Chapter 8. Financial Analysis

1 Vertical Analysis

Vertical Analysis is a technique to identify how the company has applied its resources and in what proportion its resources are distributed across the income statement and the balance sheet. In the case of the Income Statement, each element of income and expenditure is defined as a percentage of total sales. The assets, liabilities, and shareholder’s equity are represented as a percentage of total assets.

Horizontal Analysis

In Horizontal Analysis, the Funds financial statements over several years, and it is also called a long-term analysis. This may be used for long-term planning and compares figures of two or more years. This shall be determined by the current year’s growth rate compared to the previous year to identify opportunities and problems.

Trend Analysis

Trend analysis involves collecting the information from multiple periods and plotting the collected information on the horizontal line to find actionable patterns from the given information.

Liquidity Analysis

Liquidity Analysis determines the company’s ability to meet its short-term financial obligations and how it plans to maintain its short-term debt repayment ability.

Ratios used for Liquidity Financial analysis are as follows

Turnover Ratio Analysis

The turnover Ratio primarily identifies how efficiently the Fund’s resources are utilized. The following Ratios are used to do Turnover Analysis –

Profitability Analysis

Profitability financial analysis helps us understand how the company generates its profit from its business activities. The following tools are used to analyze the same –

Profit Margin
Operating Profit Margin
EBIT Margin
EBIDTA Margin
Earnings Before Taxes

Business Risk Analysis

Business Risk Analysis measures how investment in fixed assets affects the sensitivity of the company’s earnings and the debt on the balance sheet. The top ways to analyze Business Risk is as follows –

Operating Leverage
Degree of Operating Leverage
Financial Leverage
Degree of Financial Leverage

Financial Risk Analysis

Here we measure how leveraged the company is and its place concerning its debt repayment capacity. Tools used to do leverage financial analysis –

Debt to Equity Ratio
DSCR Ratio

Stability Ratios

The stability ratio is used with a vision of the long-term. It is used to check whether the company is stable in the long run or not.

Coverage Analysis

This type of financial coverage analysis is used to calculate dividend, which needs to be paid to investors or interest to be paid to the lender.

Coverage Ratio Formula
Interest Coverage Ratio

Control Analysis

Control ratio from the name itself, it is clear that it used to control things by management. This type of ratio analysis helps management to check favorable or unfavorable performance.

There are mainly three types of ratios used here – Capacity Ratio, Activity Ratio, and Efficiency Ratio

Capacity Ratio Formula = Actual Hour Worked / Budgeted Hour * 100
Activity Ratio Formula = Standard Hours for Actual Production / Budgeted Standard Hour * 100
Efficiency Ratio Formula = Standard Hours for Actual Production / Actual Hour Worked * 100

Valuation Analysis

Valuation Analysis helps us identify the fair value of the business, investment, or company. While valuing a business, choosing the correct valuation methodology is very important. You may use one of the following valuation financial analysis tools –

Dividends Discount Model DDM
Discounted Cash Flow Formula
Trading Multiples
Transaction Multiples Valuation
Sum of the Parts Valuation

Variance Analysis

Variance analysis in budgeting is the study of the deviation of the actual outcome against the forecasted behavior in finance. It is essentially concerned with the difference between actual and planned behavior and how business performance is being impacted.

Scenario & Sensitivity Analysis

Scenario analysis takes account of all the scenarios and then analyzes them to find out the best and worst scenarios. You can use the following to do sensitivity analysis –

Sensitivity Analysis in Excel
Data Table in Excel
Two-Variable Data Table in Excel
One Variable Data Table in Excel

Rate of Return Analysis

The internal rate of return is a metric employed in capital budgeting, which is used to measure the extent of profitability of potential investments. It is also known as ERR or economic rate of return. IRR is defined as the discount rate that sets the NPV of a project to zero is the project’s IRR. The following tools can be used to rate of return analysis.

Advantages

With the help of financial analysis, method management can examine the company’s health and stability.
It provides investors an idea about deciding whether to invest a fund or not in a particular company, and it answers a question such as whether to invest? How much to invest? And what time to invest?
It simplifies the financial statements, which helps compare companies of different sizes with one another.
With the help of financial analysis, the company can predict the company’s future, forecast future market trends, and do future planning.

Disadvantages

One of the disadvantages of financial analysis is that it uses facts and figures as per current market conditions, which may fluctuate.
False data in the statement will give you false analysis, and companies may manipulate data, and it may not be accurate.
Comparing different companies is not possible if they adopt other accounting policies.
If any company is working in a rapidly changing and highly competitive environment, its past results in the financial statement may or may not be indicators of future results.

Limitations of Financial Analysis

When companies do financial analysis, they often fail to consider the price changes, and due to this, they are unable to show inflation impact.
It only considers the monetary aspects of companies’ financial statements and does not consider the non-monetary aspects of financial statements.
It is based on past data in financial statements, s and future results can’t be like the past.
Many Intangible assets are not recorded in the statement due to Intangible assets not considered while doing financial analysis.
Due to different accounting policies, it is limited to a specific period and not always comparable with different companies’ statements
Sometimes financial analysis influences personal judgment, and it doesn’t necessarily mean that strong financial statements analysis of companies have a strong financial future.

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