Financial Analysis

Financial analysis is the process of evaluating the financial condition and performance of companies, projects, or any other entities based on the study of their financial statements. The primary goal is to determine the stability, profitability, and development prospects of the analyzed object to make informed management, investment, and credit decisions. As a discipline, it lies at the intersection of accounting, finance, and economics, using quantitative data to form qualitative conclusions. In modern practice, financial analysis is an integral part of strategic planning and risk management.

The methodology of financial analysis is based on several key approaches. Horizontal analysis involves comparing financial indicators over several periods to identify growth or decline trends. Vertical analysis, in turn, examines the structure of financial statements by expressing each item as a percentage of a base value (e.g., revenue in the income statement or total assets in the balance sheet). The most common and powerful tool is ratio analysis, which involves the calculation and interpretation of relative indicators of liquidity, profitability, solvency, and business activity.

The users of financial analysis are various stakeholder groups, each with its own objectives. Company management uses operational analysis to control costs, manage working capital, and evaluate the efficiency of business processes. Investors (both shareholders and potential ones) focus on profitability and growth indicators to assess the future return on their investments. Creditors (banks, suppliers) analyze solvency and liquidity to assess the risks of loan default. Government agencies may apply analysis for tax control or to assess the stability of systemically important enterprises.

With the development of technology, financial analysis has undergone significant changes. Modern analysts use specialized software and business intelligence (BI) systems that automate data collection and visualize results in real-time. Predictive (prospective) analysis, based on statistical models and big data, is becoming increasingly important, allowing not only to ascertain the current situation but also to build scenarios for future development. However, despite automation, the professionalism of the analyst remains critical, as they must account for industry specifics, macroeconomic context, and qualitative factors not reflected in the numbers.

What is financial analysis?

Financial analysis is a systematic examination and interpretation of financial statements (balance sheet, income statement, cash flow statement) to form a comprehensive understanding of an organization’s financial health. At a fundamental level, it answers key questions: whether the company can generate profit, whether it has sufficient funds to meet its obligations, how efficiently it uses its assets, and what its long-term prospects are. This process transforms raw accounting data into meaningful information suitable for decision-making.

The principle of comparability underlies all financial analysis. Absolute values of statement items (e.g., a profit of 1 million rubles) are uninformative by themselves. Their significance is revealed when compared with indicators from previous periods (trend analysis), planned targets (budget execution analysis), or data from competitor companies (comparative analysis). Without such context, it is impossible to objectively assess whether the result obtained is good or bad, making comparison the cornerstone of the entire analytical procedure.

A key tool that concretizes the concept of financial analysis is the calculation of financial ratios. These ratios are conventionally divided into several groups, each illuminating a specific aspect of activity. Liquidity ratios (e.g., current ratio) show the company’s ability to meet short-term debts. Profitability ratios (Return on Equity, ROE) measure the ability to generate profit from invested capital. Financial stability ratios (equity ratio) demonstrate the degree of the company’s dependence on borrowed sources of financing.

Thus, financial analysis is not merely a mechanistic calculation of formulas but a holistic diagnostic process. It requires from the analyst not only technical skills in working with numbers but also a deep understanding of the company’s business model, the specifics of its industry, and the external economic environment. The final product of a quality financial analysis is a substantiated judgment about current and potential problems, the business’s strengths, and opportunities for its growth and optimization.

In-Depth Financial Analysis: Methods, Role, and Application

Horizontal Analysis

Horizontal analysis is a method of financial analysis that allows for the assessment of changes in financial statement items over several periods. Its key goal is to identify trends of growth or decline in key indicators such as revenue, cost of goods sold, net profit, or total assets. This method is also often called trend analysis because it focuses on changes over time. By comparing absolute and relative changes, an analyst can determine whether a company is developing steadily, accelerating its growth, or facing stagnation and problems.

The primary tool of horizontal analysis is the construction of tables where data for each period is presented in comparison to a base period (usually the earliest one). Two key metrics are calculated: absolute deviation (the difference between the current period’s indicator and the base period’s indicator) and relative deviation (the absolute deviation expressed as a percentage of the base period’s indicator). For example, if a company’s revenue increased from 100 million rubles to 150 million rubles in a year, the absolute deviation would be +50 million rubles, and the relative deviation would be +50%.

The strength of horizontal analysis lies in its clarity. It immediately reveals which financial statement items are changing most dynamically. A sharp increase in accounts receivable may signal problems with collection, while cost of goods sold growing faster than revenue may indicate pressure on margins. However, the method has a limitation: it does not show structural changes within the financial statements. A company may be increasing revenue, but its debt burden may be growing even faster, which is not always obvious from a simple comparison of figures.

To increase effectiveness, horizontal analysis is often combined with other methods, such as vertical analysis. Furthermore, for a more accurate assessment, it is necessary to account for inflation by conducting the analysis in comparable prices and to study data not only for 2-3 years but also for longer periods to separate temporary fluctuations from sustainable trends. This transforms it from a simple comparison into a powerful tool for diagnosing a business model.

Vertical Analysis

Vertical analysis is a method in which each item in a financial statement is presented as a percentage of a base value taken as 100%. This approach allows for the evaluation of the structure of a company’s assets, liabilities, and financial results. For the balance sheet, the base value is usually Total Assets, while for the income statement, it is Revenue. As a result, the analyst sees not absolute amounts but their specific weight, making it possible to compare companies of different scales and identify structural shifts.

Applying vertical analysis to the balance sheet helps understand the sources of a company’s capital (the share of equity versus debt) and how it is allocated (the share of non-current and current assets). For example, a high share of non-current assets may characterize a company as capital-intensive (e.g., an industrial enterprise), while a high share of inventory in current assets may indicate a trading company. Analyzing the income statement allows for the calculation of key margins: gross margin (Gross Profit / Revenue), operating margin (Operating Profit / Revenue), and net margin (Net Profit / Revenue).

The main advantage of vertical analysis is the ability to conduct cross-sectional comparisons. Since the data is presented in percentages, one can compare the cost structure of an oil company and an IT giant to understand which one is more material-intensive or labor-intensive. It is also a powerful tool for benchmarking—comparing one’s own company’s structure with that of an industry leader to identify bottlenecks and optimization opportunities.

However, interpreting the results of vertical analysis requires an understanding of industry specifics. For a technology company, a low share of inventory and a high share of intangible assets would be normal, while the opposite would be true for a retail chain. Therefore, vertical analysis is most valuable not as a standalone tool but as part of a comprehensive approach that, in conjunction with horizontal and ratio analysis, provides a three-dimensional picture of a business’s financial condition.

Ratio Analysis

Ratio analysis is considered one of the most informative and widely used methods of financial analysis. It involves the calculation of relative indicators (ratios) that characterize various aspects of a company’s financial condition: its liquidity, solvency, profitability, and business activity (efficiency). Unlike absolute indicators, ratios eliminate the influence of the scale of operations, making them an ideal tool for comparing companies and tracking dynamics over time.

The process of ratio analysis begins with the calculation of key indicators. The obtained values are then compared with normative values (if they exist for the industry), competitors’ indicators, the company’s own data from previous periods, and its strategic goals. For example, a current ratio of 1.5 by itself says little. But if it was 2.5 last year, and the main competitor’s is 1.8, this signals a potential deterioration in short-term solvency.

The strength of this method lies in its systematic and multifaceted nature. The analyst does not look at one indicator but evaluates them as a whole. Low profitability can be compensated by high asset turnover, and vice versa. On the other hand, the weakness of ratio analysis is its dependence on the quality of the source data. Accounting statements can be distorted due to accounting policy specifics, and calculations do not account for non-financial factors, such as staff qualifications or brand reputation.

Despite its limitations, ratio analysis remains the cornerstone of financial diagnostics. It is used by creditors to assess risks, by investors to find undervalued assets, and by management for operational control and strategic planning. Modern business intelligence (BI) systems often automate the calculation and visualization of key ratios, making this tool accessible for real-time decision-making.

Required Lessons of Financial Analysis

The required lessons of financial analysis are the body of knowledge, skills, and competencies necessary for professionally conducting analytical procedures and formulating substantiated conclusions. These lessons go beyond simply memorizing formulas and include a deep understanding of the economic essence of the processes occurring within a company, the ability to critically evaluate source data, and the capacity to consider the context of the external environment. The first and main lesson is the understanding that the numbers in the statements are only a starting point, and the true value of analysis lies in their interpretation.

The second important lesson is the necessity of a comprehensive approach. Relying on a single method or ratio is a sure path to erroneous conclusions. For example, a high profitability ratio may please an investor, but if it was achieved by cutting critical investments in development, it is a negative signal for long-term prospects. Only the combined use of horizontal, vertical, and ratio analysis, along with the study of non-financial information (e.g., market share), allows for a holistic view of the business’s condition.

The third lesson lies in the importance of industry and macroeconomic context. Normative values for ratios vary greatly across different economic sectors. A current ratio below 1 might be a disaster for a machine-building plant but absolutely normal for a successful IT services company that has insignificant inventory and operates on prepayment. An analyst must constantly compare a company’s indicators not only with its own past but also with industry benchmarks.

The fourth, and perhaps most practical, lesson is the communication of results. Complex analytical findings must be translated into understandable language for decision-makers. Whether it’s a presentation for the board of directors, a report for a credit committee, or a justification for an investment for a private investor, the analyst must be able to highlight the main points, indicate risks, and formulate concrete recommendations. Without this stage, all the analytical work loses its practical value.

Financial Analysis Portfolio

A financial analysis portfolio is a systematized set of tools, methodologies, and documents used by an analyst or a company’s finance department for regular monitoring and assessment of financial condition. It can be viewed as a specialist’s “working library,” ensuring standardization, completeness, and efficiency of the analytical process. Forming such a portfolio allows for a transition from one-off, episodic research to building an integrated system of financial control and management.

The core of the portfolio consists of standardized reporting forms and templates. These include models for conducting horizontal and vertical analysis, automated spreadsheets for calculating key financial ratios with pre-set formulas, and dashboards for visualizing key trends. Having templates not only saves time but also minimizes the risk of arithmetic errors and ensures comparability of data across different periods.

Another key element of the portfolio is a benchmarking system. This is a database of normative and industry values for key indicators, as well as the financial metrics of main competitors. Such a tool allows for instantly assessing whether, for example, an inventory turnover of 30 days is a good or bad result for a company in its specific market segment. This information is critically important for the objective interpretation of internal analysis results.

Finally, the portfolio includes methodological materials and regulations describing the procedure for conducting analysis, its frequency, responsible persons, and formats for presenting results. This ensures continuity and prevents the analytical function from depending on one specific employee. In a modern company, such a portfolio is increasingly implemented within specialized software or BI systems that consolidate data from various sources and provide analysts with powerful tools for modeling and forecasting.

Financial Analysis Forecasting Methods

Forecasting methods in financial analysis are a set of quantitative and qualitative techniques aimed at estimating a company’s future financial results and cash flows. Forecasting is a logical extension of retrospective analysis and serves as the basis for budgeting, financial planning, and the evaluation of investment projects. The accuracy of forecasts directly impacts the quality of strategic decisions, making proficiency in these methods a key skill for a financial analyst.

One of the most common quantitative methods is the forecasted income statement and cash flow statement based on drivers. In this approach, the analyst identifies key factors (drivers) affecting revenue (e.g., market growth rate, company’s market share) and then, based on historical patterns and expectations, forecasts expense items. This method requires a deep understanding of the business model and the factors determining its cost of goods sold and operating expenses.

Another important method is statistical forecasting, including time series analysis. It uses historical data to identify patterns (trend, seasonality, cyclicality) and extrapolate them into the future. Tools such as regression analysis, moving averages, and more complex models like ARIMA are used for this purpose. While these methods can be very accurate in stable conditions, they often fail to account for sudden market changes or radical strategic shifts by the company itself.

In conditions of high uncertainty, scenario analysis and the Monte Carlo method come to the rescue. Scenario analysis involves developing several versions of the future (e.g., “base,” “optimistic,” and “pessimistic” scenarios) and building a financial model for each. The Monte Carlo method is more complex: it uses computer modeling to generate thousands of possible outcomes based on probability distributions of key variables (e.g., raw material prices, exchange rates), allowing for the assessment of not only the expected result but also the risks of achieving it.

What is the Role of Financial Condition Analysis

The role of financial condition analysis in the modern business environment cannot be overstated, as it performs the functions of diagnosis, control, and planning, forming the basis for managerial decision-making at all levels. For internal users, such as management and owners, it acts as an early warning system, identifying negative trends (e.g., declining profitability, growing overdue debt) before they become catastrophic, allowing for timely corrective measures.

For external users—investors and creditors—the analysis of financial condition is the main tool for risk assessment and investment decision-making. A potential shareholder, studying the statements, seeks an answer to the question: “Will the value of my investment grow?” A creditor (bank) asks a different question: “Will the company repay the loan with interest and on time?” The answers to these questions directly depend on the results of the financial analysis, which reveals the company’s solvency, financial stability, and profitability.

At the macro level, financial condition analysis plays a vital role in ensuring the stability of the financial system. Regulatory bodies (e.g., the Central Bank) analyze systemically important enterprises and banks to assess their resilience to crises and prevent a chain reaction of bankruptcies. Thus, this activity extends beyond the interests of an individual company and acquires national importance, contributing to the health of the entire national economy.

Finally, the role of financial analysis is to enhance the transparency and accountability of business. By publishing their financial statements and undergoing audits, companies report to society on how effectively they use the resources provided to them. This builds trust, which is the foundation for attracting capital, establishing long-term relationships with counterparties, and strengthening business reputation, which ultimately is one of the key intangible assets.

Key Ratios of Financial Analysis

Key ratios of financial analysis are derived indicators that standardize information from financial statements, allowing for comparisons and substantiated conclusions. They are traditionally grouped into several blocks, each illuminating a specific aspect of a company’s vital activity. Operating with these ratios is the “alphabet” that anyone working in finance, economics, or investments must know.

1. Liquidity Ratios show the company’s ability to meet its short-term obligations. The most important are:
   • Current Ratio = Current Assets / Current Liabilities. Shows whether the company has sufficient resources to cover short-term debts.
   • Quick Ratio = (Current Assets – Inventory) / Current Liabilities. A more stringent measure, excluding the least liquid part of assets—inventory.
2. Profitability Ratios measure the efficiency of the company from the perspective of generating profit. These include:
   • Return on Sales (ROS) = Operating Profit / Revenue. Shows how much operating profit the company makes from each currency unit of revenue.
   • Return on Equity (ROE) = Net Profit / Equity. A key indicator for shareholders, demonstrating the return on their invested funds.
3. Financial Stability Ratios (or capital structure ratios) characterize the degree of the company’s dependence on borrowed sources of financing and its long-term solvency. The main ones are:
   • Equity Ratio = Equity / Assets. Reflects the share of assets financed by equity.
   • Debt-to-Equity Ratio = Total Debt / Equity. Shows the ratio between debt and equity.
4. Activity (Efficiency) Ratios assess the efficiency of the company’s use of its assets. These include:
   • Inventory Turnover = Cost of Goods Sold / Average Inventory. Shows how many times during a period the company replenishes its inventory.
   • Accounts Receivable Turnover = Revenue / Average Accounts Receivable. Demonstrates how quickly the company collects payments from customers.

Subjects and Objects of Financial Analysis

A clear distinction between the subject and object of financial analysis is important for understanding its essence and boundaries. The object of financial analysis is the specific carriers of economic information that are subjected to study. Primarily, this is the business entity itself—the company (enterprise, corporation), understood as an integral property complex. However, the object can also be a broader structure, such as a holding, a financial-industrial group, or, conversely, a narrower one—a separate investment project, business segment, or even a transaction.

The subject of financial analysis is the financial relations, financial results, and efficiency of this object’s activities, manifested in the system of cash flows, indicators, and ratios that can be extracted from financial statements and other information. If the object is “what we analyze,” then the subject is “what specifically we study in this object.” The subject focuses on aspects such as the ability to generate profit, solvency, financial stability, efficiency of capital use, and business value.

The difference also lies in the level of detail. The object is typically defined at the macro level of the study (the entire company). The subject, however, is always specific and can be broken down into numerous components: liquidity analysis is one subject of study, profitability analysis is another, cash flow analysis is a third. All are conducted within the same object but answer different questions and use different sets of tools.

Thus, the object sets the framework of the research, and the subject determines its content and methodology. Understanding this difference allows for the correct formulation of the analysis’s goals and objectives, the selection of adequate tools, and ultimately, obtaining relevant and useful results for decision-making.

Conclusion

Financial analysis emerges not as a set of disparate formulas but as an integrated, multi-level system of knowledge that serves as the universal language of business. From basic methods like horizontal and vertical analysis to complex forecasting and risk management tools, it provides stakeholders—from a line manager to a strategic investor—with a powerful apparatus for understanding the past, assessing the present, and anticipating the future of a company.

The key conclusion is that the maximum effectiveness of financial analysis is achieved only through a comprehensive and contextual approach. No single ratio or method in isolation can provide an exhaustive assessment. It is the synthesis of various techniques, supported by an understanding of industry specifics and the macroeconomic environment, that allows for the transformation of raw data into the most valuable information—strategic insight necessary for winning in a competitive environment and achieving sustainable long-term development.