Methods of Financial Analysis

Conducting a review of how a business is performing can prove daunting, since it requires an organised collection and evaluation of financial information. Financial analysis may be defined as the process of highlighting the financial strengths and flaws of a business by studying both the balance sheet and income statement elements. Financial statements produce a summary of data from which important analysis and interpretation can be made.

There are three main methods of financial analysis:

1. Horizontal and vertical analysis

When using the horizontal analysis method, financial information is compared over a sequence of reporting periods. The vertical analysis method allows analysing financial information in a proportional manner, where every line item on a financial statement is recorded as a proportion of another item. Naturally, this implies that each line item detailed on the income statement is quantified as a proportion of gross sales, whereas each line item detailed on a balance sheet is quantified as a proportion of total assets.

2. Ratio analysis

Ratios are used to calculate the comparative size of a number in relation to another number. After a ratio is calculated, it can be used to compare a similar ratio calculated for a previous period, or a ratio founded on an average of a particular industry in order to establish whether the company’s performance is in harmony with set expectations. In a typical financial analysis exercise, the majority of ratios will be within set expectations while a few will highlight potential issues, thereby attracting the reviewer’s attention. Ratios have been generalised into four categories namely: liquidity ratios, activity ratios, leverage ratios, and profitability ratios. 

3. Trend analysis

This entails reviewing financial statements of three or more periods, an extension of horizontal analysis. The earliest year in the set data represents the base year. In trend analysis, users assess statements for incremental change patterns. A change in financial statements can indicate that there are either increased income or decreased expenses. 

Which method do you prefer?

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