Identifying the core components of financial analysis

Financial analysis can be a powerful tool in the hands of any business leader. It provides the insights you need to make sound decisions and ensure your business is headed in the right direction.

Data Collection

The first component of financial analysis is data collection. This includes gathering financial information related to your business, such as income statements, balance sheets and cash flow statements. This data will be used in the analysis process.

Companies should create supporting schedules that show additional information related to the data collected and can help provide better insight into how a business is performing. For example, you may need to create a schedule of accounts receivable and accounts payable, split costs into different categories, or break down sales into product and customer segments.

You’ll need to determine the data sources and systems that you will use to collate and report your financial analysis. This could include software packages, an automated accounting system and online resources such as subscription services or public databases.

This data should be analyzed on a regular basis to provide the most accurate picture of your business and allow you to see changes over time. You should analyze this data at least annually, or quarterly if possible. Most established companies will perform this at least on a monthly basis and their finance functions will produce detailed management information tailored for key stakeholders.

Ratio Analysis

Once you have gathered all the financial information, it’s time to start analyzing it. Ratio analysis involves evaluating key ratios derived from the financial data collected to gain an understanding of the performance and health of your business. Commonly used ratios include profitability ratios, liquidity ratios, activity ratios and debt management ratios.

Here are some examples of how you may calculate each ratio, which can vary by industry and location:

Profitability Ratios

These measure your company’s ability to generate profits and can include gross profit margin, operating profit margin and net profit margin:

• Gross profit is calculated by subtracting the cost of goods sold from total sales.
• Operating profit is calculated by subtracting operating expenses (excluding interest expense) from gross profit.
• Net profit is calculated by subtracting all expenses including taxes and interest expenses from sales.

The margin is then calculated by dividing each of these figures by total sales and and is typically expressed as a percentage.

Liquidity Ratios

These measure how liquid your business is and includes the current ratio and quick ratio:

• The current ratio is calculated by dividing current assets by current liabilities.
• The quick ratio is calculated by subtracting inventories from current assets and then dividing the result by current liabilities.

Both of these ratios measure your company’s ability to pay its short-term obligations without having to sell off long-term investments or liquidate other assets.

Activity Ratios

These measure how efficiently you are using resources and can include inventory turnover, accounts receivable turnover and fixed asset turnover ratios:

• Inventory turnover measures how quickly you are selling off your inventory. It is calculated by dividing cost of goods sold by average inventory.
• Accounts receivable turnover measures how quickly customers pay their bills. It is calculated by dividing net credit sales during the period by average accounts receivable.
• Fixed asset turnover measures how productive you are with your fixed assets such as equipment, buildings and land. It is calculated by dividing total sales by average net fixed assets.

Poor activity ratios may indicate that your resources are not being used efficiently.

Debt Management Ratios

These measure how your company is financing its operations and includes debt-to-equity ratio, times interest earned ratio and cash flow coverage ratio:

• The debt-to-equity ratio is calculated by dividing total liabilities by total equity. A higher number can indicate the company has more debt than it can manage.
• The times interest earned ratio is calculated by dividing earnings before interest and taxes (EBIT) by total interest expense. This indicates the company’s ability to cover its interest payments.
• The cash flow coverage ratio is calculated by dividing cash flows from operations by total debt service cost. This shows how easily the company can meet its debt obligations.

Understanding these core components of financial analysis helps business leaders understand their current financial performance, identify strengths and weaknesses and plan for future growth. With this understanding, you can make better strategic decisions to ensure the success of your business.

Trend Analysis

The third component of financial analysis is trend analysis. This involves examining the data over time to identify any trends in performance or variables that may be influencing the performance of your business.

There are many popular methodologies for performing trend analysis, such as time-series analysis, regression analysis and moving averages. By studying the data points over a period of time, you can better understand how your business is performing and potentially uncover any issues that need to be addressed.

Most companies will study graphs or charts over time to identify any trends in performance. If a particular variable is having a negative effect on the performance of your business, this can be identified and addressed with the necessary measures.

Financial performance trend analysis can help you identify opportunities for improvement or areas where your business may be falling short. It also helps you determine when it might be time to shift strategies or take other proactive measures.

Forecasting

Finally, the fourth component of financial analysis is forecasting. This involves making predictions about future financial performance based on past trends and current data. This provides a basis for decision making and planning in the future.

Some companies generate five-year financial models, whilst others forecast on an annual basis. Larger companies typically revise their forecasts every quarter.

Forecasting helps identify potential risks and opportunities so you can make the necessary adjustments to ensure your business remains on track. It also provides a benchmark against which you can measure actual performance, allowing you to identify any discrepancies or changes in trends over time.

Summary

By understanding these core components of financial analysis, business leaders can unlock the power of this powerful tool to make informed decisions and drive their businesses forward. With the right information, you’ll be well-equipped to steer your business in the right direction.