What is financial analysis?
Financial analysis is the process of determining financial performance and stability by evaluating different business projects and company budgets. It helps stakeholders understand whether an entity is profitable or not.
When conducted internally within a company, financial analyses simplify the processes of reviewing historical trends and making future business decisions. During external analysis, investors use the data to decide whether the business can prove its funding needs.
Financial analysis software is a valuable tool for monitoring financial performance and is integral to the financial planning and analysis process. Since financial analysis uses ratios and financial statements, businesses leverage the software to create dashboards and plans.
Financial analysis is important because it:
- Improves tax management
- Provides information to investors and stakeholders
- Guides internal decision making
- Ensures profitability
- Aids in raising capital
- Gives a better understanding of financial ratios
- Lowers financial risks
Components of financial analysis
Financial analysis is essential for consolidating transactions and tracking financial KPIs during financial ratio analysis. Knowing what comprises a financial analysis indicates that a business cares about its financial health. Here are the different components of financial analysis.
Revenues: The primary source of cash for a company is called its revenue. There are three different types of revenue based on quantity, quality, and timing.Revenue growth: Shows change in revenue from last period to this period.
Revenue growth = {Current revenue-past revenue}/ Past revenue
Revenue concentration: Revenue generated by highest-paying customers.
Revenue concentration = {Amount paid by client} / total revenue
Revenue per employee: Measures the business’s productivity.
Revenue per employee = {Total revenue} / number of employees
Gross profit margin: Positive profit margins allow for revenue loss while keeping the ability to spend intact.
Gross profit margin = (Revenues - cost of goods sold) / revenues
Operating profit margin: Determines how a business makes a profit; does not include interests and taxes.
Operating profit margin = {Revenues - cost of goods sold - operating expenses} /revenues
Net profit margin: The amount remained after all calculations to give back to stakeholders in dividends.
Net profit margin = Revenues - the cost of goods sold - operating expenses - other expenses
Operational efficiency: This metric measures how efficiently the company uses its resources and whether it streamlines operational efficiency across all processes for bigger profits and better growth.
Technology like accounting software helps leaders automate financial management processes and get accurate records.
Ways to measure operational efficiency:
Accounts receivables turnover measures the efficiency of credit extension and customer management.
Accounts receivables turnover = {Net credit sales} / average accounts receivable
Inventory turnover measures operational efficiency through inventory management.
Inventory turnover = {Cost of goods sold }/ average inventory
Capital efficiency and solvency: These parts of financial analysis are essential to lenders and investors assessing a business.
Two ratios that determine a company’s solvency:
Return on equity: Amount of return being received by investors.
Return on equity = Net income / shareholder equity
Debt to equity: Measures how much leverage a company uses for operations.
Debt to equity = Debt / equity
Liquidity: Many companies perform a liquidity analysis to check whether they have sufficient funds to pay debts and liabilities without borrowing money. Low liquidity implies that the business cannot meet its short-term obligations and face bankruptcy.
Two ratios that help determine liquidity:
Current ratio: Measures the ability to pay off short-term debts from cash and separate assets. A ratio above 2 indicates that the business has sufficient liquid resources.
Current ratio = Current assets / current liabilities
Interest coverage: Measures the ability to pay interest expenses from revenue generated.
Interest coverage = Earnings before interest / interest expense
Types of financial analysis
Financial analysis is specific to business type, corporate performance, supply and demand, and other factors. These are the most common types of financial analysis.
Vertical analysis
This process is also called a common-sized income statement and is done by reviewing the components of the income statement and dividing them by total revenue.
The percentage obtained is most valuable when compared against industry competitors to assess financial performance.
Horizontal analysis
This type of analysis compares previous years of financial data to current statements to determine the company’s growth rate. Horizontal analysis is also helpful in understanding industry trends and analyzing those insights.
Leverage analysis
Business performance is most usually analyzed through leverage ratios. Some popular leverage ratios include:
- Debt to equity ratio
- Debt to earnings before interest, taxes, and depreciation (EBITDA) ratio
- Earnings before interest and taxes (EBIT) to interest coverage ratio
- DuPont analysis (a combination of leverage and liquidity ratios)
Growth rates
This type of financial analysis is part of any business plan as it considers historical growth to make financial projections. Financial analysts calculate growth rate in different ways:
- Year-over-year (YoY)
- Using a regression analysis
- Top-down analysis (market size to individual revenue sources)
- Bottom-up analysis (separate sources to significant revenue drivers)
Profitability analysis
A business’s profitability is measured by analyzing the economics of its operations to evaluate the attractiveness of its working model. Some examples are:
- Gross margin
- EBITDA margin
- EBIT margin
- Net profit margin
Liquidity analysis
This financial analysis primarily focuses on company balance sheets and liquid assets. Examples of liquidity analysis include:
- Current ratio
- Quick ratio: (current assets - inventory) / current liabilities
- Cash ratio
-
Net working capital
Efficiency analysis
This type of analysis evaluates the capital efficiency and solvency of a business. It is an important part of the overall financial analysis process. Common efficiency ratios are:
- Asset turnover ratio: (net sales / average total assets)
- Fixed asset turnover ratio
- Cash conversion ratio
- Inventory turnover ratio
Cash flow
The main focus of this analysis is to check whether the company can generate positive cash flow and review cash flow profiles. The main aspects covered include operating activities, investing activities, and financing activities. Examples of cash flow analysis are:
- Operating cash flow
- Free cash flow
- Free cash flow to the firm
- Free cash flow to equity
Rates of return
Assessing return on investment (ROI) is critical to stakeholders such as investors, lenders, senior company leaders, and financial analysts. Examples include:
- Return on equity
- Return on assets
- Return on invested capital
- Dividend yield
- Capital gain
- Accounting rate of return
- Internal rate of return
Valuation analysis
This analysis measures how much a business is worth and employs various methods to find a realistic estimation. Common approaches include:
- Cost approach: Measures the cost to build or replace
- Market approach: Measured by the relative value of the company and precedent transactions
- Intrinsic value: Measured by the discounted cash flow analysis
Scenario and sensitivity analysis
Building scenarios and performing sensitivity analysis helps reflect a company's best and worst financial situations. The process is a way of measuring associated risks and determining uncertainties. Budgeting and forecasting software is often used to prepare for the future and make reasonable estimates and assumptions.
Variance analysis
Variance analysis is the process of comparing actual financial outcomes with proposed budgets. It’s an essential part of internal financial planning and categorizes each variance as favorable or unfavorable.
Other common financial analysis techniques used by businesses:
- Trend analysis
- Business risk analysis
- Control analysis
Financial analysis best practices
For a financial statement analysis to be effective, businesses must follow certain tips and best practices.
- Organize data. Being organized with all information simplifies financial analysis. Testing and auditing different spreadsheets software to build tables and charts helps companies pay attention to detail.
- Keep it simple. Undertaking financial planning is a lot of work. Keeping all calculations and formulas clear and simple prevents unnecessary stress and helps businesses stay focused on the big picture.
- Conduct continual reviews. Analysts cannot do financial analysis without having peers and experts check data, redundancies, and assumptions. Have several eyes look at the analysis to identify best strategies, make sound decisions, and maintain growth.
Financial analysis vs. economic analysis
Financial analysis is the process of comparing the costs and benefits of a business. It uses market prices to check financial performance, stability, and balance of investments. Financial analysis is specific to companies and projects.
While complimentary to financial analysis, economic analysis is more focused on the business's actual value for the entire society. The analysis employs economic costs such as taxes, profits, and subsidies, instead of market prices, to reflect the absolute cost-benefits of goods and services.
Aayushi Sanghavi
Aayushi Sanghavi is a Campaign Coordinator at G2 for the Content and SEO teams at G2 and is exploring her interests in project management and process optimization. Previously, she has written for the Customer Service and Tech Verticals space. In her free time, she volunteers at animal shelters, dances, or attempts to learn a new language.
