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 a spreadsheet to analyse 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:
- Cash Flow
- Rates of Return
- Scenario & Sensitivity
- Vertical Analysis
This type of financial analysis involves looking at various income statement components and dividing them by revenue to express them as a percentage. For this exercise to be most effective, the results should be benchmarked against other companies in the same industry to see how well the company is performing.
This process is also sometimes called a common-sized income statement, as it allows an analyst to compare companies of different sizes by evaluating their margins instead of their dollars.
- Horizontal Analysis
The horizontal analysis involves taking several years of financial data and comparing them to each other to determine a growth rate. This will help an analyst determine if a company is growing or declining and identify significant trends.
There will typically be at least three years of historical financial information and five years of forecasted information when building financial models. This provides 8+ years of data to perform a meaningful trend analysis, which can be benchmarked against other companies in the same industry.
- Leverage Analysis
Leverage ratios are one of the most common methods analysts use to evaluate company performance. A single financial metric, like total debt, may not be that insightful, so it’s helpful to compare it to a company’s total equity to get a complete picture of the capital structure. The result is the debt/equity ratio.
Common examples of ratios include:
- 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 they say in finance, cash is king, and, thus, a significant emphasis is placed on a company’s ability to generate cash flow. Analysts across a wide range of finance careers spend a great deal of time looking at companies’ cash flow profiles.
The Statement of Cash Flows is a great place to get started, including looking at each of the three main sections: operating activities, investing activities, and financing activities.
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 is a major component of financial analysis, and professionals in the industry spend a great deal of time building financial models in Excel. 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.
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
Another component of financial modelling and valuation is performing scenario and sensitivity analysis to measure risk. Since the task of building a model to value a company is an attempt to predict the future, it is inherently very uncertain.
Building scenarios and performing sensitivity analysis can help determine the worst-case or best-case future for a company. Managers of businesses working in financial planning and analysis (FP&A) will often prepare these scenarios to help a company prepare its budgets and forecasts.
- Variance Analysis
Variance analysis is the process of comparing actual results to a budget or forecast. It is an integral part of the internal planning and budgeting process at an operating company, particularly for professionals working in the accounting and finance departments.
The process typically involves looking at whether a variance was favourable or unfavourable and then breaking it down to determine its root cause. For example, a company had a budget of $2.5 million of revenue and had actual results of $2.6 million. This results in a $0.1 million favourable variance due to higher-than-expected volumes (as opposed to higher prices).
Financial Analysis Best Practices
The above methods are commonly performed in Excel using a wide range of formulas, functions, and keyboard shortcuts. Analysts need to be sure they are using best practices when performing their work, given the enormous value at stake and the propensity of large data sets to have errors.
Best practices include:
- Being highly organised with data
- Keeping all formulas and calculations as simple as possible
- Making notes and comments in cells
- Auditing and stress testing spreadsheets
- Having several individuals review the work
- Building in redundancy checks
- Using data tables and charts/graphs to present data
- Making sound, data-based assumptions
- Extreme attention to detail while keeping the big picture in mind
It is also worth noting here that just because everything can be analysed doesn’t mean it would be worth analysing.