Financial analysis uses a company’s financials to assess its health, performance and potential. Investors and companies use this data generated through financial statements and other reports to inform strategic decisions. Some types of financial analysis are profitability, horizontal and vertical analysis, ratio analysis, cash flow analysis, and more. For outsiders, that might be whether to start buying stock in the company. For management, it might be about figuring out how to run the business more effectively and set goals. Financial analysis is a broad area that can refer to all the methods by which a firm analyzes its financial performance and health, with horizontal and vertical analysis, ratio analysis, cash flow analysis, etc.
What is Financial Analysis?
Financial analysis involves the review of financial statements, ratios, and other relevant data to help you make good business decisions. It is also used for assessing economic trends, developing long-term plans for business activity, framing financial policy, and identifying projects or companies for investment.
Financial analysis is using financial data to evaluate a company’s performance and recommend how it can do better going forward. So, financial analysts do most of their work in Excel, using spreadsheets to analyze historical data as well as make projections of how they think the company will do in the future.
In the world of business, success is measured by numbers. They have a lot of data in their accounts and statements. Financial analysis seeks to convert these numbers into actionable intel.
Types of Financial Analysis
Enterprises use different types of financial analysis to evaluate the performance of an enterprise, make decisions, and predict the future accordingly. Following are the different types of financial analysis:
Vertical
Vertical analysis takes different portions of the income statement and divides those by total revenue or total assets to form a % comparison. They are often used on income statements, balance sheets, or cash flow statements. It helps to visualize the link between individual items and the balance sheet and to explore operational differences on the same base. In addition, it aids them in comprehending the impact of expenses on their overall net profit.
Horizontal
Horizontal analysis explains the changes in the financial statements across two accounting periods, Year over Year (YoY) or Quarter over Quarter (QoQ). You may be accustomed to working with horizontal analysis, which is used to compare financial data over time and identify trends, patterns, and performance changes. So they can make informed decisions because they can assess financial stability identify risks and opportunities and track progress. To do horizontal analysis correctly, multiple periods of financial data need to be chosen, with the earliest period used as a baseline.
Liquidity
Apart from working capital analysis, another important kind of financial analysis is liquidity analysis, which helps in the short-term study of day-to-day expenditures such as funds borrowed over a brief period, salary, statutory payments, etc. It examines the capacity of liquid assets to meet current liabilities. This allows the company to continue functioning without becoming mired in cash flow woes and maintain its routine. Net working capital, cash ratio, acid test, current ratio, etc.
Profitability
The profitibility analysis sheds light on the revenues of the companies. This is a powerful analysis of income statements for investors because it ensure them that their funds are kept safely and at the same time ensures the rate of return at a specific time frame. Profits can be analyzed by product, geographic area, store, product line, subsidiary, etc., with profitability measures including EBIT margin, net profit margin, gross margin, and EBITDA margin
Scenario and Sensitivity
The scenario and sensitivity analysis is an example for the financia analysis type. This is the type of analysis that the treasury department does, and it is useful for companies to realize how banking rates or changes in tax structures or economic outlook, etc., would have on companies. Additionally, they can assist businesses in preparing budgets and forecasts. Scenario and sensitivity analysis are risk metrics so creating the scenarios and doing sensitivity analysis can help companies identify what their best and worst-case future could be.
Variance
Variance analysis is a useful type of financial analysis that investigates the differences between actual and planned behavior in budgeting to determine the effect on business performance. This makes understanding variance a key diagnostic of where the business hit home runs or missed the mark. The process consists of two stages: determining and recording individual variances and understanding the reason for each variance. Some causes of variances are changing market conditions, unrealistic budgeting objectives, specific activities that cannot be planned accurately, etc.
Valuation
Valuation of assets can be done to derive the approximate value of different kinds of assets like real estate, business, commodity, equities and many other assets. The value of an asset is the present value (PV) of all future cash that the asset is expected to generate. Valuation begins with a number of assumptions around financing costs, tax rates, capital expenditures, sales growth, and so on. Different approaches that financial analysts can adopt to measure the value of an asset which could either be cost approach or intrinsic value and relative value.
Leverage
Leverage analysis is another tool financial analysts utilize to evaluate a company’s performance. The leverage ratio measures how much capital comes in the form of debt. Or it assesses the company’s ability to meet its financial obligations. As companies rely on a mix of equity and debt to finance their operations, leverage ratios can give the company an idea of how changes in output will affect the operating income. Examples of leverage ratios include Dupont analysis, EBIT/interest (interest coverage), Debt/EBITDA, and Debt/equity.
Growth
This is an important tool to inform investors on how a company performs and the location of undervalued companies. Financial analysts spend an awful lot of time on figuring out the historical growth rates and how future growth rates may look; in order to understand how things may change in the future. Regression analysis, Year over year (YoY) analysis, bottom-up analysis (meaning: you start at the level of revenue drivers and work your way up), and top-down analysis.
Cash Flow
Essential for the success of any business is the ability to create cash flow. So, financial techs of various industrial backgrounds commonly spend an extensive hour assessing cash flow profiles. Cash flow analysis helps to clarify its liquidity position, working capital management, and overall financial health. Additionally, it highlights the companies’ willingness to pay their debts and reinvest in growth. In other words, a cash flow statement demonstrates how much money a company has after paying its expenses.
Rates of Return
One of the main types of financial analysis is the rate of return (RoR), and it can be used by investors, financial professionals, and lenders to determine the profit or loss of an investment over a specific investment time period. Investment horizontal can be used for any type of investment and any type of asset inclusive of equity, debt, art, and real estate. RoR measures can be capital gain, the return on invested capital (ROIC), return on assets (ROA), return on equity (ROE), internal rate of return (IRR), etc.
Relevance to ACCA Syllabus
Candidates will need to apply different forms of financial analysis throughout the ACCA qualification, particularly in the papers of FM (Financial Management), SBR (Strategic Business Reporting) and PM (Performance Management). These consist of trend analysis, ratio analysis, common-size analysis, and cash flow analysis. These capabilities are necessary for assessing profitability, liquidity, solvency, and efficiency in service of internal and external reporting and strategic decision-making.
Types of Financial Analysis ACCA Questions
Q1: Why do resource firms use ratio analysis?
A) Market share only
B) Past year’s inflation
C) Financial performance and financial position
D) Staff productivity
Ans: C) Financial performance and position
Q2: Which of the following does a common-size financial statement express all items as a percentage of?
A) Total liabilities
B) Net profit
C) Some other base amount, like total assets or sales
D) Prior year’s figures
Ans: C) A base figure like total assets or sales
Q3: What category of financial analysis looks at how performance varies over time?
A) Horizontal analysis
B) Vertical analysis
C) Sensitivity analysis
D) Internal control review
Ans: A) Horizontal analysis
Q4: Which type of financial analysis assesses the firm’s ability to pay its short-term obligations?
A) Profitability analysis
B) Solvency analysis
C) Liquidity analysis
D) Activity analysis
Ans: C) Liquidity analysis
Q5: The purpose of trend analysis is primarily to:
A) Eliminate errors
B) Compare fixed assets to liabilities
C) Watch financial data across multiple periods
D) Prepare tax returns
Ans: C) Approximately monitor financial information for multiple cycles
Relevance to US CMA Syllabus
Leverage the types of financial analysis in US CMA Part 1: Financial Planning, Performance, and Analytics to evaluate performance and make strategic decisions. CMAs utilize techniques like variance analysis, trend analysis, and benchmarking to track profitability, measure efficiency and match risk. Management accounting practices focus on the use of new tools to help management accountants make data-driven decisions to enhance organizational performance.
Types of Financial Analysis CMA Questions
Q1: What type of analysis is used to compare actual results to budgeted amounts?
A) Common-size analysis
B) Vertical analysis
C) Variance analysis
D) Liquidity analysis
Ans: C) Variance analysis
Q2: Benchmarking is used in CMA practice to:
A) Prepare payroll
B) Benchmark company performance against industry peers
C) Reconcile bank statements
D) Allocate overheads
Ans: B) Assess a corporation’s performance against its peers in industry
Q3: What type of analysis is used to measure a company’s ability to generate profit?
A) Efficiency analysis
B) Profitability analysis
C) Liquidity analysis
D) Budget analysis
Ans: Industry analysis — Profitability analysis
Q4: Activity ratios are used to measure:
A) Tax planning accuracy
B) Fixed asset disposal
C) A company’s efficiency utilizing its assets
D) Policies of declaration of dividends
Ans: C) How efficiently a company uses its assets
Q5: An ecosystem expansion on days inventory outstanding could indicate the:
A) Faster turnover
B) Improved liquidity
C) Poor inventory management
D) Lower fixed costs
Ans: C) Bad inventory management
Relevance to CFA Syllabus
Financial analysis is covered in depth in the CFA Level I and Level II syllabus. Candidates should apply types of analysis for assessing corporate financial performance, detecting red flags, and supporting investment decisions, including horizontal and vertical analysis, ratio analysis, and cash flow analysis. These tools make it easier for CFA charterholders to analyze equity and creditworthiness with precision and clarity.
Types of Financial Analysis CFA Questions
Q1: Which ratio helps us see how effectively a company uses its equity to generate profit?
A) Return on Equity (ROE)
B) Current Ratio
C) Inventory Turnover
D) Debt Ratio
Q: If one wants to gauge the profitability of a company, what is the most common measurement used?
Q2: Vertical analysis is particularly helpful in comparison of :
A) A company’s multi-year data
B) A company’s data as a percentage of a base figure
C) Cash flows coming from different regions
D) Tax rates year-on-year
Ans: B) A company’s figures as a proportion of a base item
Q3: When you look at financial statement trends over time, which is the most useful method of analysis?
A) Vertical analysis
B) Regression analysis
C) Horizontal analysis
D) Qualitative analysis
Ans: C) Horizontal analysis
Q4: Which financial metric best indicates firm’s ability to meet its interest obligations?
A) Gross Profit Margin
B) Inventory Turnover
C) Interest Coverage Ratio
D) Debt-to-Equity Ratio
0) Ans: C) Interest Coverage Ratio
Q5: An equity analyst analyzing the return dispersion of a firm over five years is most likely performing:
A) Trend analysis
B) Common-size analysis
C) Profit sharing analysis
D) Peer group analysis
Ans: A) Trend analysis
Relevance to US CPA Syllabus
Financial analysis is an important area of focus in both FAR (Financial Accounting and Reporting) and BEC (Business Environment and Concepts), both of which are sections of the US CPA exam. Types of analysis like , trend analysis, and vertical and horizontal analysis are used by CPAs to evaluate a business’s financial condition and performance. These techniques help in supporting strategic advisory services and ensuring financial statement accuracy.
Types of Financial Analysis CPA Questions
Q1: A company’s debt-to-equity ratio measures its:
A) Profitability
B) Liquidity
C) Capital structure and gearing
D) Market share
Ans: C) Leverage and savision of capital structure
Q2: What does vertical analysis of an income statement measure?
A) Efficiency of tax planning
B) Comparative sales growth
C) The portion of the dollar amount for each expense item as a percentage of total sales
D) Future interest rates
Ans. C) Every expense item as a fraction of total sales
Q3: What do liquidity ratios tell you about a firm?
A) To measure profitability
B) To assess asset valuation
C) To assess ability to pay short-term debt
D) To calculate depreciation
Ans: C) For assessing short-term debt-paying ability
Q4: Which type of analysis supports CPAs in detecting potential misstatements by comparing data over time?
A) Ratio analysis
B) Budgetary control
C) Horizontal analysis
D) Variance analysis
Ans: C) Horizontal analysis
Q5: Which section of the CPA exam is mainly on financial analysis?
A) BEC
B) AUD
C) FAR
D) REG
Ans: C) FAR
