The question of what is financial analysis can be answered using basic and technical terms. However, most small businesses may not be familiar with the technical jargon. It is, therefore, necessary to introduce a definition using basic terms.
What is financial analysis? It is the evaluation of a business or project performance and viability using available financial data.
The reliability of every financial analysis depends on the quality of the financial data used for the analysis.
Financial analysis can be used to determine the viability of present and future projects.
Financial analysis can help you determine your positioning in the goal meter. The two types of financial analysis are: fundamental or ratio and technical or trend analysis.
There are three basic elements of financial analysis. It can be used to determine the liquidity, solvency, and profitability of a business.
Three basic sources of data for financial analysis are the cash flow, income statement, and balance sheet.
Generally, when you look at a balance sheet, you should tell what a business is worth.
Similarly, when you look at an income statement, you should tell the viability of a business. The cash flow tells you the liquidity of a business. It tells how a business manages its incoming funds at a specified period.
Finance is key to the growth of every business. Small businesses, therefore, need to constantly analyze their financial stand to ensure its alignment with set out goals. When you constantly finance a business without focusing on these elements, you may head towards extinction.
There are key elements of financial analysis that small businesses should focus on to achieve strategic growth. Identifying and monitoring these elements for your small business has the following benefits:
1. It helps you to align your resources so you can achieve your set out goals.
2. Financial analysis will help you determine your operational efficiency at all levels of your business. You will be able to answer the question, are resources correctly aligned to achieve optimal results?
3. It also helps you determine which areas or segments of your business require more attention. This is where flexible business plans become important. It is advised that you make your plans flexible. When such areas are determined, you will have to quickly make adjustments to meet set targets.
4. Financial analysis metric helps you to understand your positioning in the goal meter. It will help you to answer the question, are you making progress or not?
What is Financial Analysis?
In every business, there is a need to evaluate the stability of some business elements. Some of these elements include profitability, liquidity, and solvency.
Financial analysis is therefore the process of evaluating business elements to identify their level of performance.
Financial analysis helps investors choose between alternative investment opportunities. It also helps entrepreneurs determine the efficiency of investment resources. Therefore, when looking at what is financial analysis, we are not considering existing businesses only, but:
- business ventures – as an entrepreneur, you may want to venture into other businesses. With financial analysis, you can determine the viability of such a business.
- projects – you may decide to embark on product promotion or other projects that will help you reach your goals. With financial analysis, you can determine the feasibility of such a project. Will the returns compensate for the capital investment in the short-run and long-run?
- investment capital – there could be a need for business expansion where you need to buy another machine. With appropriate financial analysis, you can determine the suitability of a given investment.
Because financial analysis is all-encompassing, the question still stands, what is financial analysis?
Financial analysis is the evaluation of businesses and projects to determine their viability and suitability. This business decision matters a lot to investors and entrepreneurs because the essence of business is to make a profit.
There are two basic types of financial analysis, namely:
- fundamental or ratio analysis – here ratios derived from a company’s financial data are used. This is basic for small businesses and is used to determine the suitability and viability of businesses and projects. You can also use this type of analysis to evaluate proposed businesses and projects.
- technical or trend analysis – here price movements derived from trend analysis are used. This is used for corporate organizations that have sustained economic data known and acceptable to the public.
The reliability of every financial analysis depends on the quality of the financial data used for the analysis.
There are basic financial terms that every business owner should know. Fundera listed about 60 of them, but we will consider the few that are basic and financially related.
- Capital – Capital refers to the entire worth of a business. It includes everything a business has that enables it to operate and make a profit. It can be tangible, e.g. machinery, intangible, e.g. patent or goodwill, or cash owed, e.g. loan.
- Asset – Assets refer to valuable items owned by a business used in day-to-day business operations. There are fixed and current assets. Fixed assets cannot be easily converted to cash, examples include vehicles, buildings, etc. Current assets can be easily converted to cash, examples are raw materials, cash at the bank, etc.
- Liability – This refers to business items owed by a business to clients and vendors. They include loans, accounts payable, accrued salaries and wages, etc. There can be a current liability and long-term liability. Debts that must be paid within 12 months fall under current liability, while debts payable after 12 months are long-term.
- Working Capital – This is a term used to define the assets a business need for day-to-day operations. Working capital can be derived by using the formula:
〈Working Capital=Current Asset-Account Payable〉
Current assets include cash in hand, cash at the bank, account receivable, and inventory.
- Account Payable – Accounts payable refers to financial records of the amount of money your business owes to its vendors.
- Accounts Receivable – Refers to the financial records of all money owed by customers/ clients to your business. All small businesses should maintain these two records.
- Inventory – Inventory refers to the stock or raw materials stored in a warehouse or kept in a shop. If it is a stock, then businesses will convert them to cash by selling them. But if it is a raw material, the business will use them to produce a product for sale.
- Markup – Every business must make a profit to survive and grow. To make a profit, businesses add price to the actual cost of a product. The added price to the cost of a product is called markup. Markup is usually expressed in percentage, hence, you can have a markup of 35%. Meaning that for every $100 product you sell, you add $35. To get actual markup of your product, use the formula:
Markup = (Margin/Cost)×100
margin = (selling price – cost price)
- Turnover – Turnover is the total product/service sales in a given period. The period maybe a week, month, quarter, or year. This term is a very important component of an income statement.
- Gross Profit – This is the total sales (turnover) minus the cost of goods sold. When calculating the cost of goods sold in a production environment, it is important to include the direct production costs. For example, in pig farming, the actual cost of producing a mature pig include the cost of piglet, cost of feeding, and salary of farm attendant.
- Net Profit – Net profit is the difference between gross profit and indirect costs. Indirect costs are other costs incurred in the day-to-day running of a business. For example, marketing costs, administrative costs, etc. These costs are not directly incurred during production. For a business to survive and grow, the markup technique adopted should be able to cover both direct and indirect costs.
- Return on Investment (ROI) – ROI is a measure used to assess the viability of a business or project. Before or after you have invested in a business or project, you will want to know if it is viable. This is usually the reward of your hard work or capital commitment. To compute this value, use the following formula:
ROI = (Net profit)/(Total investment)×100
Elements of a Financial Analysis
There are three (3) basic elements of financial analysis. These elements are derived from a company’s financial statement. We shall briefly explain these elements below.
Liquidity refers to the availability of cash in a company’s cash drawer. When considering the liquidity of a company, we are looking at the company’s cash flow to answer the following questions:
- does the company maintain a positive cash flow within the period under review?
- does the company have the necessary cash to meet its short-term obligations? This obligation is the ability to settle its current liability.
The liquidity of a company is used to determine its ability to meet immediate and impending obligations. It also includes the ability of a company to turn its current assets into cash.
Using this approach entails the computation of different financial ratios such as cash ratio, quick ratio, and current ratio. The data for this computation is usually derived from the balance sheet.
Profitability analysis is a business management test analysis. This is because it focuses on the financial returns of a business based on the efficient management of resources.
When money is invested in a business, the investor usually hopes for a cash return that out-weighs the investment. To demonstrate the viability of a business, we usually consider the profitability of such investment.
The data for this analysis is usually obtained from the income statement which tells what a company earns. For small businesses, gross profit margin and net profit margin ratios can be computed.
When resources are efficiently managed, businesses gain more from each sale made. But when resources are not efficiently managed, expenses may out-weigh gain from each sale made.
Liquidity considers the short-term financial obligations of a company while solvency looks at long-term obligations.
A company might have great liquidity and still, be insolvent. This means that it is not able to pay up its debts in the long-run, though it services short-term debts. If this is the case with a business, the business should consider computing its efficiency ratios. Such ratios as asset turnover ratio, fixed asset turnover ratio, and inventory turnover ratio.
Particularly, if the assets that incurred the debt are not efficiently used to generate income, the business will collapse.
Hence, solvency is important to every business that incurs long-term debt obligations. The simplest way to determine the solvency of a business is to compute the following:
Solvency = (Total asset)/(Total liability)
Information for this computation can be derived from the balance sheet.
Sources of Financial Data for Analysis
When performing fundamental financial analysis, there are basic sources of financial data every small business must provide. These financial statements or documents can be derived manually from accounting data or by using accounting software. Some small businesses use Excel templates to derive these financial documents while others use QuickBooks accounting software. Whichever one you use, the following documents must be made available for appropriate financial analysis.
Cash flow statements
Cash flow statements give a clear picture of a company’s liquidity. It states how a company manages its cash inflow and outflows. It shows the items that bring in cash and the items that take away cash from the business.
To easily determine the liquidity of a business, we use the cash flow balance. The cash flow balance is determined by subtracting the cash outflows from the cash inflows every month.
Items in a cash flow can also be used to prepare the income statement, except for few additions. When evaluating a cash flow, we usually classify them into three sections:
- cash flow for operating activities
- cash flow for investing activities
- cash flow for financing activities
The income statement is a key financial document that states the profitability of a business. It is also called the profit & loss account/ statement. It shows at a glance the profitability or loss of a business venture at a stated period.
The income statement contains components that determine the overall performance of a company and the efficient management of resources. Within an income statement, we see items such as sales revenue, cost of sales, gross profit, expenses, net profit, etc.
The balance sheet is a financial document that states the worth of a business at a given time. It highlights all business resources owned and owed by a business within a given period.
The balance sheet is usually divided into two:
- the assets, and
- the liabilities sections
The assets section lists available resources at the disposal of a business for future business performance. While the liability section lists the available obligations which a business needs to meet within a given operational period.
Items in a balance sheet are important for calculating different financial ratios used to determine business performance.
In this article, we looked at what is financial analysis and went ahead to explain its three key elements.
Small businesses should ensure that they generate financial statements that will enable them to perform simple financial analyses. To generate such documents, you can use Excel templates or accounting software.
The worst thing that can happen to you is to run a business with excess liquidity but is insolvent. Cash is important in every business, but excessive cash can ruin your business. This is why banks and business financiers take time to study your cash flow to determine the optimum investment amount.