Financial analysis refers to analyzing the financial statements of a company’s financial statements and reviewing it to make the right economic decisions in the future. It is a process to examine the financial strength and weaknesses, and it involves items like balance sheet, profit-loss account, and similar statements. The process usually works by forming a strategic relationship between the items of financial statements.
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What It Means Financial Analysis
Financial analysis usually means to simplify financial data from statements through a methodical process or system. The analysis assesses the performances of the company and points out the sections that need improvement. Excel or spreadsheets are used in this regard. There are several types and kinds of financial analysis, so let’s not waste any time and jump right into the categories!
Now there is no specific number on types of financial analysis, mostly because you can custom it by yourself, by different means and processes. But to jot the types down to a few very common ones, we get a few names:
1. Vertical Analysis: Also known as the common-size income statement, this analysis looks at components of an income statement and divides them with their revenue to get the answer as a percentage.
2. Horizontal Analysis: In this analysis, we take several years of financial data and compare them for determining a growth rate.
3. Leverage Analysis: This is one of the most common and popular analysis methods. Here, they consider a few ratios, with a debt/equity ratio being one of them.
4. Growth Rate Analysis: One of the more crucial jobs of a financial analyst is to analyze and compare the historical data while predicting future data. The growth rate can analyze here.
5. Profitability Analysis: In this analysis, the analyst keeps profitability in mind and assesses the attraction of business in economic perspectives. Figuring out the net profit margin is a kind of profitability analysis.
6. Liquidity Analysis: This one generally focuses on a company’s ability to meet obligations due in less than a year. The balance sheet is used in this regard. Current and cash ratio are kinds of liquidity analysis.
7. Efficiency Analysis: The name says it all. This analysis is all about measuring the efficiency of the company through the efficiency ratio. It checks how well the company is using the assets and how the revenues are.
8. Cash Flow Analysis: Cash flow is a very essential thing in finance, because cash is king, after all. Modern-day financial analysts spend most of their time observing the cash flow profiles.
9. Rates of Return Analysis: End of the day, your main target will always be the amount you obtain after returning the profit. This analysis talks about it.
10. Valuation Analysis: Any analysis needs to have the information on how valuable the company is. An analyst can do a cost-approach or a relative approach to find the exact value of a company.
Elements of Financial Analysis
Now all kinds of proper financial analysis contain a few essential elements that make them proper and unique. Here goes a list of 5 elements that make a proper analysis:
To start a business you need cash. To continue a business you need revenues. The number of revenues can actually determine the rate and longevity of success. Revenues can calculate in a few different ways using a few equations.
Revenue growth can be found out by subtracting revenue from the last period from revenue of this period and dividing the result by revenue last period. Revenue concentration can be found out by dividing the revenue from the client by the total revenue. Finally, revenue per employee can be found out by dividing the revenue by the average number of employees.
While doing these calculations, do keep in mind that a client should never represent more than 10% of your revenues. The productivity ratio, the one that we can find through the revenue per employee- is also important as the higher the ratio, the better.
In order for your business to properly survive, you need profits. Or else, in the long run, the business will probably die. There are a few equations to calculate profit margins too.
Gross profit margin can be found out by subtracting the cost of sold goods from revenue and dividing the result by revenue. Operating profit margin can be found out by subtracting the cost of sold goods from revenue, and again subtracting operating expenses, finally dividing by revenue. Net profit margin can be found out by subtracting the cost of sold goods from revenue and again subtracting the operating expenses from the result. Finally, dividing the result by revenue will show the profit margin.
A decent gross profit margin will help you get through shocks to revenues, while the operating profit margin declares the ability to make a profit. The net profit margin remains as the money for reinvesting.
3. Operational Efficiency
This very element measures your ability to use the company resources. If you’re not efficient enough that may lead to weak growth. There are a couple of equations on measuring the efficiency too:
Accounts receivables turnover: (net credit sales ÷ average accounts receivable)
Inventory turnover: (cost of goods sold ÷ average inventory)
If your company’s receivable turnover is high, this means the credit management is going well. The inventory turnover measures the efficiency level of you managing the inventory. A high number shows progress here as well.
Liquidity is related to generating the cash flow, and analysis on this refers to your capability to generate enough cash to cover the cash expenses. This is essential because no matter how much your profit or revenue growth is if liquidity is poor it’s bad news for you. There are a couple of equations to identify liquidity:
Current ratio: (current assets ÷ current liabilities)
Interest coverage: (earnings before interest and taxes ÷ interest expense)
The current ratio works with current assets and short-term obligations. A ratio of fewer than 1 means you don’t have sufficient resources, and a ratio above 2 means you have more than enough. The interest coverage measures your ability to cover the interest expenses. If the ratio is less than 1.5 we have a problem here.
5. Capital Efficiency and Solvency
The interest to lenders and investors can be stated as capital efficiency and solvency. There are a couple of equations to derive these, too.
Return on equity: (net income ÷ shareholder’s equity)
Debt to equity: (debt ÷ equity)
Return on Equity represents the amount of return your investors are getting from the business. Debt to equity usually means the measure of leverage you’re applying to operate the business.
If you know your company’s financial state and keep the five elements into consideration, you surely will get a decent, proper financial analysis.