Financial analysis is the process of assessing a company's performance and making recommendations about how it's going to perform in the future. Financial analysts carry out their work in Excel and use historical data to then generate projections about the future. Let's look at the most common types of financial analysis and the ones that we're going to discuss in this tutorial.
These 12 types are extremely important and we're going to outline what each of them are and how they're useful. Let's begin with a vertical analysis. In vertical analysis, an analyst will take each line item on the income statement and divided into revenue to see it as a percentage.
This enables the analyst to compare the company to other companies in the same industry, which is why it's also called a common sized income statement. So this is a very good first step in comparing companies. Another type of analysis is horizontal. With horizontal, instead of moving up and down the income statement, we move across the income statement, comparing year-over-year performance. It's typically done with 3-5 years of historical data, and the numbers are divided into each other to express them as a growth rate either up or down year-over-year.
This is commonly referred to as trend analysis. Leverage ratios are very important to analyze for a company. It tells the analyst how much debt or equity a business has relative to its assets or to some type of cash flow generation. Below are four examples of commonly used leverage ratios that an analyst should know about. Growth rates are another important type of financial analysis.
Based on historical results, an analyst can forecast how it expects a company to grow in the future. Common examples are listed on the right here, with the most common being year-over-year growth rates, Regression analysis, bottom-up and top-down approaches to forecasting. Profitability analysis looks at how much income a business earns relative to its revenue. You can look at gross profit, EBITDA, EBIT, and net profit margins to see how much earning a company can generate. Liquidity analysis is also very important.
Liquidity analysis looks at the short-term Ability of a company to meet its obligations. You can look at the current ratio, perform an asset test, the cash ratio, and look at networking capital to understand how easily a company can meet its obligations that are due in less than a year. Efficiency analysis is very important and looks at a company's balance sheet as well as its ability to generate revenue.
So essentially, it looks at a company's assets and its sales and tries to assess how well it's using those assets to generate revenue. Cash flow analysis, there is an expression that cash is king and this is very true in finance. Thus cash flow analysis needs to be performed in addition to profitability analysis. Looking at the cash flow statement will give a clear picture of how much cash a company is generating.
On the right here are four common cash flow metrics that an analyst should use to analyze a business. Rates of return are very important for investors. When they make an investment, they want to get a return on it, or an ROI.
There are many types of ways to measure return. Common examples are listed below, with internal rate of return being the ultimate measure of return for an investor. Valuation analysis is when an analyst attempts to value a company based on cash flow or other metrics. Let's look at the main methods of valuing a company.
business or an asset. There is the cost approach, the market approach, and the discounted cash flow approach or intrinsic value. In CFI's courses we focus mostly on the market approach and the intrinsic value approach.
These are the most common methods used by industry practitioners. Scenario and sensitivity analysis can be layered on top of valuation work and it looks to understand how sensitive the value of a company is relative to changes in operating assumptions. Scenarios can be used to understand how a business might perform in different future states of the world.
And finally, variance analysis looks to assess how a company performed relative to its budget or to a forecast. It seeks to understand, using root cause analysis, what was the lead or the cause of over and under performance. A waterfall chart as shown on the right here can help summarize the impact of various assumptions in the results that the company achieved.
At the end of the day, all 12 methods of financial analysis are very important and should all be done together in conjunction with each other, so that you can have a full picture of a business's performance and how you expect it to perform in the future. Thank you so much for joining us for this tutorial on financial analysis.