5 common types of financial analysis to assess your company’s financial health

A financial analysis is the selection , evaluation , and interpretation of financial data to assist in making informed decisions. The analysis may be used by internal parties, such as business owners, managers or employees. The analysis may also be used by parties external to the organization, such as bankers, investors or vendors. For the purpose of this article, we will focus on financial analysis for business owners, whose primary focus is usually profitability and cash flow. Five common types of financial analysis used by business owners are:

  1. Gross profit analysis

  2. Break-even analysis

  3. Vertical analysis

  4. Horizontal analysis

  5. Ratio analysis

Gross Profit Analysis (also known as gross margin analysis)

  • Gross profit = Sales - Cost of goods sold

  • Gross profit percentage= Gross profit ÷ Sales

  • Conduct gross profit analysis for each product, service offering or business segment to understand the most or least profitable offerings.

  • Recommendations for improvement:- (a) incentivize the sales of offerings with the highest gross profit (b) Stop offering s with the lowest gross profit (c) evaluate based on the pareto principle(80/20 rule), that is 80% of your profits will come from 20% of your offerings.

Break-even Analysis

  • Break-even analysis identifies how an organization needs to sell, in dollars or units, to cover its fixed costs. Every additional sale over and above breakeven will result in a profit.

  • To calculate breakeven (a) identify the organization’s fixed costs (b) calculate the overall gross profit % (c) The formula to calculate breakeven in dollars is Fixed costs ÷ Gross profit percentage (d) The formula to calculate breakeven in units = Fixed costs ÷ Gross profit per unit.

Vertical Analysis

  • Also known as a common size analysis.

  • A technique that expresses each line item on a financial statement as a percentage of a base figure on the statement.

  • For the income statement the base figure is usually total sales.

  • For the balance sheet, base figure is usually total assets

Horizontal Analysis

  • Compares financial data from one period to another and computing the change between periods.

  • It might be current month compared to last month, or current year results compared to last year’s results.

Ratio Analysis

  • Ratios can be broken down into two types : (1) effect ratios (2) causal ratios

  • Effect ratios define only what has happened- the outcome. They describe only symptoms.

  • Causal ratios help identify the underlying cause of the effect ratio.

  • Effect ratios are divided into four categories :

(a) Profitability ratios- measures profitability compared to size, margins and returns. They include:

(i) Gross profit ratio measures product or service mark-up. Formula is Gross profit ÷ sales

(ii) Return on sales measures the net profitability of each dollar of sales. Formula is Net income ÷ sales

(iii) Return on equity measures how much profit a company generates for each dollar of shareholder equity. Formula is Net income ÷ equity

(b) Operating or efficiency ratios. These include:

(i) Total asset turnover ratio measures the effectiveness of an entity in using its assets during a specific period. The formula is