namely; percentage analysis and absolute analysis.
In absolute analysis, comparisons are made using the figures published in the financial statements, while in percentage analysis, comparisons involve presenting the relative change in figures in percentages.
- vertical analysis
Also known as common size analysis, this vertical analysis involves comparing separate item figures to a standard figure on the balance sheet for a specific accounting period. For example, by taking the total income for an accounting period as 100%, other items such as employee benefits and debt repayment for a particular period can be calculated as percentages against the total income for the specific accounting period.
This form of analysis is most useful for determining the efficiency of business elements by comparing how they compare to common elements such as revenue.
- Ratio analysis
This method of financial analysis correlates the different elements of a balance sheet with the income statement to determine the financial performance of the company. Assets are compared to liabilities and presented in a simpler way that is understandable without quoting huge numbers.
Ratio analysis is most important when analysts and stakeholders seek to determine the viability and sustainability of an entity’s short-term and long-term financial strategies.