Financial Analysis: Your Window to Success
Finance is the language of business. You have to make the best decisions possible for yours or your client’s business. And, understanding data financial analysis is the key to making this happen.
Financial analysis is one part of the business finance process. It examines historical financial data to gain information about the current and future financial health of a company. Any successful business owner is constantly analyzing the performance of his or her company. He or she also compares it with the company’s historical figures, with its industry competitors, and even with successful businesses from other industries.
Financial analysis can be applied in many different situations. To get you more familiar with financial analysis, we compiled the most important parts of it: financial analysis tools, financial statement analysis, financial analysis ratios, and financial analysis techniques.
Financial Analysis Tools
There are many financial analyses techniques, though three important methods will be discussed below: Horizontal, and Vertical Analyses, and Financial Ratios.
Horizontal and Vertical Analysis
Horizontal analysis is the comparison of financial information over a specified period of time. Vertical analysis is the proportional analysis of a company’s financial statement, meaning that each financial statement line item is listed as a percentage or another item, for easy comparability across different line items and easy observation of a line item’s relative size in comparison to a primary account for comparison.
For example, each line item on an Income Statement is stated as a percentage of Gross Sales or Total Revenue, or even Net Sales (Revenue – discounts or rebates), while each Balance Sheet line item is listed as a percentage of Total Assets (or Total Liabilities for the Liabilities & Net Worth side of the Balance Sheet).
Seeing these proportional relationships is illuminating, also allowing for easy comparability between different operating periods or when benchmarking performance to industry peers. We will discuss financial statements in more depth in the next section.
There are many Financial Ratios used in financial analyses, all conveying important information about the relationship of one metric (or metrics) to another. It’s this relationship between a set of metrics that conveys a financial picture, for example: The Current Ratio (Current Assets divided by Current Liabilities) will reveal a company’s ability to pay its short-term obligations (as a Liquidity Ratio). Once you calculate one ratio, you can then compare it to the same ratio calculated for a prior period.
Or, you can compare (benchmark) the ratio to an industry peer to determine if your company is performing better, or worse than peers at the median (or average, though medians are preferred). Learn more about ratio analysis in our Financial Analysis Ratios section later in this article.
Financial Statement Analysis
One part of financial analysis includes using the business’s financial statement’s numerical data to shed light on patterns of activity that may not be clear on the surface. This numerical data can be found on these company financial statements: the Income Statement (or Profit & Loss statement), the Balance Sheet, and the Cash Flow statement.
The Income Statement reveals a summary of a company’s revenue minus expenses “through” a certain period of time (e.g. monthly, quarterly, annually). An Income Statement, also known as a Profit & Loss (P&L) statement, show the overall profit a company earns after expenses are incurred.
A simplified example or format of a P&L will begin with Revenue, or Net Sales as the top line. The first group of expenses deducted includes Cost of Sales or Cost of Goods Sold (service versus manufacturing company, respectively), which typically include Materials, Labor & Overhead (whichever applicable). Net Sales – COGS = Gross Profit, the P&L’s first profit metric.
Gross Profit is further deducted from by Operating Expenses (like administrative Salaries, Advertisement, Rent, etc.) to reveal Earnings Before Interest, Taxes, Depreciation & Amortization (EBITDA), another important metric.
After Depreciation & Amortization is further deducted (if applicable), Earnings Before Interest & Taxes (EBIT), is revealed. EBIT is also known as Operating Profit. Deducting Interest expenses, leaves Earnings Before Taxes (EBT), and after Income Taxes are deducted, Net Income reveals the final profit left after all expenses are incurred.
Very important metrics can be observed in a P&L, especially when applying a vertical analysis as briefly described above. For example, when showing each P&L line item as a percentage of Net Sales, observing trends in expenses, and profit metrics are certainly illuminating. Take a look at an example P&L below, each account as a percentage of Net Sales:
Analyzing this P&L on its own is useful, for cost controls and observance of impacts on profit metrics, such as Gross Profit, EBITDA, EBIT, EBT, and Net Income. However, placing each line item as a percentage of Net Sales allows for one-to-one comparability across various operating periods. Most businesses compare performance against other operating periods, observing increases or decreases in revenue, expenses and profitability.
These comparisons also make industry peer benchmarking a breeze, because the percentages within a P&L could be directly compared against the percentages observed in other companies, from the same industry, helping an analyst understand just how far out of alignment each line item is, when compared to same-size industry peers.
Applying a similar analysis to the Balance Sheet is a natural next step to understanding your company’s financial health.
If an Income Statement (P&L) is a measurement of financial activity “through” time, a Balance Sheet is a snap shot of your company’s financial activity at a “point” in time. Typically, when financial statements are generated for analysis, the P&L will reflect activity through time, ending at a certain date.
The Balance Sheet reflects a snap shot of accounts, as they exist at the “point” in time, typically resonating with the point in time when the P&L ends. For example, a P&L reflecting activity from July 1st 2014 – June 31st 2015 will usually be accompanied by a Balance Sheet revealing Asset & Liability accounts, as they exist on June 31st 2015.
This financial statement tells a completely different story than the P&L, however. A Balance Sheet will highlight your company’s Assets and Liabilities, as well as Net Worth. A few general rules of thumb are important to understand. In short, Assets – Liabilities = Net Worth (Owner’s Equity).
So if your company has $100,000 in Assets, with only $60,000 in Liabilities (what your company is due to pay out, to lenders, vendors, payroll, taxes, etc.), your company’s Net Worth is $40,000.
The Balance Sheet should also “balance” meaning Total Assets must equal Total Liabilities + Net Worth. Thus, Assets = Liabilities + Net Worth. So, the higher your company’s Liabilities, the smaller the Net Worth, if Assets were to remain the same. Typically, Liabilities and Owner’s Equity reflect the funding source of your company’s Assets. Make sense?
Let’s dive just a little deeper. The Balance Sheet is categorized into both short, and long-term perspectives. Assets held for less than one year are categorized as Current Assets, while those held for longer than one year are Non-Current Assets. Current Assets include Cash, Accounts Receivable, Inventory, etc. Non-Current Assets include Property, Plant & Equipment (PPE) or Fixed Assets, Intangible Assets (like patents), Long-Term Investments, etc.
Liabilities are similarly divided into short & long-term perspectives. Current Liabilities are due to be paid within one year, like Accounts Payable (typically owed to vendors), Short-Term Notes Payable (revolving credit lines), Bank Loan Payable, etc. Long-Term Liabilities are obligations due to be paid back over a period of time longer than one year, like Long-Term Notes Payable (e.g. mortgage) and the like.
In Summary, a Balance Sheet reveals the financial, physical and intangible resources available for future use, in light of the Liabilities typically used to fund those Assets. An analysis of the Balance Sheet is extremely important, particularly for lenders, as it reveals whether or not a company is healthy enough to borrow money, and service that debt.
A company that is too highly leveraged (high Liabilities in comparison to Assets) is likely to be turned away by lenders. In some cases, companies have more Liabilities than Assets, thus producing the unwanted anomaly of Negative Net Worth. Remember, a Balance Sheet must balance!
Cash Flow Statement
If there is any financial statement never to be neglected, it should be the Cash Flow Statement. This statement reveals, typically on a month-to-month basis, the cash inflows and outflows of a business. Starting with Revenues (or Net Sales) for that period, all itemized expenses (fixed, variable or seasonal) are deducted to reveal either a positive or negative Cash balance.
A negative Cash balance will typically draw from a Line of Credit (LOC), to be paid back immediately upon realizing a positive Cash balance.
Seasonal businesses may dip heavily into a LOC for several months, taking several months to pay back when seasonal sales and profits are higher, and a positive Cash balance allows for repayment.
Cash Flow projections are critical for any business, but especially important for growth-oriented companies. It’s not without a bitter sense of irony, that most businesses that fail do so during their fastest periods of growth. How can this be?
We’ve increased our sales by 25%, what could possibly go wrong? For businesses providing goods or services on credit, or taking longer than 30 days to collect revenues from recent sales activities (Accounts Receivable), expenses incurred by that business to provide those goods or services (cash outflows) may be due before revenue is realized, or collected (cash inflows). A business may quickly become insolvent, and if already highly leveraged, chances of getting that credit line increased greatly diminish, matched by your company’s diminishing financial future.
The good news? You can avoid Cash Flow shortages and insolvency by becoming intimate with Cash Flow statements and projections.
Financial Analysis Techniques
Once an Income Statement (P&L), Balance Sheet and Cash Flow statement are compiled, there are many analyses that could be performed, revealing trends, strengths and weaknesses in financial performance. In this article, we cover five commonly used financial analyses techniques. These are generally described, though should give you a sense of what’s possible.
This is the most popular way to analyze financial statements. Ratio analysis develops a meaningful relationship between the individual items found on the Income Statement and Balance Sheet. These relationships reveal quantifiable assessments of a company’s Liquidity, Asset Efficiency, Profitability, Growth, Solvency and more. We’ll dive deeper into this topic in the next section.
Comparative Financial Statements
This horizontal analysis technique compares two financial statements of the same kind from different periods in time, involving the Income Statement or Balance Sheet. Each statement is from a different specified period of time.
This comparison allows you to review the company’s operational performance and to draw conclusions. It’s very common for a business to compare past trends or performance to current.
However, it’s also helpful to compare, or “benchmark” past and current trends to industry peers to reveal how your company compares to similar companies in the same industry, across the similar period(s) of time. You’ll be able to answer these questions: How did your company perform through the economic downturn? How did other companies in your industry perform? Did you observe for instance, industry peers have reduced their Operating Expenses to improve Profitability, while your company did not?
Common Size Statements
If your objective is to compare two similar statements from different periods, or even between different companies, a Common Size Statement helps comparability. By far, the easiest way to compare two statements is to convert all accounts into percentages (typically, as a % of Net Sales for the P&L, and % of Total Assets for the Asset side of the Balance Sheet, and % of Liabilities & Net Worth for the other side of the Balance Sheet).
Percentages easily allow for one-to-one comparisons. But what if you’re preparing to compare statements in U.S. Dollars?
A meaningful comparison could only occur after both statements are “common-sized”, or more accurately, one statement is held at the same “size” as the other. A conversion to percentages is still necessary, however. Take for example, two P&L statements, one with $1.5M in Net Sales, $525k in COGS leaving $975k in Gross Profit, while the other has $1.2M in Net Sales, $396k in COGS leaving $804k in Gross Profit.
Before these two statements could be compared in a meaningful way, one statement has to be “common-sized” to match the other. To do so, first convert into percentages all accounts of the statement you wish to “common-size”. Second, hold the Net Sales of this statement to match the comparable.
Third, apply the new, “common-sized” Net Sales to that statement’s actual percentage distributions, and voila, you’re comparing apples to apples. Which statement reveals better profitability? How far off was one period to the other, in U.S. Dollars?
Statement of Changes in Working Capital
This simple technique extracts working capital information from the Balance Sheet, to provide information pertaining to working capital between two financial periods (thus, two Balance Sheets). The amount of Net Working Capital is calculated by deducting Total Current Liabilities from Total Current Assets.
After performing this for each Balance Sheet within the period you wish to calculate Changes in Working Capital, simply compare the Net Working Capital from one period to the next, observing the change!
Trends occur through time, so naturally this fits into the horizontal category of analysis. Ratios or metrics could be calculated for one period, and then these are compared to ratios or metrics of another, revealing whether financial health is improving, declining, or remaining constant through time. Thus, this analysis shows a “trend” or direction the company is experiencing.
Financial Analysis Ratios
Financial Ratios are highly important business analysis tools. To assess a company’s financial health, you need to examine performance comprehensively, across Liquidity, Asset Efficiency, Profitability, Growth, Leverage, etc. When assessing a company’s performance, it’s not a simple matter of observing what the company has in terms of Assets, Liabilities, Equity, Gross Margin, Net Income, etc.
What Financial Ratios help illuminate, is the relation of certain aspects of the Income Statement and Balance Sheet to one another.
Financial Ratios are computed by dividing a numerical value by another, resulting in a value highlighting the “relationship” of all values involved. It’s this relationship that’s important. Some Financial Ratios analyze various aspects of the Income Statement alone, others involving the Balance Sheet alone, and yet others analyzing values across the Income Statement and Balance Sheet.
Consider the Assets to Sales ratio, which measures Asset Efficiency. Relatively simple, this ratio takes Total Assets divided by Sales. Let’s consider two companies; Company A has $100k in Total Assets, and this company produces $1M in Sales, and it’s Assets to Sales ratio yields .1 or 10%. Company B has $200k in Total Assets, also producing $1M in Sales, yielding .2 or 20%. Which company has a more efficient use of Assets?
If you’ve guessed Company A, you’re absolutely right. Company A produces as much Sales as Company B, though with less Assets. Thus, Company A has a more efficient use of its Assets, than does Company B. Figuratively speaking, if Company B used its Assets as efficiently as Company A, it would produce $2M in Sales. So, some general rules of thumb accompany Financial Ratios. For the Assets to Sales ratio, the smaller the number, the better.
Assets to Sales examined a component from the Income Statement (Sales) and the Balance Sheet (Total Assets). Now, consider a ratio that examines values only from the Income Statement: Gross Profit to Net Sales, a Profitability ratio. Its formula is Gross Profit divided by Net Sales. Gross Profit is the result of Net Sales – Cost of Goods Sold (COGS).
In example, Company A has $1M in Sales, $350k in COGS, leaving $650k in Gross Profit. Its Gross Profit to Sales ratio yields .65 or 65%. Company B has $1M in Sales, $320k in COGS, leaving $680k in Gross Profit.
Its Gross Profit to Sales ratio yields .68 or 68%. For the Gross Profit to Sales ratio, the larger the number, the better. Thus, in this case, Company B is outperforming Company A, at least with regards to their cost management, and profitability.
This article isn’t meant to be an exhaustive overview of ratios, though should give you an idea as to their applicability and usefulness. Also note, that once Financial Ratios are calculated for your company for any given period, they could be compared to another period, historically, to determine improvements or decline in financial performance, in any ratio’s given category of analysis (e.g. Profitability, Asset Efficiency, Liquidity, etc.).
To learn how to calculate the top five most powerful and widely known financial ratios, read our Guide to Financial Ratio Analysis.
Likewise, industry-peer benchmarking is also important, and your company’s Financial Ratios could be compared against that of your industry-peers or competitors.
Financial Analysis in Action
How Financial Analysis Impacted One Engineering Design Company
DesignCo is a successful engineering design company with 46 employees. Last year, they had sales of $5.4 Million with a net profit just over $200,000.
They used financial analysis to answer questions like, “How do I compare to others in my industry on critical financial measures?”
DesignCo analyzed its income statement and balance sheet to compare itself to other engineering design companies of its size. At first glance, the company seemed fine.
Here’s how DesignCo stacked up against their industry average on their income statement (click on any image to enlarge it):
This shows that DesignCo is a little more profitable than the average.
But, a balance sheet comparison raises a red flag.
This tells you that DesignCo is carrying a lot more Accounts Receivable and they’re low on cash. It’s not shown here, but the rest of the balance sheet shows that DesignCo is also carrying more debt than the industry average.
Using Financial Analysis to Address Cash Flow Concerns
DesignCo also used financial analysis and industry-peer benchmarking to address Cash Flow concerns. They used Net Balance Position (NBP), a stringent measure of Cash Liquidity, to see the projected health of their Liquidity and Cash Flow. Essentially, NBP is the Working Capital Available for the year, minus Working Capital Required. The NBP measure focuses intently on working capital needs, including Cash, and accounting for their Accounts Receivable and Inventory. In essence, you don’t want to see a negative number as a result. If so, this indicates you’re likely to have a Cash Flow issue.
One of the inherent assumptions is that you’re projecting forward using the current year’s financial statement, but unless you’ve made a significant change in how you do business, it’s a reasonable planning approach.
Below is a view of DesignCo’s Net Balance Position, which as you can see doesn’t paint a very pretty picture. They’re projected to be short on cash by over $700,000.
Cash flow is driven by how efficiently you manage and convert your Inventory into Cash, how quickly you get paid by your customers (Accounts Receivable) and how quickly you pay your vendors (Accounts Payable). For DesignCo, Inventory doesn’t apply, so the focus is really on the Accounts Receivable (AR) and Accounts Payable (AP) situations. We can start out by seeing what reducing the AR’s Collection Period would do for the NBP of DesignCo.
The current Collection Period for DesignCo is at 107.8 days (top left of previous chart)! Their industry-peers at the median are collecting in roughly 12 days! DesignCo is amongst the poorest performers in their industry on this metric, also illuminating one of the largest drivers behind their Cash Flow issue. If we could reduce the collection period by just 60 days to 47.8 days (which is still worse than the median of 11.56) than the NBP goes from negative $721,030 to a positive $167,237 – a positive swing of nearly $900,000!
Using a similar approach with Payment Deferral (how quickly DesignCo pays their vendors), we can also see some room for improvement.
DesignCo had been paying their vendors in 10.7 days, well below the industry median of 21.03 days. If they improved that number by 10 days to get them to 20.7, which drops the NBP from negative $721,030 to negative $584,072 for an improvement of $136,958. This is not quite as good as the collections fix, but still well worthwhile. Doing both measurements together results in a phenomenal improvement to their NBP.
Financial Analysis helped DesignCo identify key areas of weakness that are impacting their future Cash Flow for their business. Using that data, DesignCo brainstormed ideas and identified a high level plan on ways to address their biggest problem areas. Then, they implemented change, which required constant action and follow up.
To summarize, financial analysis and industry-peer benchmarking is a powerful tool for small, medium, and large-sized companies to measure their progress toward optimizing financial performance, reaching their goals and moving toward better resonance with their industry peers. It provides the main measurements of a business’s success, and help map out better strategies for improving financial performance. Plus, financial analysis helps businesses discover and adapt to trends!
Tools To Help You Understand Financial Analysis
- Industry Metrics
- How to Perform a Company Financial Analysis in Just 12 Steps
- Your Guide to Financial Ratio Analysis
- The 8 Best Podcasts For Business-Savvy Listeners