Understanding Financial Analysis: An Introductory Guide
Financial analysis is the process of evaluating a company, sector, or other entity to determine the overall financial health and prospects for future growth or contraction. By studying the past and present financial data, investors and financial professionals can get a better understanding of a business's potential and make more informed decisions about whether or not to invest. There are several techniques used in financial analysis, and in this blog post, we will explore the different types of financial analysis techniques.
Definition of Financial Analysis
Financial analysis refers to the process of analyzing a company's financial statements and performance. It typically includes the analysis of a company's balance sheet, income statement, cash flow statement, and other financial statements, as well as the economic environment in which it operates.
Overview of Different Types of Financial Analysis
There are various techniques and approaches that can be used in financial analysis. These include:
- Fundamental Analysis
- Relative Valuation
- Technical Analysis
- Cash Flow Analysis
- Discounted Cash Flow Analysis
- Ratio Analysis
- Porter's Five Forces Analysis
Types of Financial Analysis
Financial Analysis is a process of identifying the financial strengths and weaknesses of a business by assessing its past, present and potential performance. Different analytical techniques help to find areas of improvement in a business. The most common types of financial analysis techniques are listed below.
Ratio Analysis surveys the financial statements to draw relationships between different financial variables and its overall performance. Different types of ratios are used to compare the efficiency, liquidity, and profitability of a company. This helps to see the company's resources and abilities to generate income.
Common Size Analysis
Common Size Analysis is a financial tool that helps to compare companies of varying sizes. This technique converts the financial data such as balance sheets and income statements into uniform percentages. It helps to identify the trends in a particular financial statement with the corresponding same amount of sales.
Break- Even Analysis
Break-Even Analysis is a cost accounting technique that shows when a company's sales reach a level that covers the cost of production. This technique helps to identify the amount of sales needed to reach the 'break-even' point where profits begin to increase.
Liquidity Analysis helps to measure a company's financial health by determining its ability to meet its short-term debt obligations. It calculates the relationship between a company’s current assets and its current liabilities.
Profitability Analysis monitors the performance of a company over time by identifying its ability to generate profits from its resources. This technique helps to measure the overall performance of the company and its resources by dividing the net income from the total sales.
Solvency Analysis helps to assess a company's overall financial strength by estimating its long-term debt-paying ability. It measures the company's ability to withstand any unexpected financial burden in the event of an unexpected fall in cash flows.
Comparative Analysis is an analytical tool used to compare the financial performance of different companies over a period of time. This technique helps to assess the performance of a company and identify areas of improvement.
Cash Flow Analysis
Cash Flow Analysis measures the amount of money coming into and out of a business. It shows the total cash generated and spent during a particular time period. This technique helps to manage the cash better and plan for future cash requirements.
Ratio analysis is a type of financial analysis that involves calculating ratios from a company’s financial statements. Ratios are used to evaluate a company’s performance and compare it with other businesses. They eliminate the need to compare absolute numbers, which can vary greatly between companies. Ratios provide a picture of a company’s performance over time and can indicate potential problem areas.
Examples of Ratios Used in Financial Analysis
The most common financial ratios are:
- Profitability ratios, which measure a company's ability to generate income relative to the revenue it takes in;
- Liquidity ratios, which measure a company's ability to pay short-term debts;
- Leverage ratios, which measure a company's ability to use debt to finance operations;
- Activity ratios, which measure a company's ability to use its resources efficiently;
- Valuation ratios, which measure a company’s stock performance relative to its peers.
These ratios can be used to analyze a company's financial health and to compare it to other firms in its industry. For example, a company with a higher debt-to-equity ratio than its peers may be at greater risk of bankruptcy, while a company with higher operating margins may be more profitable than its competition.
Common Size Analysis
Common size analysis is a financial statement analysis technique which is used to compare the relative size of different line items on a financial statement. This technique expresses all line items as a percentage of the total sales figure and therefore enables a comparison to be made of the size of all line items between two different reporting periods or between two different companies.
Explanation of Common Size Analysis
Common size analysis is a useful tool when looking at financial statements as it provides insights into trends and performance. By expressing all line items as a percentage of total sales, the statement becomes easier to read and compare, for examaple by spoting quickly any ratios which increase or decrease compared to a similar reporting period. Common size analysis is also refered as 'vertical analysis' and is particularly popular with the investor community.
Examples of Common Size Analysis
An example of common size analysis would be comparing the relative size of the Cost of Goods Sold (COGS) to the Total Sales for two different reporting periods. If COGS is 75% of Total Sales in both periods, then the cost structure of the company has remained compactable throughout the period. However, if one period shows COGS as 80% of Total Sales and the other shows COGS as 70%, then changes in the cost structure are being highlighted which could be further investigated.
Common size analysis can also be used to compare two different companies in the same industry. If one company has COGS as 90% of their Sales, but the other has COGS as only 70% of Sales, then this can be indicative of each company's respective efficiency in cost management for the reporting period.
Break-even analysis is a financial analytic technique used to calculate the amount of a product or service that must be sold in order to cover all costs associated with its production and/or delivery. It is commonly used as an indicator of a business’s likelihood of success and to assess the viability of a new product, campaign, or business model. This type of analysis is also useful in understanding the costs and benefits of different pricing strategies.
Explanation of Break-Ever Analysis
Break-even analysis takes into account both fixed and variable costs associated with producing a good or service. Fixed costs are non-negotiable expenses, such as rent, insurance, and legal fees, that must be paid regardless of sales volume. Fixed costs remain constant in the short-term and are not affected by increases or decreases in sales volume. Variable costs are expenses that directly involve the production and/or delivery of a product or service, such as material costs, payroll, and shipping expenses. These costs are directly proportional to sales volume and fluctuate when sales volume increases or decreases.
Examples of Break-Even Analysis
Using break-even analysis, businesses can easily determine the minimum revenue necessary to cover all associated costs. For example, a business that produces t-shirts may have total fixed costs of $5,000 (including rent and manufacturing equipment) and variable costs of $20 per shirt. In order to cover all associated costs, the business must sell 250 shirts in order to break-even.
In terms of pricing, break-even analysis can help businesses set prices that ensure profitability. For example, a business that manufactures digital cameras may have total fixed costs of $100,000 (including rent, legal fees, and the cost of labor and materials) and variable costs of $300 per camera. To cover all costs, the business must sell a minimum of 333 cameras at a price of $433 ($100,000 ÷ 233 = 433).
As such, businesses can use break-even analysis to assess their profitability and make informed decisions regarding pricing and production, helping them to maximize their profits and minimize their losses in the long-term.
Liquidity analysis is a method of financial analysis which is used to assess a company's ability to pay off its short-term debts. An analysis of liquidity looks at the ratio of current assets to current liabilities and helps to identify the ease of the company to pay off its liabilities and obligations. Liquidity analysis is helpful to detect any potential insolvency problems. Businesses and creditors often conduct liquidity analysis to ensure that a business has the necessary cash flows to cover its debt commitments.
Explanation of Liquidity Analysis
Liquidity analysis uses the company's balance sheet and income statement to analyze the liquidity of the company. This can be done by distinguishing current assets from the long-term ones on the balance sheet. On the income statement, companies have to specify their receipts and payments such as debt repayments, outstanding loans and investments, and other short-term liabilities. The analysis then figures out the excess of the current assets over the current liabilities. This indicates the amount of cash or near-cash assets that a company has available to pay off its short-term liabilities.
Examples of Liquidity Analysis
One of the most popular liquidity ratios is the liquidity ratio. It is calculated by subtracting current liabilities from current assets to find the net current assets. It shows the relationship between a company's current assets and its current liabilities. A high liquidity ratio indicates that the company has the ability to quickly pay its debts. Another liquidity ratio is the current ratio. It is calculated by dividing current assets by current liabilities. It compares quick assets to quick liabilities, which helps determine the company's ability to meet its obligations.
- Liquidity Ratio = Current Assets/Current Liabilities
- Current Ratio = Current Assets/Current Liabilities
Financial analysis is a powerful tool used by investors, analysts, and managers to review a company’s financial data and draw conclusions about its overall financial health and performance. It involves evaluating past, current, and projected financial information to gain insights and make better-informed decisions. Investing the time to research and understand the different types of financial analysis techniques is essential for any savvy investor or manager.
The various types of financial analysis techniques can be categorized into four main groups: fundamental analysis, ratio analysis, discounted cash flow analysis, and comparative analysis. Fundamental analysis involves evaluating a company’s fundamental financial information to determine its intrinsic value. Ratio analysis compares key ratios to industry averages and performance over time to identify opportunities for improvement. Discounted cash flow analysis evaluates a company’s future performance by analyzing the present value of its future cash flows. Comparative analysis evaluates a company’s performance relative to its peers and competitors.
By understanding the different types of financial analysis techniques and appreciating their relative strengths and weaknesses, investors, analysts, and managers can leverage them to improve their decision making and take actions that benefit their companies.