In today’s article, we will look at what Financial Analysis stands for, how to perform it and, most importantly, why it is essential for businesses.
What is Financial Analysis?
If you google the definition, what you get is something along the lines of
Financial analysis is the assessment of the profitability, stability, and viability of a business, part of the business or a project, to support the process of strategic decision making.
We usually analyze financial data to support the decision-making process, which can relate to various areas and questions. For example, by analyzing the financial statements of our company, we can answer the following questions:
- Should we purchase a specific part or produce it ourselves?
- Is it better to buy machinery and equipment, or to lease it?
- Should we get a bank loan to increase our working capital or should we issue shares?
- Is it a good idea to lend capital, or is it better to invest it?
- Should we discontinue a part of the business?
We perform financial analysis by calculating and reviewing ratios based on various metrics, usually coming from a company’s financial statements. Typically, such analysis is performed to determine if a business is stable, solvent, and liquid enough to remain profitable. Financial analysts usually focus on the Income statement, Balance sheet, and the Cash Flow statement of a company, and base their analysis mostly on this data. The objective of financial analysis is to evaluate the performance of management in the areas of Profitability, Efficiency, and Risk.
Financial analysis can be performed either in an investment finance scenario or within corporate finance. In investment finance, financial ratios are usually analyzed externally by consulting companies to summarize past performance, forecast the future of the company, and decide if the company is a good investment opportunity. In corporate finance, financial ratios are analyzed internally to support the strategic decision-making process; for example, when determining whether to proceed further with a new project.
Financial Analysis Approach
When we perform the analysis, we can look at different sources of information, which will define our approach and data collection:
- Historical data – we often focus on the past performance of the same company/project, and our analysis compares financial data between different periods
- Forecasted data – this approach adds an extra step to using Historical data approach – we use the past performance data to project and forecast the estimated performance of the company/project we are analyzing for future periods so that we can extend our analysis into the expected future performance
- Benchmarking – this approach looks at the performance of similar businesses/projects and draws conclusions based on comparing against their performance over the same period.
Financial Analysis Methods
When approaching a financial analysis, the three most common methods which can be applied are:
- Trend Analysis, also known as Horizontal Analysis. This method compares financial statement data over subsequent periods to analyze the absolute and percentage changes for the same metrics over the periods. This method is usually used to forecast future performance by examining the performance of the same company/project over a few years.
- Percentage Analysis, also known as Vertical Analysis. This method uses a base metric, and we present all other lines of the financial statements as a percentage of this base metric. Usually, Income statement items are presented as a percentage of Sales, while we show Balance sheet items as a percentage of Total Assets/Total Liabilities. This analysis method is standard when we want to analyze relative relations between lines in the Financial Statements. For example, we can analyze the Cost of Goods Sold as a percentage of Sales and note that if the portion of COGS in Sales grows, this might mean we have increasing material prices, or we might have a pricing issue. We will talk more about these in future articles.
- Ratio Analysis. This method puts values in perspective with other related values. It is also easier to compare different sizes of companies/projects when using ratio analysis. Ratios show meaningful relationships between various individual values in the financial statements.
Financial Analysis Areas
Performing a proper financial analysis of a company/project requires that we cover four key areas:
- Revenue is usually the main cash-generating item for a business, which makes analyzing it essential. We can focus on analyzing the growth rate of revenue over the last few years, revenue generated per salesperson, revenue distribution over regions or clients.
- Gross margin and operating profit
These show us the result of the company/project performance. No amount of revenue can sustain the business if the expenses exceed sales.
- The efficiency of operations and Solvency
In this area, we focus on analyzing how well the management employs the assets and capital of the company/project to generate returns. These areas can often be separated, as operations efficiency is geared more towards the sustainability and growth of the business, while solvency ratios are used mostly to analyze whether a company is generating enough net returns to reward its investors.
This area focuses on cash generation with the primary objective to analyze whether the company/project can generate enough cash to cover expenditures. Here we have to note that cash generated differs from sales/revenue. For example, a company may have stable sales growth, but it may have poor receivables collection (when the money comes in the company). If the collection is too weak, the company may not be able to cover its cash expenditures, even if sales are booming.
Challenges to Financial Ratios
Comparing financial ratios over periods or between companies/projects has some problems and faces criticism:
- Financial ratios depend heavily on the accounting policies applied and the adopted reporting frameworks. This puts the objectiveness of ratios under question, as accounting policies are usually subject to some judgment from management, which can be influenced by subjective matters. Differences in the accounting policies chosen may cause two companies to have vastly different ratios only due to different underlying information.
- A seasonal business might have year-end financial ratios that are not representative of their performance over the period. Whenever possible, we should use average data for such ratios.
- Financial ratios don’t say a lot about the business/project future potential on their own. We use information from reference points in time or similar companies, as ratios only provide relative performance indications. Also, on its own, one ratio can be interpreted in varying ways. Therefore, usually, a combination of financial ratios is analyzed, to get a more comprehensive overview of the performance of the business/project.
Financial analysis is an essential tool for business owners and managers to measure progress towards company goals and benchmark performance against competitors and other businesses within the industry. Performing financial analysis regularly and preparing future forecasts helps businesses recognize trends and better adapt to the changing environment and circumstances affecting their operations.
For smaller business owners, financial analysis is also essential because it provides one of the most critical measures of a company’s performance in the eyes of potential investors and banks.
In the following articles, we will delve deeper into financial analysis and explore various techniques we can apply to utilize available data from a company’s financial statements. Doing so will give us a better overview of the performance of the company and a better outlook for the future.
Thank you for reading and Never stop exploring!
Hi! I am a finance professional with 10+ years of experience in audit, controlling, reporting, financial analysis and modeling. I am excited to delve deep into specifics of various industries, where I can identify the best solutions for clients I work with.
In my spare time, I am into skiing, hiking and running. I am also active on Instagram and YouTube, where I try different ways to express my creative side.
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