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Financial health may be one of several indicators of your business's potential for long-term growth, and a step toward improving financial literacy could be to conduct a financial analysis of your business. Doing so means that you could have a foundational tool to help understand your business performance and help guide planning decisions, including automating payments.
What Is Financial Analysis?
Financial analysis uses a business's financial data to assess its performance and identify potential trends. Data is taken from financial statements, and its metrics are then used to help support decision making.
Key Types of Financial Data Analytics
The four main types of financial analysis include:
- Profitability analysis: Businesses measure how much profit they make, using tools like return in invested capital and profit margin.
- Liquidity analysis: This looks at the ability to pay short-term financial obligations. One way to do so includes looking at how soon a business may pay them down using resources like expected revenue and cash.
- Efficiency analysis: This analysis looks at how well a business uses its resources, like existing inventory and other types of assets.
- Trend analysis: Businesses may use this analysis to look at historical data to see patterns or changes to help identify trends.
The Financial Areas That Could Matter Most for Your Business
A financial analysis may include six areas, each containing its own set of data points and ratios.
1. Revenues
Revenues could be your business's main indicator of performance. When learning how to analyze financial data, remember that quantity, quality, and timing of revenues may influence long-term success.
Some ratios to consider when conducting your financial analysis may include:
- Revenue growth: This ratio is calculated by the difference between your revenue this period from the last period, and divided by last period’s revenue. You may consider reviewing one-time revenues separately when analyzing revenue growth.
- Revenue concentration: If a single customer generates a high percentage of your revenues, you could face financial difficulty if your customer leaves.
- Revenue per employee: This ratio measures your business's productivity. A higher ratio may indicate greater productivity. A good ratio for your business could depend on factors like your industry and other relevant benchmarks.
2. Profits
Profitability, especially a high one, may be a measure of business sustainability and success. If you can't produce quality profits consistently, your business may not survive in the long run. Some key terms include:
- Gross profit margin: This data point is calculated by taking the difference between your revenues and cost sold and dividing it by your revenues. A healthy gross profit margin may help you absorb shocks to revenues or cost of goods sold without losing the ability to pay for ongoing expenses.
- Operating profit margin: This helps determine your company’s ability to make a profit regardless of how you finance operations. To calculate your operating profit margin, subtract your cost of goods sold and operating expenses from revenues and then divide it by your revenues.
- Net profit margin: Calculate net profit margin by subtracting all of your expenses (including operating and all others) and cost of goods sold from your revenues, then dividing that number by your revenues. Net profit margin helps indicate how much profit a business retains relative to its revenue after accounting for expenses.
3. Operational Efficiency
Operational efficiency helps measure how well you're using the company’s resources. Some signs of healthy operational efficiency may include cost control, company productivity, and optimizing processes.
Some ways to assess operational efficiency may include:
- Accounts receivables turnover: This measures how efficiently you manage the credit you extend to customers by dividing your net credit sales by the average accounts receivable. A higher number may mean your company is managing credit well.
- Inventory turnover: By dividing the cost of goods sold by your average inventory you may measure how efficiently you manage inventory. A lower number may mean you either aren't selling well or are producing too much for your current level of sales.
4. Capital Efficiency and Solvency
Capital efficiency and solvency could be of interest to lenders and investors because they may reveal how a business uses its capital and manages their long-term financial obligations.
Some financial analyses used to calculate capital efficiency and solvency may include:
- Return on equity: This represents the return investors are generating from your business, which you may calculate by dividing the business net income by the shareholders’ equity.
- Debt to equity: This analysis may indicate how much leverage you're using to operate. The appropriate level of leverage may depend on your business's financial circumstances.
5. Liquidity
Liquidity analysis addresses your ability to generate sufficient cash to cover cash expenses. No amount of revenue growth or profits may be able to compensate for poor liquidity.
- Current ratio: By dividing your current assets by your current liabilities, you may measure your business’s ability to pay off short-term obligations from cash and other current assets.
- Interest coverage: This ratio measures a business's ability to cover interest expenses using earnings before interest and taxes.
6. Basis for Comparison
Establishing a basis for comparison could help to determine if business performance is aligned with appropriate benchmarks. There are generally two ways you may look at this:
- Your company’s past: This basis helps to determine if your business’s financials are improving or worsening. The past three years of performance may be sufficient, though you could use older data.
- Direct competitors: Looking at how competitors are faring may provide an important reality check. For instance, if you have a 10 percent revenue growth and competitors are growing at 25 percent, you may need to assess your business performance.
Examples of Financial Analysis
Here are some real-world examples of how financial analysis might be used.
Inventory Review
You run a craft store and notice that cash flow is not as high as it used to be, and you're concerned about having to borrow more funds. After conducting a financial analysis, you discover that your inventory turnover is low.
Looking deeper, you identify the types of merchandise that aren't selling well, and consider putting on a sale, and using the proceeds to purchase items that are more popular with customers.
Investor Analysis
You’re interested in understanding a business's financial performance. You use different analyses like the debt income ratio and the gross profit margin to see whether the business is showing an upward growth trend.
Applying Financial Data Analysis
Understanding how to analyze financial data could be an important step to see how well a business is doing and discover any data that could potentially help improve operations. Using relevant financial analysis, businesses may spot trends, problems, and other ways to help improve productivity.
A potential challenge for many businesses is cash flow. Learn how you may mitigate some cash-flow issues, like effective ways to respond to late invoices.
Frequently Asked Questions About Financial Analysis
What is financial analysis?
Financial analysis is the process of evaluating a business or individual's financial situation. This may be done by reviewing their financial statements, such as their income statement or balance sheet. Financial analysis may also involve looking at economic trends to determine how they might impact a company’s financial health.
What are the types of financial analysis?
- Fundamental analysis: This approach looks at a company's financial statements and other key indicators to help determine its intrinsic value.
- Technical analysis: This approach uses past market data to help identify trends that may be relevant to assessing potential future price movements.
What is the importance of financial analysis?
Financial analysis may help you make informed decisions about your business's financial planning. It may also help you assess the financial health of a company and make decisions about whether to do business with them.
What are the steps in financial analysis?
There are different steps involved in financial analysis depending on the type of analysis. Some common steps may include the following:
- Gathering financial data: Financial data may be collected from various sources, such as financial statements, annual reports, and government records.
- Analyzing the data: Try to have the right types of financial data you need.
- Interpreting the results: You may interpret the results of your analysis to help make conclusions about a company's financial health.
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