Financial analysis: Framework and Techniques
Financial heath of an organisation is key indicator that has always been of great value both internally as well as outside of an organisation. This article aims to provide more clarity on what financial analysis is, what is it’s objective and what data and techniques are being used to achieve this objective. This article will be wrapped up by giving you an overview of the frameworks and key techniques to be used when engaging in financial analysis.
What is financial analysis?
A company’s data carries enormous amount of information, allowing financial analysts not only to derive conclusions on the past and present, but also to try and predict into the future as well. Therefore, financial analysis is best described as the process of using financial data to assess a company’s performance and make recommendations about how it can improve going forward.
Typically, financial analysis is used to assess the status of an organisation by looking at how stable, solvent, liquid or profitable it is so that a correct monetary value could be further allocate against it. This is generally used internally in an organisation as a tool for monitoring and managing the finances, while external investors tend to use it to understand the overall health of an organization as well as to evaluate financial performance and business value.
What type of data is used for financial analysis?
A primary source of data is a company’s annual report, including the financial statements and notes, and management commentary (operating and financial review or management’s discussion and analysis). However, financial reports do not contain all the information needed to perform effective financial analysis. Although financial statements do contain data about the past performance of a company (its income and cash flows) as well as its current financial condition (assets, liabilities, and owners’ equity), such statements do not necessarily provide all the information useful for analysis nor do they forecast future results.
Consequently, the financial analyst must be capable of using financial statements in conjunction with other information to make projections and reach valid conclusions.
The objective of financial analysis
When proceeding with the analysis of the financial information, it is essential to clearly identify and understand the final objective and the steps required to reach that objective. In addition, the financial analyst needs to know where to find relevant data, how to process and analyse the data (in other words, know the typical questions to address when interpreting data), and how to communicate the analysis and conclusions.
Prior to the beginning of any financial analysis, by asking themselves the following questions, analysts can create a strong foundation for their work:
- What is the purpose of the financial analysis?
- What questions will this financial analysis answer?
- What level of detail will be needed to accomplish this purpose?
- What data are available for the financial analysis?
- What are the factors or relationships that will influence the financial analysis?
- What are the analytical limitations, and will these limitations potentially impair the financial analysis?
Having clarified the purpose and context of the analysis, the analyst can select the set of techniques that will best assist in making a decision. Although there is no single approach to structuring the financial analysis process, a general framework can be put together by identifying a few main phases:
- Articulate the purpose and context of the financial analysis
- Collect input data
- Process data
- Analyse/interpret the processed data
- Develop and communicate conclusions and recommendations (e.g., with an analysis report)
With that said, there are also multiple tools and techniques at an analyst’s disposal to help in reaching their objective. Find below some of the main techniques and tools to conduct the financial analysis.
Financial analysis: Horizontal vs vertical analysis
Financial analysis can be of two types: Horizontal analysis and vertical Analysis. The main difference between horizontal and vertical analysis is that the former considers the comparison between a percentage amount of an item in the financial statement with that of a base year’s corresponding item, while the latter talks about each amount separately in the financial statement as a percentage for another amount in the same financial period.
What is horizontal analysis?
The horizontalanalysis or “trend analysis” considers all the amounts in financial statements over many years. The amounts from financial statements will be considered as the percentage of amounts for the base.
One tool used in horizontal analysis are the financial ratios, which are particularly useful for gauging the trend and direction over the period. This is often known as trend analysis, effectively allowing the assessment of relative changes in different items over time. What is more, analysts tend to compare these ratios to industry averages (known as benchmarking), industry standards and also against internal trends.
The five major categories in the financial ratios list include the following :
- Liquidity Ratios
- Activity Ratios
- Debt Ratios
- Profitability Ratios
- Market Ratios
What is vertical analysis?
On the other hand, vertical analysis considers each amount on the financial statement listed as a percentage of another amount. For example, in vertical analysis, the line of items on a balance sheet can be expressed as a proportion or percentage of total assets, liabilities or equity. However, in the case of the income statement, the same may be indicated as a percentage of gross sales, while in cash flow statement, the cash inflows and outflows are denoted as a proportion of total cash inflow.
With the help of this financial analysis, the percentages computed can be directly compared with the result of the equivalent percentages of the past years or other companies operating in the same industry, irrespective of their size. So, common size financial statement not only helps in intra-firm comparison but also in inter-firm comparison.
Summary: Financial analysis and how to use it
Financial analysis is helpful in accurately ascertaining and forecasting future trends and conditions. The concepts of horizontal and vertical analysis are often the main tools used in getting a clear picture of the financial health and performance of the company, while also serving as enablers for the expansion of the business.
The primary aim of horizontal analysis is to compare line items in order to ascertain the changes in trend over time. As against, the aim of vertical analysis is to ascertain the proportion of item, in relation to a common item in percentage terms. The two analysis are helpful in getting a clear picture of the financial health and performance of the company.
In addition to that, financial ratios or otherwise known as accounting ratios can be further used to provide even more information into how a business performs. What is more, ratios are particularly useful in identifying trends in the business while also providing warning signs when it may be time to make a change. Ratios tend to be particularly useful when results over several periods are compared.
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