7 types of financial analysis (with useful examples)
By Indeed Editorial Team
Published 20 May 2022
The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.
Companies use financial analysis in corporate and investment finance settings. All types of financial analysis help businesses better understand their finances and where they can make improvements. Often, investors care a lot about the results of the financial analysis because it may determine whether they should invest in a company or take their money elsewhere. In this article, we discuss what financial analysis is, the types of financial analysis, provide examples of financial analysis and why financial analysis is essential.
What is financial analysis?
Financial analysis is a critical step in determining a company's financial situation. By analysing finances, a company can decide if their finances are stable, what actions they should take and financial prospects for the future. Business owners conduct financial analyses with varying goals in mind. For example, one company may conduct a financial analysis to identify if they are making a profit. Another company may conduct a financial analysis to determine if they are breaking even. To perform financial analysis, a company typically keeps organised records of their finances, such as income statements, cash flow statements and balance sheets.
Typically, companies use financial analysis to examine internal aspects of their company and external elements, like the environment and market. Financial analysts evaluate economic trends, select areas for investment, set monetary policy and create long-term plans for business activity. A financial analyst can predict a company's future earnings by using financial analysis. In a corporate finance setting, one or more people in the accounting department conduct financial analysis. A financial analyst who works outside of the company operates an analysis in an investment setting.
Related: What is financial risk?
Types of financial analysis
Financial analysis is a broad domain, and within the general parameters of financial analysis, there are several types to consider. Here's a list of the primary types of financial analysis:
The first way you can conduct a financial analysis is through horizontal analysis. The horizontal analysis revolves around analysing past financial figures and how they evolve. By doing this, a financial analyst can compare and contrast a company's performance from one year to the next. Horizontal analysis, also called dynamic analysis or trend analysis, can help determine trends. Financial analysts usually present horizontal analysis as a percentage of growth using the same item and the base year.
In vertical analysis, a financial analyst analyses the relationship between items on various financial statements. Analysts represent each line within a financial statement as a percentage of a base figure within each statement. Professionals use vertical analysis when a financial analyst wants to understand how specific items compare on the balance sheet and the bottom line. When used in conjunction, financial analysts can determine a significant amount of information from the vertical and horizontal analysis. The primary difference between vertical analysis compared to horizontal analysis is that companies only use vertical analysis over one time period.
Using profitability analysis, a financial analyst can determine a company's rate of return. Most companies have the primary goal of turning a profit. By using profitability analysis, companies can measure their costs compared to their revenue in a specific period. A company considers itself to be profitable if its revenue outweighs its costs. Professionals use two main ratios when calculating profitability: margin and return ratios. Margin ratios include operating profit margin, gross profit margin, cash flow margin and net profit margin. Return ratios include cash return on assets, return on equity and return on investment, also known as assets.
Financial analysts use liquidity analysis to determine if a company is financially capable of paying back debts and cancelling out other expenses. Debts and expenses are liabilities for a company. If a company cannot pay off its liabilities, it may experience significant financial difficulties. Lenders and creditors use a company's liquidity analysis to determine if the company qualifies for a credit or a business loan. The first step towards calculating a liquidity analysis is calculating a company's current ratio. A current ratio shows how many times a company can pay its current debts with its existing assets. You can use this formula to determine this:
Current assets / current liabilities = current ratio
5. Scenario and sensitivity
A financial analyst measures an investment's value based on current changes and circumstances in a scenario and sensitivity analysis. This type of analysis helps investors determine the number of risks and potential benefits of their investment. The difference between scenario and sensitivity analysis is that sensitivity analysis only examines the effects of one changing variable over time. This helps a company determine the likelihood of success or variable based on a minor change. Scenario analysis examines the impact and the potentially occurring risks and consequences.
A financial analyst uses a valuation analysis to determine a company's current value. A company often presents a valuation analysis when an event such as a merger, acquisition or taxable event occurs. Financial analysis can determine the value of assets like a commodity, a business, fixed income security, equity or real estate. A company can determine its value by comparing it to other companies or evaluating its assets. The two primary models for valuation are absolute valuation and relative valuation. To determine the actual value, fundamental valuation focuses on dividends, cash flow and growth rate.
A financial analyst uses variance analysis to determine discrepancies between the amount a business is spending and a company's budget. It is helpful to conduct a variance analysis to determine if the quantity of materials and resources initially allocated for an aspect of production is enough to maintain a profit. Financial analysts compare a company's costs with costs incurred across the industry. For example, a company may have budgeted €3,000 for raw materials cost and spent €2,000. This would be a variance of €1,000.
Examples of financial analysis
Financial analysis can play an integral role in a company's success. Here are some examples of financial analysis for technology companies, Electric Technology and New Tech Solutions:
Electric Technology: current assets of €1,000,000 / current liabilities of €300,000 = 3.33%
New Tech Solutions: current assets of €900,000 / current liabilities of €450,000 = 2%
Using the current ratio formula, a financial analyst determines that Electric Technology has a better current ratio than New Tech Solutions. Overall, Electric Technology is in a better financial position than New Tech Solutions, as they have more significant assets than liabilities compared to New Tech Solutions.
Electric Technology and New Tech Solutions have hired a financial analyst to determine the profitability of the companies in terms of comparing their production capabilities. For this example, the financial analyst is using the operating profitability ratio. Electric Technology has net sales of €400,000 and an operating profit of €40,000. New Tech Solutions has net sales of €500,000 and an operating profit of €50,000. The operating profit ratio is equivalent to a company's earnings before interest and tax divided by sales.
Electric Technology: 40,000 / 400,000 = 10%
New Tech Solutions: 50,000 / 500,000 = 10%
Based on the calculations, Electric Technology and New Tech Solutions have the same operating ratio.
Electric Technology wants to determine what effect changing its leading supplier will have on the company. After deciding what the company wanted to test, the financial analyst may spend a considerable amount of time considering potential scenarios that may occur due to the decision. The financial analyst may determine that changing suppliers will result in a loss of €20,000 for the year. Based on these results, the company may decide not to change suppliers.
Why should a company use financial analysis?
There are many benefits to conducting a financial analysis within a company. Here are some of the primary reasons a company may conduct a financial analysis:
understand where money is being allocated
identify areas where the organisation can minimise spending
mitigate financial mistakes before they occur
make more informed business decisions
prepare more accurate budget estimations
qualify for better businesses loans and credits
improve all weaknesses within the organisation's finances
increase accountability with a company's money spenders
find trends to increase opportunities
improve debt management
comply with industry regulations
satisfy stakeholders with in-depth analysis of specific investments
protect a company from legal repercussions
react to changing circumstances with enough information to make wise decisions
Explore more articles
- A guide to event marketing: importance, event types and tips
- Is sales and revenue the same? A guide to the differences
- How to increase conversion rate (benefits and key elements)
- What is operation costing? (and how to calculate it)
- Skills development plans and the benefits of using them
- What is a servant leader? (With steps to become one)
- A guide to revenue vs income (with uses and definitions)
- What is security for email and why is it important?
- How to complete customer modelling (with definitions)
- How to invoice a company in 7 steps (plus benefits)
- How to transition from an employee to a manager in 11 steps
- Dealer markets and how they differ from other markets