Are you new to finance analysis and feeling a little lost? No worries! Learning about finance analysis can be a bit daunting at first, but we’re here to help. In this easy guide, we’ll break down the basics of finance analysis in a way that’s easy to understand, even if you’re completely new to the subject.
Whether you’re interested in personal finance or business finance, this guide will provide you with the knowledge you need to get started. So, let’s dive in and explore finance analysis together!
What’s Financial Analysis All About?
Financial analysis involves using financial data to evaluate a company’s performance. This is usually done in Excel. The main parts of financial analysis include vertical analysis, horizontal analysis, leverage analysis, growth rates, profitability analysis, liquidity analysis, efficiency analysis, cash flow analysis, rates of return, and valuation analysis. These help in assessing a company’s performance, growth, profitability, liquidity, efficiency, and value.
Financial analysis is important for businesses and investors as it allows them to evaluate economic trends, set financial policies, make long-term plans, and identify potential investment opportunities. It is crucial for making informed decisions about investment and financial planning. Different types of analysis, such as vertical, horizontal, leverage, profitability, and liquidity analysis, provide insights into a company’s financial health by examining different aspects of its operations.
For example, profitability analysis helps to assess a company’s ability to generate profits, while liquidity analysis assesses its ability to meet short-term financial obligations. These analyses provide a comprehensive view of a company’s financial situation and help in making informed investment decisions.
Different Ways to Do Financial Analysis
Looking at Numbers: Vertical Analysis
Vertical analysis is a way to understand a company’s financial health. It looks at the proportion of different line items in its financial statements. This helps investors and analysts see the relative importance of things like revenue, expenses, and assets in relation to total sales or total assets. This can show the strengths and weaknesses of a company, and areas for improvement.
The main parts of vertical analysis are profit and loss statements, balance sheets, and cash flow statements. By comparing these parts to the total, analysts can learn about a company’s performance.
For example, if a company’s cost of goods sold is much higher compared to its revenue than its competitors in the same industry, it might show problems in manufacturing or sourcing.
Vertical analysis can also compare different companies in the same industry. It does this by standardizing their financial statements as percentages of the total. This makes it easier to compare their financial performance, and spot any differences.
For example, if two companies in the retail industry have similar revenue but very different operating expenses as a percentage of revenue, it might show differences in efficiency.
Comparing Over Time: Horizontal Analysis
Horizontal analysis compares financial data over different periods of time. It helps evaluate a company’s performance and identify trends.
Key components of horizontal analysis include examining and comparing line items on a financial statement, like revenues, expenses, and net income. This assesses changes and trends.
Analysts use this to understand a company’s financial performance by identifying increases or decreases in specific line items.
Horizontal analysis also helps identify trends and patterns in a company’s financial statements over time. This provides insights into the company’s financial position.
For example, increasing revenues over several years indicate a positive trend. Conversely, declining net income may signify financial challenges.
Therefore, horizontal analysis is important for financial professionals. It helps them make informed decisions and recommendations about a company’s financial health, strengths, and weaknesses.
Understanding Company Debts: Leverage Analysis
1. Leverage analysis looks at how a company uses debt to run its business. It helps see how debt affects the company’s profits and risks. This analysis also checks if the company can handle its debt.
2. In leverage analysis, specific measurements (like debt-to-equity ratio, debt ratio, interest coverage ratio, and debt service coverage ratio) are used to understand the level of debt a company uses and its ability to pay it back.
3. This type of analysis also helps understand the risk linked to a company’s debt. It checks if the company makes enough money to cover its interest and debt payments. Plus, it shows how changes in interest rates or the business environment could affect the company’s ability to repay its debts.
How Fast is a Company Growing?
Indicators for assessing a company’s growth rate include vertical analysis, horizontal analysis, leverage analysis, growth rates, profitability analysis, liquidity analysis, efficiency analysis, cash flow analysis, rates of return, and valuation analysis. These metrics offer insights into the company’s performance, growth, profitability, liquidity, efficiency, and value.
Historical data and industry benchmarks are used to analyze the speed of a company’s growth by looking at past performance to estimate future performance. Comparing a company’s financial statements and ratios against other companies or historical data provides a basis for understanding its growth trajectory and identifying any patterns or anomalies. Industry benchmarks allow for understanding a company’s growth within the broader market, providing insights into its competitive position and potential for expansion.
A company’s growth rate can significantly impact its financial health and performance. Rapid growth may strain a company’s resources, leading to liquidity issues or inefficiencies. Slow growth or decline may indicate underperformance. By closely analyzing a company’s growth rate, financial analysts can gauge its ability to generate profits, optimize resources, and maintain operational stability, all of which are critical for ensuring sustained financial health and performance.
Is the Company Making Money? Profitability Analysis
Financial analysis involves using financial data to assess a company’s current profitability. This includes comparing it to industry benchmarks or competitors. Analysis also identifies factors influencing profitability levels.
Professionals in finance and accounting analyze a company’s financial statements and calculate ratios to gain insight into its performance, growth, profitability, liquidity, efficiency, and value.
This process allows for the extrapolation of past performance to estimate future performance. Investors and financial analysts use this information to make recommendations for the future. However, financial statement analysis often relies on historical data, which may not accurately predict future performance due to the pace of business today.
It’s important to note that this type of analysis typically omits key factors such as industry trends, regulatory issues, and management capabilities. Additionally, insufficient data governance policies or the manual gathering and preparation of financial data can result in inaccurate data, impacting the outcome of the analysis.
Can the Company Pay its Bills? Liquidity Analysis
The company’s current ratio and quick ratio are important metrics for analyzing liquidity. The current ratio measures the ability to pay short-term obligations using short-term assets. Meanwhile, the quick ratio evaluates the ability to quickly pay off these obligations without relying on inventory sales.
A current ratio of less than 1 indicates potential difficulty in meeting short-term liabilities. Similarly, a quick ratio below 1 may imply a reliance on inventory liquidation, which can be risky due to potential obsolescence.
The company’s cash conversion cycle, representing the time to convert sales into cash, directly impacts its ability to meet bill payments on time. A longer cycle may indicate potential cash flow issues hindering timely bill payments.
It’s important to compare the company’s liquidity position to industry benchmarks for assessing financial obligations. If the company’s liquidity position is weaker than industry standards, it may face difficulties in meeting financial obligations. Conversely, a stronger liquidity position may provide advantageous negotiating power with suppliers and creditors.