What is Financial Analysis?
Financial analysis is a complex process that checks whether a business or project will work, be stable, and make money. It involves looking at a business’s financial statements and other relevant information to get a sense of its health and success and its chances of growing and making money in the future.
In short, some critical parts of financial research are:
- Profitability analysis: a company’s ability to generate enough income to sustain operations and growth
- Solvency analysis: its capacity to meet its long-term financial obligations
- Liquidity analysis: its ability to cover its short-term liabilities
- Stability analysis: its potential to continue operations in the long term without incurring significant losses
- Leverage and growth rate analyses: the company’s capital structure and its historical and projected growth rates
- Efficiency analysis: how well a company uses its assets to generate revenue and cash flow
- Cash flow analysis: reviewing a company’s cash flow patterns to understand its ability to generate cash from operations, investments, and financing activities
- Rates of return and valuation analyses: assessing the risk-adjusted returns from investments and estimating the business’s value using various methodologies
- Scenario and sensitivity analysis: building models to predict future financial performance under different scenarios
Businesses use financial analysis to make intelligent choices, look at investment possibilities, and determine their industry and economic competitiveness. In addition, they use it to let investors, creditors, and board members know about the company’s plans and current financial state.
Other words
- Financial study for a business
- Analysis of financial data
- Analysis of financial ratios
- Analysis of financial statements
Why financial analysis is important
Investors, creditors, and company management need to do financial analysis because it gives them the information they need to make innovative business and investment choices. It helps them make critical strategic decisions, like whether to keep running or stop, buy assets, handle debt, and make other vital choices.
It’s not just about numbers, either. To get a complete picture of a company’s situation, these groups must look at market trends, business benchmarks, and the regulatory environment as part of financial analysis.
Why investors should care
There is a considerable risk when you invest. Seventy-five percent of venture-backed businesses fail, and many more never give back the money to angel investors, venture capitalists, and private equity funds.
Investors know this. The ones or two “rock star” companies in a portfolio make the most money. Fund sizes are set by venture capitalists so that they can make one of these; it’s that hard to come up with a grand slam.
Any investor needs to use financial analysis to find the businesses that are most likely to give them these gains. They need to look at current and possible purchases, determine their pros and cons, and decide if the money and time spent on them is worth it.
The financial records of a reasonable investment prospect will usually look good. It’s also true the other way around.
How important it is for management to plan and make decisions
Every business owner, executive, and manager does some financial analysis as part of their daily management duties.
- Financial management teams need research to make budgets, decide how to use resources, and guess how much money the company will need in the future.
- Sales managers always look over cash flow statements to figure out what items to buy, when and how much to discount, where to set sales goals, and how many new sales reps they can afford.
- Operations managers use analyses to keep quality standards high, handle supply chains, and find the best ways to improve production and inventory.
- To make intelligent choices about budgets and campaigns, marketing managers look at how much it takes to get a new customer, how much money the marketing strategies make back, and how much each customer is worth throughout their lifetime.
Good financial analysis skills are essential for management because “money in vs. money out” determines everything in the business. Correct financial analysis is necessary for strategic planning, decision-making, and the company’s success.
Why Lenders Should Care
When lenders give money to a business, they must know a lot about it. Financial analysis helps them determine the business’s risk and make intelligent choices.
- Before accepting a loan application, lenders look at past financial statements, such as balance sheets, income statements, and cash flow statements.
- They also compare companies in the same business or sector using industry benchmarks.
- Lenders also usually look at things outside the loan, such as possible changes to the law and new market trends.
- People who owe money on debt also use financial analysis to check if a business has enough assets to pay its debts and can make interest payments on time.
When they give money to a business, lenders take on some of the same risks as buyers. Lenders could run into big cash flow problems if the business fails or doesn’t have the money to pay on time. Financial analysis gives them the information they need to choose who can get credit and who can’t.
Types of Financial Analysis That Are Common
Analysis from the side
Horizontal analysis is a way to find trends and changes in your business by comparing financial records from different periods. It helps you determine where your business is substantial or weak financially and shows how your company has changed over time.
Let’s say that over the year, your company makes more money than it spends. It looks good. It means you have more cash on hand than you spend.
In the same way, if your costs are higher than your income, you need to either cut costs or boost sales.
You can use horizontal analysis to make budgets, make predictions, and find changes in your company’s success over time.
A look at the income statement from the side
When you analyze your income statement horizontally, you look at the line items (your income and costs) as a share of the total sales revenue.
In the first year of your business, let’s say sales were $100,000. Here are some possible lines on an income statement and how they might look as a share of income:
- Cost of Things Sold (COGS): Let’s say the things or services you sold for $100,000 cost you $40,000. The cost of goods sold (COGS) is 40% of the money made in this case.
- Gross profit: If the cost of goods sold was $40,000, your gross profit is $60,000, or 60% of your total income.
- Operating expenses: These are costs like rent, utilities, office supplies, employee wages/salaries, and other costs of doing business. In this case, let’s say those expenses total $20,000. As a percentage of sales, that’s 20%.
- Operating income: Subtract your operating expenses from your gross profit to arrive at operating income — $60,000 (gross profit) – $20,000 (operating expenses) = $40,000. That’s 40% of sales.
- Net income is how much money the business “takes home” after all its costs are taken out of its gross profit. Let’s say all the other costs, like taxes, add up to $10,000. We now have a 30% net income.
A look at the balance sheet from the side
A horizontal study of a balance sheet looks at how your business’s assets, debts, and equity have changed over time. That being said, let’s say your company had the same $100,000 worth of assets at the end of its first year. These would include cash, inventory, and tools.
- Current assets: Out of the $100,000 assets, $40,000 is kept in cash. 30% of your company’s assets are now cash on hand.
- Fixed assets: If the last $60,000 comprises fixed assets like real estate and tools, that’s 60% of your company’s asset mix.
- Current debts: You owe $10,000 to debtors and suppliers out of your $100,000 in assets. That means 10% of your assets are tied to your present debts.
- Stock: Your company’s stock makes up the last 10%, assuming no other outstanding debt or equity exists.
A look at the cash flow statement from the side
A horizontal study of a cash flow statement looks at how cash came into and went out of the business over time. It shows when and where your business got money and what it did with it (paid or invested).
As an example:
- Cash from operations: If your business made $100,000 in the first year, its cash flow will come from its running activities.
- Investing: You spent $20,000 in cash to buy new tools or other assets. That’s 20% of everything you do.
- Money: If you need extra money in that first year, let’s say you got a partner to put $10,000 into the business. In that case, the last 10% would come from funding.
A look up and down
One way to look at money is with vertical analysis, which shows each part of a financial statement (like an income statement or balance sheet) as a percentage of the primary number in the statement. In real life, the first line of a financial statement is always set to 100% as the base number, and everything else is shown as a percentage of this base.
A look at the income statement from top to bottom
A vertical analysis looks at your income statement and compares each line item (income and costs) to the total amount of money you made from sales. In terms of percentage of sales, it shows you how much each bill costs.
We’ll use the same numbers as before:
- Cost of goods sold (COGS): $40k in COGS out of $100k in total sales, or 40%.
- Gross profit: $60,000 in gross profit from $100,000 in total sales, or 60%.
- Operating costs: $20,000 out of $100,000 in total sales, or 20%.
- Operating income: $40,000 out of $100,000 in total sales, or 40%.
- Net income: After taking out taxes, the net income is $10,000 out of $100,000, or 30%.
A look at the balance sheet from above
To do vertical analysis on a balance sheet, you must make the first line item the base number and then compare everything else on the sheet to that base.
What if we say:
- Current assets: Your company has $100,000 in current assets, of which $40,000 is cash and $60,000 is fixed assets.
- Present liabilities: You owe suppliers and debtors $10,000 out of your $100,000 in present assets. That means that only 10% of your current assets are current expenses.
- Equity: If your business has no other outstanding debt or equity, the last 10% of its current asset base is made up of its equity.
A look at the cash flow statement from top to bottom
Vertical analysis looks at a cash flow statement. It compares each line item to the total amount of money coming in or going out during the period shown on the statement.
As an example:
- Cash from operations: Your operating actions bring in all $100,000 in cash from sales.
- Investing: You spent $20,000 in cash to buy new tools or other assets. That’s 20% of all the money you made during that time.
- Loans: If you needed more money and your total cash flow was $100,000, the partner who put down $10,000 would be responsible for 10%.
The main difference between horizontal and vertical research is that vertical compares each line item to a base figure, while horizontal looks at how things change over time.
Analysis of Financial Ratios
You’ll need information from your financial records to figure out financial ratios. You can use these ratios to look at different parts of your business’s financial success, let stakeholders know about it, and make intelligent choices about what to do next.
Rates of Liquidity
The liquidity numbers show how quickly your business can turn its assets into cash to pay its bills.
These are some commonly used cash ratios:
- Current ratio: how well you can pay off your current debts with your current assets
- The quick ratio is your current ratio minus your assets.
Ratios of Profitability
Profitability numbers show how well a business can make money. When they look at the income statement and the balance sheet together, they can help you figure out how profitable your business is.
This is a list of some commonly used income ratios:
- Gross profit margin is the difference between your gross profit and sales income. This number tells you how much each sale adds to your bottom line.
- Operating margin: how much of each sale is left over after operating costs and cost of goods sold are taken out
- Net profit margin: the amount of sales revenue left over after taxes, interest payments, and costs from the income statement are taken out.
Ratios of efficiency
Ratios of efficiency show how well a company handles its assets. They are used to judge how healthy management can make money and cut costs. These are some commonly used efficiency ratios:
- Asset movement is how well your business uses its assets to make sales.
- Inventory movement, or how quickly items are bought and put back on shelves
- Days Sales Outstanding (DSO): This is how long your business gets paid by customers.
Ratios of Solvency
Solvency rates make it easy to see if a company can pay its long-term debts. They look at how much debt a company has compared to its assets, profits, and equity.
Most of the time, a solvency number will look like one of these:
- The debt-to-equity ratio shows how much equity is used to back up every dollar of debt.
- Debt-to-assets ratio: This shows how much of your company’s assets are paid for by debt.
- Interest coverage ratio—a way to see how easily your business’s income could cover its interest costs.
- The debt-to-EBITDA ratio shows how much of your company’s overall debt can be paid off with the money it makes before interest, taxes, depreciation, and amortization.
- The equity ratio shows how much of your company’s equity cash is used to pay for its assets.
Ratios of market value
The market value ratio tells you how much people are ready to pay for a share of your company’s stock. You can use them to learn about market trends and how investors feel.
Here are some common market worth ratios:
- Price-to-earnings (P/E) ratio: the stock price divided by the company’s profits
- Earnings per share (EPS): how much of your company’s profit is given to each outstanding piece of stock.
- Market-to-book ratio: the difference between the share price on the market and its book value
- Dividend yield: the amount of dividends your company pays out compared to its stock price.
Best Practices for Financial Analysis
Use signs that look ahead.
Even though past information is helpful, it shouldn’t be used only for financial analysis. Considering market trends, changes in customer behavior, new technologies, and upcoming changes to regulations can help you get a fuller picture.
Add measures that aren’t related to money.
Along with financial data, you must look at non-financial metrics such as brand strength, customer involvement, customer satisfaction (CSAT), and innovation pipeline.
These measures can often give early warnings about how well a business will do in the future and can affect how long earnings last. For example, a high turnover rate could mean problems at the root that could finally affect the company’s bottom line.
It would be best if you did scenario and sensitivity studies.
This kind of math helps you figure out how changes in essential factors, like interest rates, exchange rates, or sales volume, affect the results of your financial models. That way, your business will be ready to act if things don’t go as planned.
Keep the conversation and data visualization working well.
To clearly and convincingly present complicated financial information, you need to be able to report the numbers and tell the story behind them using suitable data visualization methods and a straightforward narrative. Making the message fit the audience, like management, investors, or non-financial stakeholders, ensures the insights are known and can be used.
