According to Kamal Lidder financial analysis is the process of evaluating a company’s performance using financial data and making suggestions for future improvement. Financial analysts spend the majority of their time working in Excel, where they use a spreadsheet to analyze historical data and forecast how the company will perform in the future. This guidebook will cover the most prevalent types of financial analysis performed by professionals. The Financial Analysis Fundamentals Course at CFI has more information.
The following are the most typical types of financial analysis:
- Vertical
- Horizontal
- Leverage
- Growth
- Profitability
- Liquidity
- Efficiency
- Cash Flow
- Rates of Return
- Valuation
- Scenario & Sensitivity
- Variance
In this kind of financial analysis, different parts of the income statement are examined and their percentages are expressed by dividing them by revenue. The results of this activity should be compared to those of other businesses in the same sector to determine how well the company is doing.
This method, often known as a common-sized income statement, enables an analyst to compare businesses of various sizes by analyzing their margins rather than their dollar amounts.
According to Kamal Lidder, to calculate a growth rate, the horizontal analysis compares financial data from many years to one another. This will make it easier for an analyst to see significant trends and evaluate if a company is expanding or contracting.
When creating financial models, there will typically be at least three years of historical financial data and five years of forecasted data. As a result, there are more than 8 years of data to do a useful trend analysis that can be compared to other businesses in the same sector.
Leverage ratios are one of the most widely used methods by analysts to evaluate business performance. Comparing one financial metric, like total debt to total equity for a company, can assist get a full view of the capital structure. The debt/equity ratio is the outcome.
Common examples of ratios include:
- Debt/equity
- Debt/EBITDA
- EBIT/interest (interest coverage)
- Leverage and liquidity analysis are two ratios included in the Dupont analysis, often known as the pyramid of ratios.
Any financial analyst’s job involves a significant amount of both analyzing past growth rates and forecasting future ones. Typical illustrations of growth analysis include:
- Year-over-year (YoY)
- Analysis of regression
- Bottom-up research
- Top-down evaluation
- various forecasting techniques
Kamal Lidder says that an analyst determines the attractiveness of a company’s economics as part of an income statement analysis approach known as profitability. Examples of typical profitability metrics are as follows:
- Gross margin
- EBITDA margin
- EBIT margin
- Net profit margin
This type of financial analysis focuses on the balance sheet, particularly the company’s ability to meet its short-term debt obligations. Examples of liquidity analysis include the following:
- Current ratio
- Acid test
- Cash ratio
- Net working capital
Any thorough financial study must include efficiency ratios. These ratios examine how effectively a business utilizes its resources and employs them to produce revenue and cash flow.
Typical efficiency ratios are as follows:
- Asset turnover ratio
- Fixed asset turnover ratio
- Cash conversion ratio
- Inventory turnover ratio
Kamal Lidder says that the ability of a corporation to generate cash flow is highly valued since, as they say in finance, cash is king. The cash flow profiles of organizations are a frequent focus for analysts in a variety of finance occupations.
Starting with each of the three major sections — operating activities, investing activities, and financing activities — of the Statement of Cash Flows is a fantastic idea.
Examples of cash flow analysis include the following:
- Operating Cash Flow (OCF)
- Free Cash Flow (FCF)
- Free Cash Flow to the Firm (FCFF)
- Free Cash Flow to Equity (FCFE)
Investors, lenders, and financial professionals in general are ultimately concerned with the type of risk-adjusted rate of return they may achieve on their capital. As a result, the sector must evaluate rates of return on investment (ROI).
Examples of typical rates of return measures are as follows:
- 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)
Financial analysis includes the process of determining a company’s value, and experts in the field invest a lot of time creating financial models in Excel. There are numerous ways to determine a company’s value, therefore analysts must combine several of these techniques to produce a reliable estimate.
Various methods of valuation include:
- Cost Approach
- The cost to build/replace
- Relative Value (market approach)
- Comparable company analysis
- Precedent transactions
- Intrinsic Value
- Discounted cash flow analysis
Risk measurement through the scenario and sensitivity analysis is another aspect of financial modeling and valuation. Building a model to evaluate a company is a task that is inherently quite uncertain because it involves making predictions.
Building scenarios and carrying out sensitivity analysis might assist in figuring out what a company’s worst-case or best-case future would entail. These scenarios are frequently created by business managers who work in financial planning and analysis (FP&A) to assist a company in creating its budgets and forecasts.
Using Goal Seek and Data Tables, investment analysts will examine how sensitive a company’s value is to changes in assumptions as they pass through the model.
The process of comparing actual results to a plan or forecast is known as variance analysis. According to Kamal Lidder, it is a crucial step in the internal planning and budgeting process at a running business, especially for experts in the accounting and finance divisions.
The procedure normally entails determining if a deviation was beneficial or unfavorable before dissecting it to identify its underlying causes. For instance, a business expected to generate $2.5 million in sales, but only $2.6 million was generated. This leads to a beneficial variance of $0.1 million, which was brought on by higher than anticipated volumes.
