TYPES OF FINANCIAL ANALYSIS
Financial statements are analysed by different parties for different purposed. The analysis is done from different angles. Accordingly, we can classify financial statement analysis into different categories as follows:
1. On the basis of concerned parties
According to different parties concerned with the operation of the company, the financial statement analysis can be of two types:
- External Analysis
- Internal Analysis
(a) External Analysis:
When the analysis is undertaken by outside parties namely existing and prospective investors, suppliers, lenders, government agencies, customers etc., it is external financial statement analysis. These external parties do not have any access to the internal records of the company; nor do they have any scope to know the hidden accounting policy, if any, of the management. So, they have to depend almost entirely on the published financial statements and other additional information supplied by the management.
(b) Internal Analysis:
This analysis is undertaken by the management of the company to monitor its financial and operating performance. As the analysis is done by the party who has access to the internal records and policies, it is expected to be more effective and reliable.
2. On the basis of time period of the study
Based on the time period covered for the study, the financial statement analysis can be grouped into:
- Horizontal Analysis
- Vertical Analysis
(a) Horizontal Analysis:
This analysis refers to the study of past consecutive balance sheets, income statements or statements of cash flow at a time. The analysis can be made between two periods or over a series of periods. The relevant accounting numbers of all years of the study are presented horizontally in a statement over a number of columns each representing a year. Those figures can also be graphically presented. The figures of each year are compared with those of the base year i.e., the beginning year of the study. This analysis is also called ‘Dynamic Analysis’ as it covers several years for study. This analysis is very much effective for understanding the direction and trend of the organisation particularly when it is undertaken for several years. Comparative statements and trend analysis are two important tools that can be employed for horizontal analysis.
(b) Vertical Analysis:
When the analysis is restricted to the financial statements of one particular period only, it is known as vertical analysis of financial statements. In this analysis each item of a particular financial statement is expressed as percentage of a base figure selected from the same statement. It is also known as ‘Static Analysis’ as it concentrates solely on one year’s financial statement. Common-size statements and accounting ratios are two important tools used for vertical analysis. This analysis is very much useful for understanding the structural relationship of various items in a financial statement. Vertical analysis can also be done for studying the relationship within a set of financial statements at a point of time.