Financial analysis is performed using information published in a company’s financial statements to assess current financial condition and past performance.
Financial Key performance indicators such as liquidity, profitability and solvency, among others highlighted by this process, are used to determine the financial strengths and weaknesses of the commercial entity.
This analysis can be performed internally within the organization to facilitate decision-making by management. External parties and interested parties, such as auditors, regulators, financial analysts, investors and competitors, can also conduct their analysis using the facts available to determine the financial position of the entity. These interested parties also use the information for decision-making appropriate to their respective interests.
Three types of financial analysis can be performed with the financial statements of companies: horizontal analysis, vertical analysis and ratio analysis.
- Horizontal analysis
Horizontal analysis of financial information involves evaluating and comparing relative changes in specific items in a financial statement during stipulated accounting periods. The items in question can be sales, income, etc., and the accounting periods can be months, quarters, years, and so on.
This type of financial analysis is best applied when looking to determine the dynamic behavior of an item to observe the trend of the item during specified accounting periods. This is important to determine the factors behind the trend, whether they are positive or negative. For example, the net profit of a company can be tracked over a period of five years.
However, there are two ways to perform a horizontal analysis, namely; percentage analysis and absolute analysis.
In absolute analysis, comparisons are made using the figures recorded in the financial statements, while in percentage analysis, comparisons involve presenting the relative variation of the figures in percentages.
- Vertical analysis
Also known as common size analysis, this vertical analysis involves comparing separate item figures to a standard figure on the balance sheet during a specific accounting period. For example, if the total income for an accounting period is considered to be 100%, other items such as employee benefits and debt repayment for a particular period can be calculated as percentages against the total income for the accounting period. specific.
This form of analysis is most useful for determining the efficiency of business items by comparing how they compare to common items such as revenue.
- Ratio analysis
This method of financial analysis correlates the different items on a balance sheet with the income statement to determine the financial performance of the company. Assets are measured against liabilities and are presented in a simpler and more understandable way without citing huge figures.
Ratio analysis is most important when analysts and stakeholders seek to determine the viability and sustainability of an entity’s long-term and short-term financial strategies.