Financial Analysis

What is Financial Analysis?

Financial analysis is a multifaceted process that evaluates the viability, stability, and profitability of a business or project. It involves assessing a company’s financial statements and other relevant data to understand its health and performance, as well as evaluating its potential for future growth and profitability.

Briefly, key aspects of financial analysis include:

• 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 informed decisions, evaluate investment opportunities, and determine a company’s competitive position within its industry and economic environment. They also use it to communicate the company’s outlook and current financial standing to stakeholders like investors, creditors, and board members.

Synonyms

• Business financial analysis
• Financial data analysis
• Financial ratio analysis
• Financial statement analysis

Importance of Financial Analysis

Financial analysis is a critical tool for investors, creditors, and company management, as it provides insights necessary for making strategic business and investment decisions. It helps them make strategic decisions — for example, whether to continue or discontinue operations, acquire assets, manage debt, and make other crucial decisions.

It’s also about more than just numbers. Financial analysis requires these groups to evaluate market trends, industry benchmarks, and the regulatory environment to provide a comprehensive view of a company’s situation.

Importance for Investors

Investing comes with tremendous risk. Around 75% of venture-backed companies fail, and plenty more never return cash to angel investors, VCs, and private equity funds.

Investors know this. It’s the one or two rockstar companies in a portfolio that drive the vast majority of returns. There’s a reason VCs calibrate their fund sizes around the ability to produce one of these; coming up with a grand slam is just that hard.

Investors of any stripe need to use financial analysis to root out the companies most likely to produce these returns. They need to break down existing and potential investments, understand their strengths and weaknesses, and determine if they are worth time and capital.

In general, a good investment prospect will look like it on its financial statements. And, of course, the inverse is true.

Importance for Management Planning and Decision-Making

Every business owner, executive, or manager is engaged in some level of financial analysis as part of their ongoing management responsibilities.

• Financial management teams need analysis to set budgets, allocate resources, and forecast the company’s financial needs.
• Sales leaders pore over cash flow statements to determine how much inventory to order, when (and how much) they can discount, where to set sales quotas, and how many new sales reps they can afford.
• Operations managers use analyses to optimize production and inventory processes, manage supply chains, assess the performance of their suppliers, and maintain quality standards.
• Marketing managers analyze a company’s customer acquisition costs, the return on investment from their marketing tactics, and customer lifetime value to make sound decisions about budgets and campaigns.

Since “money in vs. money out” is the determining factor for everything that happens within the business, good financial analysis skills are crucial for everyone in management. And accurate financial analysis is an absolute requirement for strategic planning, decision-making, and overall organization-wide success.

Importance for Lenders

Lenders need a clear understanding of the business they are lending to, and financial analysis helps them evaluate risk and make informed decisions.

• Before approving a loan application, lenders analyze past financial statements, including balance sheets, income statements, and cash flow statements.
• They also use industry benchmarks to compare companies in similar industries or sectors.
• Lenders normally also look at external factors like potential regulatory changes and upcoming market trends.
• Debt holders also use financial analysis to determine if a company has enough assets to cover its debt obligations and whether they’ll receive interest payments on time.

Lenders assume some of the same risks as investors when it comes to funding a company. If the company fails (or simply lacks the capital to pay on time), lenders could wind up with serious cash flow problems. Financial analysis provides them with the context they need to decide who is creditworthy and who isn’t.

Common Types of Financial Analysis

Horizontal Analysis

Horizontal analysis is a comparative method that compares financial statements from different periods to identify trends and changes in your business. It shows how your organization has grown over time and helps you pinpoint areas of financial strength or weakness.

Let’s say your company’s revenue growth outpaces its expenses over the course of the year. This is a good sign. It means you’re making more money than you’re spending.

By the same token, if your expenses outpace your revenue, you know you need to either cut costs or increase sales.

Horizontal analysis is a useful tool for budgeting, forecasting, and identifying variances in your company’s performance over time.

Horizontal Analysis of Income Statement

On your income statement, a horizontal analysis means looking at the line items (your income and expenses) as a percentage of total sales revenue.

Let’s say your business brought in $100,000 in revenue during its first year. Here are some possible income statement line items and how they might look as a percentage of total sales:

• COGS: Let’s say that you spend $40,000 on the goods or services you sold to produce the $100k in revenue. In this case, Cost of Goods Sold (COGS) is 40% of revenue.
• Gross profit: If your cost of goods sold was $40,000, then the difference between that number and overall revenue is your gross profit — in this case, $60,000 or 60%.
• 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: This is what the company “takes home” after all operating expenses are subtracted from gross profit. In this case, let’s say all other costs (taxes etc.) add up to $10,000. That brings us to a net income of 30%.

Horizontal Analysis of Balance Sheet

A horizontal analysis of a balance sheet takes into account changes in your company’s assets, liabilities, and equity over time. For example, let’s say your business owned that same $100,000 in assets (cash, inventory, equipment) at the end of its first year.

• Current assets: Assume that of those $100k in assets, $40k is held in cash. 30% of your company’s total assets are now liquid.
• Fixed assets: If fixed or tangible assets like equipment and real estate account for the remaining $60k, that’s 60% of your company’s asset mix.
• Current liabilities: Of your $100k in total assets, let’s say you owe $10k to suppliers and creditors. That means your current liabilities account for 10% of total assets.
• Equity: Assuming no other outstanding debt or equity yet exists, your company’s equity makes up the remaining 90%.

Horizontal Analysis of Cash Flow Statement

Horizontal analysis of a cash flow statement compares the source and use of cash over time. The statement shows when and where money came into your business, as well as how it was spent or invested.

For example:

• Cash from operations: If during the first year, you took in $100k in revenue, your company’s operating activities will account for 100% of total cash flow.
• Investments: Let’s say you used $20k in cash to buy new equipment or invest in other assets. That’s 20% of your total operations.
• Financing: If you needed an influx of capital during that first year, let’s say you brought on a partner who invested $10k. In that case, financing would account for the remaining 10%.

Vertical Analysis

Vertical analysis is a financial analysis method where each item in a financial statement (like an income statement or balance sheet) is represented as a percentage of a base figure from the statement. In practice, the first line of a financial statement is set as the base figure (100%), and all subsequent items are expressed as a percentage of this base.

Vertical Analysis of Income Statement

On your income statement, a vertical analysis compares each line item (income and expenses) to total sales revenue. It lets you see what percentage of sales is represented by each expense.

Let’s use the same numbers from before:

• COGS: $40k in COGS out of $100k in total revenue = 40%.
• Gross profit: $60k in gross profit out of $100k in total revenue = 60%.
• Operating expenses: $20k in operating expenses out of $100k in total revenue = 20%.
• Operating income: $40k in operating income out of $100k in total revenue = 40%.
• Net income: After subtracting taxes (etc.) to arrive at $10k in net income out of $100k in total revenue = 30%.

Vertical Analysis of Balance Sheet

On a balance sheet, vertical analysis requires setting the first line item as the base figure and then comparing all other items on the statement to that base.

Let’s assume:

• Current assets: Your business has $100k in current assets, of which 40% ($40k) is cash and 60% ($60k) are fixed assets.
• Current liabilities: Out of your total current asset base figure of $100k, you owe suppliers and creditors $10k. That means your current liabilities account for only 10% of your current asset
• Equity: Assuming no other outstanding debt or equity yet exists, your company’s equity makes up the remaining 90% of the current asset base figure.

Vertical Analysis of Cash Flow Statement

On a cash flow statement, vertical analysis compares each line item to the total amount of cash inflow or outflow for the period covered by the statement.

For example:

• Cash from operations: Out of a total $100k in cash inflow (from sales revenue), your operating activities account for 100%.
• Investments: Let’s say you used $20k in cash to buy new equipment or invest in other assets. That’s 20% of your total cash flow for the period.
• Financing: If you needed new capital, and your total cash inflow was $100k, the partner that invested $10k would account for 10% of total cash flow.

The key difference between horizontal and vertical analysis is that horizontal focuses on change over time, while vertical compares each line item to a given base figure.

Financial Ratio Analysis

You’ll use data from your financial statements to calculate financial ratios. You can leverage ratios like these to evaluate various aspects of your business’s financial performance, communicate it to stakeholders, and make informed decisions about future plans.

Liquidity Ratios

Your liquidity ratios tell you how quickly your company can turn assets into cash to meet its financial obligations.

Commonly used liquidity ratios include:

• Current ratio — your ability to pay off current liabilities with current liquid assets
• Quick ratio — your current ratio, excluding inventory

Profitability Ratios

Profitability ratios assess a company’s ability to generate earnings. They compare income statement figures with balance sheet items and can help you understand how well your business is doing in terms of profitability.

Here are a few frequently used profitability ratios:

• Gross profit margin — gross profit compared sales revenue, which tells you how much each sale contributes to your bottom line
• Operating margin — how much of each sale is left after deducting cost of goods sold and operating expenses
• Net profit margin — the percentage of sales revenue that remains after taxes, interest payments, and expenses listed on the income statement are deducted

Efficiency Ratios

Efficiency ratios measure how effectively a business manages its assets. They’re used to evaluate management’s ability to generate profits and reduce costs. Commonly used efficiency ratios are:

• Asset turnover — the efficiency with which your company uses its assets to generate sales
• Inventory turnover — how quickly inventory is sold and restocked
• Days Sales Outstanding (DSO) — how long it takes for your company to collect account receivables from customers

Solvency Ratios

Solvency ratios show how well a business can meet its long-term financial obligations. They assess the level of debt a business has relative to equity, assets, and earnings.

When you see a solvency ratio, it’ll almost always be one of the following:

• Debt-to-equity ratio — the amount of equity used to support a dollar in debt
• Debt-to-assets ratio — how much of your company’s assets are funded by debt
• Interest coverage ratio — a measure of how easily your company’s operating income could pay off its interest expense.
• Debt-to-EBITDA ratio — your company’s ability to pay off its total debt using its earnings before interest, taxes, depreciation, and amortization
• Equity ratio — the relative proportion of equity capital used to finance your company’s assets

Market Value Ratios

Market value ratios assess how much investors are willing to pay for a share of your company’s stock. They can help you understand market trends and investor sentiment.

Some common market value ratios include:

• Price-to-earnings (P/E) ratio — the price of a company’s stock divided by its earnings
• Earnings per share (EPS) — the proportion of your company’s profit allocated to each outstanding share of its stock
• Market-to-book ratio — the market price per share divided by book value per share
• Dividend yield — the amount of dividends your company pays to shareholders relative to its stock price

Financial Analysis Best Practices

Use forward-looking indicators

While historical data is important, financial analysis shouldn’t rely solely on that. Incorporating market trends, consumer behavior shifts, technological advancements, and upcoming regulatory changes, can give you a more comprehensive picture.

Integrate non-financial metrics

You have to analyze financial data in conjunction with non-financial metrics like customer satisfaction (CSAT) scores, customer engagement levels, brand strength, and your innovation pipeline.

These metrics often provide early signals of future financial performance and can influence the sustainability of earnings. For instance, high employee turnover might indicate underlying issues that could eventually impact financial results.

Run scenario and sensitivity analyses

In financial modeling, these techniques help you understand how changes in key assumptions (like interest rates, exchange rates, or sales volume) impact financial outcomes. That way, your company is prepared to take action when things don’t go as planned.

Maintain effective communication and data visualization

The ability to communicate complex financial data clearly and compellingly requires you to report the numbers and tell the story behind them through effective data visualization techniques and a clear narrative. Tailoring the communication to the audience, whether it be management, investors, or non-financial stakeholders, ensures that the insights are understood and actionable.

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