Methods of Financial Analysis
Analysts employ various methods to monitor a company’s financial performance over a specific period. Below, we outline the four most prevalent techniques for financial analysis:
Vertical Analysis
This technique involves examining individual income statement items and expressing them as a percentage of total revenues. For this method to be most effective, the results should be compared with those of competitors, enabling assessment of the company’s performance relative to the market.
Horizontal Analysis
Horizontal analysis consists of comparing several years’ worth of financial data to identify growth rates. This approach helps determine whether the company is experiencing growth or decline, as well as identifying significant market trends.
Ratio Analysis
Ratio analysis is utilized to evaluate both the current and future financial position of a company by comparing one financial statement item to another, thus highlighting overall performance. Once a ratio is calculated, it can be compared with previous periods to analyze whether the company’s performance aligns with established expectations. This analysis aids in identifying any discrepancies from anticipated figures and taking corrective measures.
Trend Analysis
This method focuses on analyzing performance trends over three or more periods (monthly, quarterly, or annually), using the prior period as a benchmark. It reveals any positive or negative shifts in financial statements, ultimately aiming to forecast future trends based on historical data and results.
Objectives of Financial Analysis
The goals of financial analysis include the following:
- Evaluating the company’s financial condition.
- Determining the company’s financial capability.
- Assessing the policies and systems implemented within the company.
- Evaluating management effectiveness.
- Identifying the actual trends of the company.
- Conducting feasibility studies for potential investors.
- Assessing the company’s position among competitors.
- Providing a reliable source of data.
Steps in Financial Analysis
There are five key steps for conducting effective financial analysis, as outlined below:
- Identify the activities involved in the creation, manufacturing, and distribution of the company’s products or services.
- Define the nature of the product or service offered, including its unique characteristics, profit margins, and cost control levels.
- Evaluate the quality of the company’s financial statements.
- Analyze current profitability and risks, specifically how profitable the company’s operations are relative to its assets and how profitable it is from the perspective of shareholders.
- Prepare forecasts of financial statements, establishing reasonable assumptions regarding the company’s performance and industry prospects, and determining how these assumptions will impact cash flow and financing.