7 Types of Financial Analysis (With Definition and Examples)

By Indeed Editorial Team

Updated February 22, 2021 | Published February 4, 2020

Updated February 22, 2021

Published February 4, 2020

Several companies use various forms of financial analysis both internally and externally. These analyses are a great way for businesses to evaluate their financial stability and for investors to evaluate whether or not your company is a worthy investment. In this article, we will define financial analysis, describe the various types and provide you with examples to further your knowledge of the various processes.

Related: Learn About Being a Financial Analyst

What is financial analysis?

Financial analysis refers to the process of analyzing a business' various finances to evaluate its financial stability and future. Financial analysis helps business owners determine any necessary courses of action they'll need to take to stay afloat, make a profit or avoid bankruptcy. It also helps investors decide whether they will invest in your business. During this process, a company's financial statements, such as their income statement and balance sheet, are analyzed.

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How do companies use financial analysis?

Companies use financial analysis both internally and externally. Internally, they analyze their financial status to improve future decisions that could be beneficial or adjust their budgets accordingly. Externally, a company uses various types of financial analyses for investment. In other words, analysts evaluate a company's finances to determine whether they'd make a worthwhile investment. Investors can even analyze a company's past performance to predict future performance. This is considered a bottom-up approach.

7 types of financial analysis

Within the general scope of financial analysis, there are several types to consider. Here are seven types of financial analysis:

1. Vertical

In vertical financial analysis, the relationship between various items on a financial statement is analyzed. For example, during one accounting period, one item is measured against another item that's considered the base and the relationship is expressed as a percentage. Though it only accounts for one time period, it can help you recognize any changes over time and compare various entities.

2. Horizontal

Horizontal analysis refers to the evaluation of how financial statement figures change over a period of time. In other words, it compares one item to another in a different time period. Because of this, it can help analyze a business' finances from one year to the next. Horizontal analysis is also known as dynamic analysis or trend analysis, the latter being because this form of analysis can be useful in spotting trends over time.

3. Liquidity

Liquidity analysis uses ratios to determine whether or not a company will be able to pay back any debts or other expenses. This type of analysis is helpful because if a business isn't able to pay off any liabilities, they're bound to face financial troubles in the near future. Liquidity analysis is particularly helpful for lenders or creditors who want some insight into your financial standing before offering you a loan or credit. Various ratios such as the cash ratio and current ratio are used in a liquidity analysis.

4. Profitability

In a profitability analysis, a company's rate of return is evaluated. Every business wants to be profitable, therefore, using the profitability analysis to measure its cost and revenue in a given period can be highly beneficial for them. If a company's revenue outweighs its costs, it's considered profitable. Profitability ratios—both margin and return ratios—are used in this type of analysis. These types of ratios include the following:

  • Margin ratios: Gross profit margin, operating profit margin, net profit margin, cash flow margin

  • Return ratios: Return on Investment (or Assets), return on equity, cash return on assets

5. Scenario and Sensitivity

During this type of analysis, an investment's value is measured based on current scenarios and changes. For example, it analyzes how variable A is affected based on changes and sensitivities in other variables such as variable B or C. Scenario and sensitivity analysis can even help analysts predict certain outcomes based on different variables. They do so by studying the various variable effects based on prior data and then making informed decisions based on their findings.

6. Variance

Variance analysis refers to the process of analyzing any differences between a business's budget and the actual amount it spent. For example, if you budgeted your sales to be $1,000 but you actually sold $250, the variance analysis would conclude with a difference of $750.

Once you know this, you can start to determine the cause for the variance and implement strategies for avoiding any negative variances in the future. Variance analysis encompasses various types of variances including purchase price variance, labor rate variance, fixed overhead spending variance and material yield variance.

7. Valuation

Through the valuation financial analysis, your business's present value is evaluated. This type of analysis can be utilized for various instances including mergers and acquisitions or taxable events. There are different types of valuation ratios including price/earnings and price sales. Once you determine your company's ratios, you can begin to compare them to your company's past ratios, your competitor's ratios or your particular industry at large.

Related: Learn About Being a Finance Manager

Examples of financial analysis

Here are three examples of financial analysis at work:

Example 1

Let's say Company A has current assets of $150,000 and current liabilities of $100,000. Now let's say Company B has current assets of $500,000 and current liabilities of $350,000. Using the current ratio (one of the liquidity ratios), you can determine that Company A's current ratio is better than Company B's. In other words, Company A is in better financial standing and will be more apt to repay any current debts or obligations. This is because current assets divided by current liabilities equals the current ratio. In formula form:

Current assets / current liabilities = current ratio

Using this formula, Company A has a current ratio of 1.5 and Company B has a current ratio of 1.43.

Example 2

Now, let's take a look at profitability ratios:
Let's say Company A has an operating profit of 50,000 and net sales of 200,000, while Company B has an operating profit of 100,000 and net sales of 25,000. Using the operating profitability ratio, the operating profit ratio is equal to earnings before interest and tax divided by sales. Therefore, the following can be calculated:

*Company A: 50,000 / 200,000 = 25%*

*Company B: 100,000 / 25,000 = 25%*

In this scenario, both Company A and Company B have the same operating ratio.

Example 3

Lastly, let's say your company had revenue of $5,000 in 2018 and in 2017 it was $4,000. The change in revenue over the course of the year is 25%. This is because using the horizontal analysis, $5,000 divided by $4,000 and subtracted by 1 is 0.25. You would then multiply by 100% to get its percentage form, 25%.

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