Financial analysis is an important tool in a company's investment planning.
Financial analysis is not an exact science for business owners. Understanding the different types of financial analysis is crucial in making informed business decisions. People who analyze the financial statements of a company include company executives, competitors, creditors, managers and potential investors. Three of the most common types of financial statement analysis are horizontal, vertical and ratio analysis.
Horizontal Analysis
A horizontal analysis compares two or more years of a company's financial statements. The analyst can find the same information from different years by reading across the page. In comparing dollar figures and percentages in this way, differences from year to year are easy to find. A variation of the horizontal analysis is called the trend analysis. The trend analysis starts with the first year a company is in business, also known as the base year. The base year percentages are shown as 100 percent, and the increase or decline in percentages can be easily shown.
Vertical Analysis
Vertical analysis is called such because the corporation's financial figures are listed vertically on the financial statement. This type of analysis involves the calculation of percentages of a single financial statement. The figures on this financial statement are taken from the company's income statement and balance sheet. Vertical financial statement analysis is also known as component percentages.
Ratio Analysis
There are several types of ratio analysis that can be used in interpreting financial statements. Ratios may be computed for each year's financial data and the analyst examines the relationship between the findings, finding the business trends over a number of years.
Balance sheet ratio analysis determines a company's ability to pay its debts and how much the company relies on creditors to pay its bills. This is an important indicator of the financial health of the corporation.
Liquidity ratios show how well the company is able to turn assets into cash. When evaluating the liquidity ratio, an analyst looks at the working capital, current ratio and quick ratio.
Working capital is a measure of cash flow. The difference between total current assets and total current liabilities equals the working capital. The working capital calculation is always a positive number.
The current ratio is a popular measure of financial strength. The current ratio is figured by dividing total current assets by total current liabilities. A favorable current ratio would be 2 to 1. If a company's current ratio is low, it may consider ways of improving this figure by decreasing the amount of financial indebtedness or putting more of the company's profits back into the working capital.
The quick ratio measures liquidity, or the ability to pay back debts in a timely manner. To figure the quick ratio, you add government securities, cash and receivables. You then divide this number by total current liabilities. A company's quick ratio is an important measure of its survivability should the sales revenues drastically decrease.
