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 its 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 you should be aware of:
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.
A background in Finance is certainly useful to be able to conduct financial analysis though this is not a pre-requisite. If you have a minimal understanding of financial concepts, however, it may be useful to up-skill by opting to study finance online or face-to-face, depending on what suits you. There is also the option of outsourcing this function to a specialist, if this is not an area you have interest in.
Picture Attribution: “Decreasing Diagram In 3d” by jscreationzs/Freedigitalphotos.net
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