What Is Financial Analysis?
Financial analysis is certain procedures and methods applied to determine the past, present and also the future status and performance of business with the aim to compare how the business performed in the past, how it performs now and use such data for forecasting purposes, making decisions about the business performace, manage it and control.
Before exploring how to perform a financial statement analysis, please note that there are three main types of financial analysis:
- Vertical analysis: it is used to gain knowledge on the structure of financial statements and its parts comparing to each other. It gives a clear picture of income statement structure, comparing different types of expenses to the revenue earned. Also it gives an indication on the structure of assets, whether they consist of current or long-term assets and also capital structure, answering the question whether the capital constitutes of long-term debts, current debts or equity.
- Horizontal analysis: it is used to find out the trends of financial performance for a particular period of time, i.e. comparing financia data of several different periods.
- Ratio analysis: it is used to compare the performance of the company with other companies and also to understand whether a company is improving or is on a downslide. Ratio analysis is useful, since vertical and horizontal financial analysis is performed only using absolute figures, and in ratio analysis ratios are used to analyse financial performace of buisness.
Purpose Of Financial Statement Analysis
While learning how to perform a financial statement analysis, it is important to understand what is the purpose of this analysis.
The purpose of a financial analysis varies with the entity conducting the analysis and the users of financial analysis data. During a financial analysis the relation between the various elements of financial statements is established and also compared with the other information obtained about the business. This is a very important tool and is used by the investors, creditors and the management in determining the future prospects as well as the plans regarding the company. This is also used to identify the areas that need improvement and also solve any type of financial and operational problem. The prime aim of a financial analysis is to analyze the current financial status and performance of the company, so that it will be possible to judge on the future performance of the business.
The purpose of financial analysis usually differes depending on the users of this data. For example, creditors are concerned with the solvency and liquidity because they are the ones who purchase bonds and debt securities of the company. Therefore they want top know the company’s ability to pay off the debts and interest. The investors (investing in the company’s stock) are mainly concerned with the profitability of the company. They wish to know what returns they are going to earn in the form of dividends and a higher stock value.
How To Perform A Financial Statement Analysis
Now, we will one by one look at the three methods on how to perform a financial statement analysis.
Vertical Analysis: as mentioned the purpose of this analysis is to get structure of financial statements. While performing this analysis, it is assumed that total assets, total liabilities, total equity and revenue in the financial statements constitue 100%. All the other part of the financial statements are compared to these basic captions, i.e. to know the structure of the assets we divide each part of assets by total assets and express the result in a percentage. In order to know structure of liabilities, we divide each part of liabilities by total value of liabilities and express the result in percentage and so on. In the picture below you can find the scheme how vertical analysis should be performed for a balance sheet.
Vertical analysis allows us to know structture of assets, liabilities and equity, and also we can compare change in this structure among the years
Horizontal Analysis: This is a method in which two or more financial statistics of a company is compared. This is referred as Horizontal analysis because while comparing one needs to refer to the horizontal counterpart of an item for e.g. sales revenue. Here the analyst can compare the amount as well as the percentage changes for the balances on financial statements for each year. Similarly, an analyst can follow the trend analysis wherein the horizontal analysis for multiple years can be compared. In a trend analysis, a balance of a financial statement for every year is calculated as a percentage of the first year. This year is called the base year and the figures for this year are taken as 100 percent. Based on this the percent changes are calculated.
In the next article I will be covering financial ration and how to perform a financial statement analysis using these ratios.