Financial analysis involves evaluating a company’s financial statements and other financial data to make informed decisions about its performance, stability, and profitability. It helps investors, managers, and other stakeholders assess the financial health of a company and make strategic decisions based on the analysis.
Types of Financial Analysis
Use: Helps in evaluating relative performance and competitiveness.
Ratio Analysis
Purpose: Evaluates financial ratios to understand a company’s performance, efficiency, liquidity, and profitability.
Key Ratios:
Liquidity Ratios: Measure the ability to meet short-term obligations (e.g., Current Ratio, Quick Ratio).
Profitability Ratios: Assess the company’s ability to generate profit (e.g., Net Profit Margin, Return on Assets).
Leverage Ratios: Evaluate the level of debt relative to equity (e.g., Debt-to-Equity Ratio, Interest Coverage Ratio).
Efficiency Ratios: Analyze how effectively a company uses its assets (e.g., Inventory Turnover, Receivables Turnover).
Trend Analysis
Purpose: Examines financial performance over time to identify patterns and trends.
Use: Helps in understanding long-term growth, cyclical patterns, and seasonality by comparing financial metrics across multiple periods.
Horizontal Analysis
Purpose: Compares financial statements over different periods to assess growth or decline.
Use: Analyzes changes in financial figures from one period to another, often expressed as a percentage change.
Vertical Analysis
Purpose: Evaluates financial statements by expressing each line item as a percentage of a base figure (e.g., total sales, total assets).
Use: Helps in understanding the relative proportion of each financial statement item to the base figure, facilitating comparisons across companies and industries.
Cash Flow Analysis
Purpose: Assesses the cash inflows and outflows to understand liquidity and financial health.
Use: Analyzes operating, investing, and financing activities to evaluate a company’s ability to generate cash and manage cash flow.
Variance Analysis
Purpose: Compares actual financial performance to budgeted or expected performance to identify deviations.
Use: Helps in understanding reasons for variances in revenues, expenses, and profits, and in making corrective actions.
Break-Even Analysis
Purpose: Determines the level of sales needed to cover total costs and achieve no profit or loss.
Use: Helps in pricing strategies, cost control, and profitability planning.
Cost-Volume-Profit (CVP) Analysis
Purpose: Examines the relationship between costs, sales volume, and profits.
Use: Assists in decision-making regarding pricing, product mix, and cost management.
DuPont Analysis
Purpose: Breaks down Return on Equity (ROE) into component parts to understand the drivers of profitability.
Use: Analyzes the effects of profitability, asset efficiency, and financial leverage on ROE.
SWOT Analysis
Purpose: Assesses a company’s strengths, weaknesses, opportunities, and threats.
Use: Provides a strategic overview by evaluating internal and external factors that impact financial performance.
Economic Value Added (EVA)
Purpose: Measures a company’s financial performance based on the residual wealth after deducting the cost of capital.
Use: Assesses how well a company generates value over its cost of capital, useful for performance evaluation.
Comparative Analysis
Purpose: Compares a company’s financial performance with that of its peers or industry benchmarks.