Financial Analysis

What is Financial Analysis?

Financial analysis involves using financial data to assess a company’s performance and make recommendations about how it can improve going forward. Financial analysts primarily carry out their work in Excel, using spreadsheets to rigorously analyze historical data and make projections of how they think the company will perform in the future. This guide will cover the most common types of financial analyses professionals perform.

Types of Financial Analysis

The most common types of financial analysis are:

Vertical
Horizontal
Leverage
Growth
Profitability
Liquidity
Efficiency
Cash Flow
Rates of Return
Valuation
Scenario & Sensitivity
Variance
Vertical Analysis

This type of financial analysis is called Vertical Analysis or a Common-Sized Income Statement analysis.

This analysis involves looking at various income statement components (e.g., Cost of Goods Sold, Gross Profit, Operating Expenses) and dividing them by revenue (or Sales) to express them as a percentage of revenue.

Purpose: This process is also sometimes called a common-sized income statement because it allows an analyst to effectively compare companies of vastly different sizes by evaluating their margins and cost structures instead of just their absolute dollar amounts.

Benchmarking: For this exercise to be most effective, the results should be benchmarked against other companies in the same industry. This comparison reveals how well the company is performing relative to its peers.

Horizontal Analysis

Horizontal analysis, also known as Trend Analysis, involves taking several years of a company’s financial data and comparing them to each other to determine a growth rate (or decline rate). This process helps an analyst determine if a company is consistently growing or declining and allows for the identification of significant trends over time.

Data Requirements for Modeling

When building comprehensive financial models, analysts typically include:

A minimum of three years of historical financial information.
At least five years of forecasted information.

This combination provides eight or more years of data to perform a meaningful trend analysis. The results of this analysis can then be benchmarked against other companies in the same industry to provide context and evaluate comparative performance.

Leverage Analysis

Leverage ratios are one of the most common methods analysts use to evaluate a company’s financial performance and capital structure. The core idea is that a single financial metric, such as total debt, is often not insightful by itself.

It is much more helpful to compare total debt to a company’s total equity (the owners’ stake) to get a complete picture of how the company is financed.

The result of this comparison is the Debt-to-Equity (D/E) ratio (Debt \ Equity). This ratio reveals:

The proportion of financing that comes from debt (liabilities) versus equity (shareholders/owners).
How heavily leveraged the company is. A high ratio suggests the company relies more on borrowing, which increases financial risk.

Common examples of ratios include:

Debt/equity
Debt/EBITDA
EBIT/interest (interest coverage)
Dupont analysis – a combination of ratios, often referred to as the pyramid of ratios, including leverage and liquidity analysis.
Growth Rates

Analysing historical growth rates and projecting future ones are a big part of any financial analyst’s job. Common examples of analysing growth include:

Year-over-year (YoY)
Regression analysis
Bottom-up analysis (starting with individual drivers of revenue in the business)
Top-down analysis (starting with market size and market share)
Other forecasting methods
Profitability Analysis

Profitability is a type of income statement analysis where an analyst assesses how attractive the economics of a business are. Common examples of profitability measures include:

Gross margin
EBITDA margin
EBIT margin
Net profit margin
Liquidity Analysis

This type of financial analysis focuses on the balance sheet, particularly a company’s ability to meet short-term obligations (those due in less than a year). Common examples of liquidity analysis include:

Current ratio
Acid test
Cash ratio
Net working capital
Efficiency Analysis

Efficiency ratios are an essential part of any robust financial analysis. These ratios look at how well a company manages its assets and uses them to generate revenue and cash flow.

Common efficiency ratios include:

Asset turnover ratio
Fixed asset turnover ratio
Cash conversion ratio
Inventory turnover ratio
Cash Flow

As the saying goes in finance, cash is king, and a significant emphasis is always placed on a company’s ability to generate cash flow. Analysts across a wide range of finance careers, including portfolio management and corporate finance, spend a great deal of time looking at companies’ cash flow profiles to assess their liquidity and solvency.

The Statement of Cash Flows

The Statement of Cash Flows is the primary report for this analysis. It details the inflows and outflows of cash over a period and is broken down into three main sections:

Operating Activities: Cash generated from the company’s normal day-to-day business operations.

Investing Activities: Cash used for or generated from the purchase or sale of long-term assets (e.g., property, plant, and equipment—PP&E) or investments in other companies.

Financing Activities: Cash flow related to debt, equity, and dividends (e.g., issuing new stock, taking out loans, or paying dividends to shareholders).

Common examples of cash flow analysis include:

Operating Cash Flow (OCF)
Free Cash Flow (FCF)
Free Cash Flow to the Firm (FCFF)
Free Cash Flow to Equity (FCFE)
Rates of Return

At the end of the day, investors, lenders, and finance professionals, in general, are focused on what type of risk-adjusted rate of return they can earn on their money as such, assessing rates of return on investment (ROI) is critical in the industry.

Common examples of rates of return measures include:

Return on Equity (ROE)
Return on Assets (ROA)
Return on invested capital (ROIC)
Dividend Yield
Capital Gain
Accounting rate of return (ARR)
Internal Rate of Return (IRR)
Valuation Analysis

Estimating what a business is worth, or Business Valuation, is a major component of financial analysis. Professionals in the industry spend a great deal of time building financial models in Excel specifically for this purpose.

The value of a business can be assessed in many different ways, and analysts need to use a combination of methods to arrive at a reasonable estimation. These methods generally fall into three categories:

Asset Approach: Valuation based on the fair value of the company’s assets and liabilities.

Income Approach: Valuation based on expected future cash flows (e.g., Discounted Cash Flow – DCF analysis).

Market Approach: Valuation based on the prices of similar public or acquired companies (e.g., comparable company analysis).

Approaches to valuation include:

Cost Approach – The cost to build/replace
Relative Value (market approach) – Comparable company analysis , Precedent transactions
Intrinsic Value – Discounted cash flow analysis
Scenario & Sensitivity Analysis

Performing scenario and sensitivity analysis is a crucial component of financial modelling and valuation used specifically to measure and manage risk. Since the task of building a model to value a company is an attempt to predict the future, it is inherently subject to significant uncertainty.

Scenarios: Building scenarios involves developing distinct, complete future paths (e.g., a “Worst-Case,” “Best-Case,” or “Expected” future) for a company based on multiple varying assumptions.
Sensitivity Analysis: This analysis measures how much a single variable (e.g., sales growth rate or cost of goods sold margin) can change the final valuation result.

Together, these methods help determine the range of possible outcomes, from the worst-case to the best-case future, allowing management to understand risk boundaries. Managers working in Financial Planning and Analysis (FP&A) often prepare these analyses to help the company prepare robust budgets and forecasts that account for market volatility.

Variance Analysis

Variance analysis is the process of comparing actual financial results to a pre-determined budget or forecast.

The Process

The analysis typically involves two key steps:

Determine the Nature: Looking at whether the variance (the difference between actual and budgeted amounts) was favourable (positive impact on profit) or unfavourable (negative impact on profit).
Determine the Root Cause: Breaking the variance down to determine its fundamental reason. For example, if a company had a budget of $2.5 million in revenue but achieved actual results of $2.6 million, this results in a $0.1 million favourable variance. The cause might then be attributed to higher-than-expected sales volumes (selling more units) as opposed to higher prices.

Financial Analysis Best Practices

The financial analysis methods discussed including Vertical Analysis, Horizontal Analysis, Variance Analysis, and Valuation are commonly performed in Excel using a wide range of formulas, functions, and keyboard shortcuts.

Best practices include: