Financial analysis is conducted using information posted on a business' financial statements to evaluate the current financial position and the past performance.
Financial Key performance indicators such as liquidity, profitability,
and solvency among others highlighted by this process are used to ascertain the
financial strengths and weaknesses of the business entity.
This analysis can be performed internally within the organization to
facilitate decision making by management. External parties and stakeholders
such as auditors, regulators, financial analysts, investors, and competitors
can also conduct their analysis using the available facts to ascertain the
entity's financial position. These stakeholders equally utilize the information
for decision-making suitable for their respective interests.
Three types of financial analyses can be performed with businesses
financial statements are horizontal analysis, vertical analysis, and ratio
analysis.
1. Horizontal analysis
Horizontal analysis of financial information entails the assessment and
comparison of the relative changes in specific items in a financial statement
over stipulated accounting period. The items in question could be sales,
revenue, etc., and the accounting periods can be months, quarters, years, etc.
This type of financial analysis is best applied when seeking to
determine the dynamic behaviour of an item so as to observe the trend of the
item over the specified accounting periods. This is important in determining
the factors behind the trend, whether positive or negative. For example, the
net profit of a business can be tracked over a five-year period.
However, there are two ways of conducting a horizontal analysis, namely,
percentage analysis and absolute analysis.
In the absolute analysis, the comparisons are carried out using the
figures posted in the financial statements whereas in percentage analysis, the
comparisons entail presenting the relative change in the figures into
percentages.
2. Vertical analysis
Also known as the common-size analysis, this vertical analysis involves
comparison of figures of separate items to a standard figure on the balance
sheet over a specified accounting period. For example, taking the total revenue
of an accounting period to be 100%, other items such as employee benefits and
debt repayment for a particular period can be calculated as percentages against
the total revenue of the specific accounting period.
This form of analysis is most useful in the determination of the
efficiency of business items by comparing how they stack up against common
items such as income.
3. Ratio analysis
This method of financial analysis correlates the different items of a
balance sheet to the income statement to determine the financial performance of
the firm. Assets are measured against liabilities and presented in a simpler
way that is comprehensible without quoting huge figures.
Ratio analysis matters most when analysts and stakeholders seek to
determine the viability and sustainability of an entity's long-term and
short-term financial strategies.
Chris Bouchard is a strategic consultant who works with non-profit
leaders and social entrepreneurs to apply concepts and techniques to identify
complex strategic issues, find practical solutions, and devise strategies to
create and win a unique strategic position. He also offers project development,
proposal writing, and project evaluation services.
Article By Chris Bouchard
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