At its most basic, financial analysis can be defined as a way to analyze the strengths and weaknesses of an organization’s financial position. Data is collected from certain financial records and then analyzed to understand how a business is paying its debts, if it has enough capital to invest and create further income and revenue streams, or even just analyze how efficiently they’re operating – are they seeing profits in line with how many employees they have, for instance.
Some may like a financial analysis to a consumer credit score, except that instead of just evaluating debts and payments, it brings in other financial criteria such as current assets and potential liquidity. This kind of full financial picture helps businesses better understand where to focus their attention and how to strategize around their goals.
The financial analysis tools you should know about
Financial statement analysis is a process, not a tool, however. There are several techniques and tools that help businesses get to the heart of financial matters.
1. Comparative statements:
Comparative financial statements are basic, but the important method of financial analysis. It takes two statements from the same organization and compares them to each other to establish trends or understand factors of growth and loss. Using company income statement and balance sheets, businesses are able to gather meaningful information about profits and losses over similar periods of time. With income statements, businesses can compare data about their operational performance. When comparing balance sheets, businesses can see how operations are affecting company assets and liabilities over time. Tracking these changes is crucial for business success.
2. Statement of changes in working capital:
Working capital is a crucial component of a successful business. The statement of changes in working capital financial analysis technique is helpful is calculated by deducting the total current liabilities from the total assets. Having an accurate working capital analysis helps businesses understand their ability to keep up with expenses. An analysis of their statement of changes helps a company to see if something specific in a financial period has helped or hurt their working capital.
3. Common size statements:
Common size statements are handy for comparing multiple companies at the same point in time or to understand the average performance of an industry. All financial dollar amounts are converted to percentages of a total. For instance, if a business has an income statement with total revenue of 100,000 dollars, that’s 100% of their income. If they have gross profit at 30,000 dollars, that’s 30% of their income statement. It’s easy to look at businesses who list their income and balance statements similarly and understand performance. How much does Competitor X’s gross profit account for as a percentage of their income statement? This comparative method only works when businesses calculate and record their financial data similarly, but it’s a useful method for business to understand its place in the industry.
4. Ratio analysis:
Ratio analysis often gets pulled into lists of the most popular or important ways to analyze financial statements. Ratios help businesses not just understand more about the overall health of their business, but about the financial relationships between parts of the business. It helps to highlight the meaningful relationships between different business departments and areas, notes significant financial discrepancies, and helps to evaluate overall financial performance. It’s a great financial technique for helping businesses best understand their debt management, asset management, liquidity, profitability, and even market value.
For businesses looking to better understand past financial trends, make more accurate financial predictions, and understand overall current performance while being able to work towards short and long-term goals, financial analysis is a must. What financial analysis tool will work for you will depend on your business goals and available data.
