Financial analysis consists of obtaining information on the health of a company, particularly in terms of solvency and profitability, from accounting documents. This analysis is based on the documents from the accounts, in particular the tax return.
Financial analysis is the process of evaluating a company’s financial performance, profitability, and solvency. It provides a snapshot of the company’s financial health and helps stakeholders make informed decisions. Financial analysis is typically performed by investors, creditors, and management to assess a company’s ability to generate profits and pay off its debts.
How to extract relevant information from financial statements and interpret them to draw valuable lessons on the state of health of a company and its development potential? Here is what you need to know about the financial analysis of a company.
Carrying out such a analysis turns out to be eminently technical. You have to know how to read, and of course understand both an income statement (or operating account) and a financial statement. Not to mention the appendices for additional information.
In addition to knowledge of finance, it is essential to master the operation of a company. Fortunately, there are books that allow easier access to knowledge.
Why do a financial analysis?
The objectives and the recipients are multiple:
- In difficulty, a business manager commissions a consultant to diagnose a situation.
- A buyer wants to know the state of health of a potential target before launching its takeover operation and to limit the risks.
- A sales manager to identify a competitor’s flaws, weaknesses…
- Potential shareholders wish to know the financial state of a company before entering the share capital.
- To feed the forecast of a business plan.
Overall financial analysis aims to study the profitability and solvency of a company, but not only! It provides valuable information on the operation of an activity, its place in its sector and the strategy followed. It provides valuable information for a financial diagnosis.
Financial analysis of a company: the steps
Financial analysis goes well beyond the sole analysis of information through the accounting information of a company’s financial statements, it must make it possible to judge its financial situation and to situate its performance in relation to others. comparable companies in the same sector.
What is the purpose of financial analysis?
Financial analysis is a process of analyzing a company’s strategic, economic and financial information. These may be documents from accounting (such as the balance sheet, income statement, cash flow statement, tax return) from management control (cost accounting and budgeting) or from human resources (evolution payroll and its cost, staff productivity, etc.).
This accounting and financial information is often enriched and supplemented by information on the business sector or market segments. These include, for example, data collected through sectoral, national, regional or local market studies, etc.), which make it possible to situate the performance of the company in relation to its sector of activity, but also by compared to his peers.
How to do a financial analysis of the company?
The financial analysis process generally goes through two stages, a qualitative analysis consisting in collecting and analyzing economic and strategic information and a quantitative analysis which analyzes the company’s financial statements.
1. Collect and analyze economic and strategic information
The first step is to identify the company’s strategic information. It is a question of better understanding its internal and external environment in order to identify the key factors which can negatively or positively influence its development, but also to check its capacity to resist vis-a-vis the changes. In order to better carry out this analysis, it is interesting to focus on the following financial analysis tools.
External analysis via market research and SWOT analysis (analysis of external factors, existing practices on its market, its competitive perimeter, its suppliers, its customers as well as its regulatory and technological environment).
Internal analysis via the business plan: the products and services offered are the attractiveness and positioning of the product compared to what the competition is offering, the method of distribution, its location, it is also important to pay close attention to the member of the management team (leadership, managerial performance, etc.).
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2. Analyze the company’s financial statements
The second step is to study the quantified part of the company, namely its financial statements. Its main objectives:
- understand how the company creates value (is it profitable?);
- understand its financial structure (is the company in a position of dependence vis-à-vis its creditors:
- is there a balance between debt and equity?);
- understand the composition of its assets (details of fixed assets, their wear and tear, its ability to renew its means of production, etc.).
We cite the main elements to be studied for an effective financial analysis.
3. Analysis of business activity
The analysis of the activity of the company constitutes the starting point of the financial diagnosis, it consists in appreciating the growth of the company (turnover, manpower, structure of the expenses, etc.), and its capacity to generate profit (margin), etc. This analysis can be made by studying the following financial statements:
- Business income statement;
- Intermediate Management Balances
- Account details, etc.
The 3 assessment areas of the analysis
This type of reflection provides a number of insights into three areas: the company’s competitiveness, its sustainability and its capacity for development. They form the 3 stages of a financial analysis.
1. Analysis of economic competitiveness with the income statement
The basic document for carrying out these investigations is the income statement reclassified in the form of interim management balances.
In this phase we seek to understand how the company is positioned on its upstream and downstream markets, in its sector. Turnover and gross margin are indicators providing this type of information.
We will also study how it is operated and how it generates value: does it have an integrated activity? What is labor productivity? etc
2. Financial sustainability analysis with balance sheet and ratios
After observing how the company exploits its markets, we are interested in its ability to deal with hazards. The questions to be asked relate to the adequacy of the financial structure with the strategy followed, the level of indebtedness, the capacity of the company to face unforeseen drops in activity, etc. The functional balance sheet and the financing table are the working documents.
An important point to study is the level and evolution of the working capital requirement with regard to the resources generated by the working capital. Turnover ratios (customer payment terms, supplier payment terms, stock rotation) provide additional relevant analysis to better understand the finding.
3. Analysis of development potential with profitability
The last area to explore is that which deals with the assessment of development potential. It is worth looking at its growth profile, in particular the evolution of profitability. In fact, insufficient profitability requires an additional contribution of capital to enable the company to meet its deadlines. The key indicator is the economic profitability with its components the operating result / economic assets.
What to measure in financial analysis?
Financial analysis involves measuring a company’s performance using various financial ratios and metrics. These ratios are calculated using financial data such as income statements, balance sheets, and cash flow statements. Some of the most commonly used financial ratios include:
- Profitability Ratios – These ratios measure a company’s ability to generate profits. Examples include gross profit margin, net profit margin, and return on assets.
- Liquidity Ratios – These ratios measure a company’s ability to meet its short-term obligations. Examples include current ratio and quick ratio.
- Solvency Ratios – These ratios measure a company’s ability to pay off its long-term debts. Examples include debt-to-equity ratio and interest coverage ratio.
By analyzing these ratios, stakeholders can determine a company’s financial performance relative to its peers and industry benchmarks.
For example, let’s say that ABC Inc. is a software development company that generated $10 million in revenue last year. After analyzing their financial statements, their gross profit margin was found to be 60%, while their net profit margin was 20%. The company’s current ratio was 1.5, indicating that they have enough short-term assets to meet their obligations. Additionally, their debt-to-equity ratio was 0.5, indicating that they have a lower level of debt compared to their equity.
Based on this analysis, stakeholders could conclude that ABC Inc. is performing well in terms of profitability and liquidity, but may need to take steps to improve their solvency ratio to ensure that they are able to pay off their long-term debts.
Profitability is a critical component of financial analysis, as it measures a company’s ability to generate profits from its operations. To measure profitability, stakeholders typically look at a company’s gross profit margin, net profit margin, and return on assets.
Gross profit margin is calculated by dividing gross profit by revenue. Gross profit is the revenue minus the cost of goods sold. This ratio measures how much profit a company is making from its core operations.
Net profit margin is calculated by dividing net profit by revenue. Net profit is the revenue minus all expenses. This ratio measures how much profit a company is making after all expenses are accounted for.
Return on assets is calculated by dividing net income by total assets. This ratio measures how much profit a company is generating relative to its total assets.
For example, let’s say that XYZ Corp. is a manufacturing company that generated $20 million in revenue last year. After analyzing their financial statements, their gross profit margin was found to be 35%, while their net profit margin was 10%. The company’s return on assets was 12%.
Based on this analysis, stakeholders could conclude that XYZ Corp. is generating a reasonable level of profit from its operations, but may need to take steps to improve its net profit margin to increase profitability.
Financial analysis is a critical tool for evaluating a company’s financial health and performance. By analyzing financial ratios and metrics, stakeholders can gain insights into a company’s profitability, liquidity, and solvency. This information is valuable for investors, creditors, and management as they make informed decisions about the company’s future.
Focus also on the profitability of investments.
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