3 Types of Financial Analysis and When They Matter
Financial analysis is conducted using information posted on a business’ financial statements to evaluate the current financial position and the past performance.
Financial Key performance indicators such as liquidity, profitability, and solvency among others highlighted by this process are used to ascertain the financial strengths and weaknesses of the business entity.
This analysis can be performed internally within the organization to facilitate decision making by management. External parties and stakeholders such as auditors, regulators, financial analysts, investors, and competitors can also conduct their analysis using the available facts to ascertain the entity’s financial position. These stakeholders equally utilize the information for decision-making suitable for their respective interests.
Three types of financial analyses can be performed with businesses financial statements are horizontal analysis, vertical analysis, and ratio analysis.
- Horizontal analysis
Horizontal analysis of financial information entails the assessment and comparison of the relative changes in specific items in a financial statement over stipulated accounting periods. The items in question could be sales, revenue, etc., and the accounting periods can be months, quarters, years, etc.
This type of financial analysis is best applied when seeking to determine the dynamic behaviour of an item so as to observe the trend of the item over the specified accounting periods. This is important in determining the factors behind the trend, whether positive or negative. For example, the net profit of a business can be tracked over a five-year period.
However, there are two ways of conducting a horizontal analysis, namely; percentage analysis and absolute analysis.
In the absolute analysis, the comparisons are carried out using the figures posted in the financial statements whereas in percentage analysis, the comparisons entail presenting the relative change in the figures into percentages.
- Vertical analysis
Also known as the common-size analysis, this vertical analysis involves comparison of figures of separate items to a standard figure on the balance sheet over a specified accounting period. For example, taking the total revenue of an accounting period to be 100%, other items such as employee benefits and debt repayment for a particular period can be calculated as percentages against the total revenue of the specific accounting period.
This form of analysis is most useful in the determination of the efficiency of business items by comparing how they stack up against common items such as income.
- Ratio analysis
This method of financial analysis correlates the different items of a balance sheet to the income statement to determine the financial performance of the firm. Assets are measured against liabilities and presented in a simpler way that is comprehensible without quoting huge figures.
Ratio analysis matters most when analysts and stakeholders seek to determine the viability and sustainability of an entity’s long-term and short-term financial strategies.