Financial analysis is an important tool that gives an overview of an organization’s financial wellbeing and helps inform strategic decisions. It helps financial advisors review company performance, sustainability, and growth by using foundational tools like income statements, balance sheets, and cash flow statements to do various calculations. In today’s data-driven world, financial advisors are expected to make compelling, fact-based suggestions supported by analytics.
What is financial analysis?
Financial analysis is the process of evaluating a company’s key financial statements to help make business projections or review historical performance. Financial analysis can be used internally to review a company’s performance or externally for investors evaluating an opportunity.
Financial analysis typically involves examination of three main documents:
- Income statements
- Balance sheets
- Cash flow statement
Calculations are often done in a tool such as Causal. It’s faster and travels better than an abacus. Financial analysis is useful because it can not only be used to make projections and guide future decisions, but can also be used to compare a company’s prior performance, track growth, and compare against competitors.
How to conduct a financial analysis
Conducting a financial analysis requires working across teams to collect data, set goals, and execute calculations. The analysis is carried out internally by the finance department and shared with executives to help them make better business decisions. Financial analysis may also be used to assess the worthiness of projects or investments with ratios such as net present value (NPV) and internal rate of return (IRR).
There are many types of financial analysis (which can be used in combination) to paint a full picture of an organization’s finances. They include:
Often used for competitive analysis to see how your financial status compares, vertical analysis shows a snapshot of one period in time. With this method, you divide elements of the income statement by revenue to calculate a percentage.
2. Cash flow
Here you capture the company’s ability to generate cash and how it’s spent over time.
The ability to generate revenue from assets shows leaders where they may be able to get more output from machinery, staff, and other resources.
Analyzing growth over a period of time, such as year-over-year growth, helps businesses scale and invest without overextending.
Comparing multiple years of financial data to calculate a growth rate, the intent of this calculation is to see how the business itself has changed at a macro level over time. Any spikes or dips can lead to trends and causality that can be further examined to reduce risk or capitalize on opportunities.
With leverage, you’re comparing financial metrics to equity. A debt-to-equity ratio is one example.
Analyzing the balance sheet, liquidity represents a company’s ability to pay short-term invoices and expenses. The main goal here is to ensure that your business maintains an appropriate level of cash. It’s a good measure of a company leveraging its assets effectively while paying it bills on time.
Assessing how a company generates profits with metrics like gross margin and EBITDA. This analysis may also be used to assure investors of good financial standing.
9. Rates of return
Assessing risk-adjusted rate of return, such as dividend yield, capital gain, etc.
Here you’re analyzing the value of a business. There are many methods to do this, and it’s up to the analyst to determine which works best.
These are just a few of the most common financial analysis models, but there are many others available to help you understand the numbers behind the business. Every business is unique and has different priorities when it comes to analyzing finances. Financial advisors should approach analysis with key performance indicators (KPIs) and business needs in mind.