Would you be able to provide someone with a detailed analysis of your company's financial strengths and weaknesses?
As a founder, you need to know this type of information about your company. To make better investment and growth decisions, you need to understand your financial performance.
It is through financial analysis that such a picture can be painted.
What is financial analysis?
The purpose of financial analysis is to evaluate a company's financial data in order to make informed business decisions. Financial analysis is used by founders and executives to assess performance and make strategic decisions, such as where to invest money to improve growth.
A financial analysis is used externally by investors to decide which companies are a good investment. When banks review loan applications, they may also use financial analysis to assess your ability to repay the loan.
The income statement, cash flow statement, and balance sheet are usually reviewed by an external finance professional.
How to do a financial analysis
1. Collect your company’s financial statements
You can identify trends in your business's performance using financial analysis. Comparing the performance of your business over time will provide you with the best insights.
Obtain your most recent financial statements, including your balance sheets, income statements, and cash flow statements. Focus on your most recent (and relevant) performance while examining the last three to five years' worth of data.
As soon as you have all your documents, arrange them chronologically.
2. Analyze balance sheets
Your balance sheets provide a snapshot of your company's finances at a particular point in time, such as the end of a fiscal year. A balance sheet shows the value of your short- and long-term assets, debts, and owner's equity.
Take a look at your balance sheets and ask yourself the following questions:
- What is the ratio of debt to equity in your company?
- Over time, has your debt increased or decreased?
- What is the business's liquidity level? (i.e., how much of the business’s assets are short term?)
- Over time, how has the business's liquidity changed?
3. Analyze income statements
Profit and loss statements (P&Ls) provide information about your company's revenue, expenses, and profits.
Analyze your income statements and look for trends in:
- Gross revenue: Total amount of income generated by sales.
- Operating income: Revenue minus the cost of goods sold (COGS). This tells you how much of your revenue remains after you account for operating expenses.
- Net profit (or loss): Revenue minus all expenses. This tells you how much money your company earned (or lost) after paying interest and taxes.
In most cases, startups take two to three years to become profitable. Tracking several financial metrics is helpful in this regard.
It is possible to generate an operating profit even if you have a net loss. You may still be paying interest on the loans you took to start the business, even though your core business is profitable.
4. Analyze cash flow statements
The cash flow statement shows you what activities generate income and what expenses make up your business's cash flow.
Your cash flow analysis should include the following steps:
- Review cash flow for each activity (operating, investing, financing). Identify whether the cash flow is positive (the activity generates income) or negative (the activity loses money).
- Compare cash flow from each activity to see which generates the most income for your business.
- Review cash inflow and outflow over time to identify trends. Do they increase or decrease?
- Review total cash to see if it is increasing or decreasing over time.
5. Calculate relevant financial ratios
Calculate financial ratios to gain a better understanding of your company's profitability, liquidity, and overall efficiency. Ratio analysis involves considering a number of metrics.
6. Summarize your findings
Put all your findings together. The following prompts can help you organize your analysis:
- What are the financial strengths of my company?
- What are the financial weaknesses of my company?
- In comparison to previous financial projections, how well did the company perform?
- What are the possible explanations for my company’s strengths and weaknesses?
- In what ways would I like to improve my financial situation?
As a result of your analysis, you'll be able to have informed discussions with stakeholders and potential investors about where your business stands financially.
As a result, you'll be able to make more informed decisions about your business's future.
In order to make impactful decisions, you need to have a clear picture of your company's financial health when making impactful decisions. That's why Gaurav Nagani, CEO of help desk software company Desku.io, recommends conducting an analysis "before investing, at regular intervals, before making strategic decisions, and during difficult times."
Common types of financial analysis
Financial analysis can take many forms, depending on what you want to gain from it.
Horizontal analysis
Comparing financial statements over different periods, such as months, quarters, or years, is a horizontal analysis of a company's performance over time.
The data can be used to identify growth trends and support financial forecasting, which involves predicting your company's future performance using historical data.
Vertical analysis
A vertical analysis compares a company's financial performance with one metric, such as its total assets. All line items on the financial statements are expressed as a percentage of total assets. Using a debt-to-asset ratio, for instance, you can determine how much debt you have compared to how much assets you have.
Let's say you have $4 million in debt and $10 million in assets. In a vertical analysis, your debts equal 40% of your total assets, which you get when you divide $4 million by $10 million.
It is easy to see relationships between metrics on different financial statements by using vertical analysis. Benchmarking is also possible by comparing companies with one another.
Valuation
A valuation is the process of estimating a business's value using its financial information.
In order to decide whether to buy shares, investors often compare a company's estimated value to its stock price. In order to raise money for a startup, valuations must be conducted before a price is set
Growth Rates
A growth rate is the percent change over time in a given metric, such as net sales over four quarters. Forecasting future performance for specific metrics can be helped by analyzing growth rates.
Profitability
Analysis of profitability ratios provides insight into how efficiently your company turns revenue into profit. As your profitability ratios increase, you'll have more resources to reinvest into your company's growth or distribute to shareholders.
Corporate Finance Institute's vice president of financial modeling, Jeff Schmidt, reminds entrepreneurs, "The point of analysis is to consider the analysis in total and make the most appropriate investment decision.".
Financial analysis example
An example of a financial analysis would be calculating your company's profitability ratios, which measure your company's ability to make money, and leverage ratios, which measure your company's ability to pay off its debt. The analyst will decide whether to recommend your company based on the results of the analysis.
A financial analysis is a key skill for entrepreneurs because it helps them understand their company's performance. Financial analysis can help you make more informed decisions about your overall strategy based on the insights you gain.
Furthermore, a financial analysis will help you understand your business from an investor's point of view, which can help you pitch your business effectively.