What is a financial analysis?
A financial analysis helps business owners determine their company’s performance, sustainability and growth by reviewing various financial statements like their profit and loss account, balance sheet and cash flow statement. Successfully managing your finances as a small business is probably the most important factor in your long-term success.
Here’s what you need to know about each of these documents, along with the ratios and calculations that will help you conduct your own financial analysis.
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The framework of a financial analysis
1. Profit and loss account
The profit and loss account reports on a business’s financial performance over the financial year and assesses its profitability. It can also be used to project future performance and cash flow. You might hear people refer to the profit and loss account as an income statement, revenue statement, statement of financial performance or statement of earnings.
The ‘top line’ of the profit and loss account displays the business revenue in a given period of time. Cost of goods sold (COGS) and other operating expenses are deducted from revenue. The net income, or ‘bottom line’, is the remainder after all revenues and expenses have been accounted for.
Here are some important analysis ratios that will help you review your profit and loss account:
- Gross profit margin is the percentage of revenue remaining after deducting your cost of goods sold. This is calculated by dividing gross profit by revenue from sales.
- Gross Profit Margin = Gross Profit ÷ Revenue from Sales
- Operating profit margin indicates the amount of revenue left after COGS and operating expenses are taken into account. To find your operating margin, divide operating earnings by revenue.
- Operating Profit Margin = Operating Earnings ÷ Revenue
- Net profit margin is the percentage of revenue remaining after all expenses have been deducted from sales and it indicates how much profit a business can make from its total sales. Net profit divided by revenue gives you the net profit margin.
- Net Profit Margin = Net Profit ÷ Revenue
- Revenue growth represents the percentage of growth during a given time period (usually the financial year). To calculate this, subtract the last period’s revenue from this period’s revenue, then divide that amount by last period’s revenue.
- Revenue Growth (%) = (Revenue from Current Period – Revenue from Previous Period) ÷ Revenue from Previous Period
- Revenue concentration tells you which clients are generating the most revenue. It’s worked out by dividing revenue from a single client by total revenue. If you realise that one client is generating the bulk of your revenue, it’s time to attract new business from others and mitigate risk.
- Revenue Concentration (%) = Revenue from One Client ÷ Total Revenue
- Revenue per employee can measure business productivity and determine the optimal amount of employees you need. Divide your revenue by the number of employees to gauge how much revenue a single employee is bringing in.
- Revenue per Employee = Revenue ÷ Number of Employees
2. Balance sheet
The balance sheet — sometimes called your statement of financial position — reports a company’s assets, liabilities and shareholder equity at a specific point in time. It’s a snapshot of your business’s financial position in a moment.
As in the name, your balance sheet needs to balance. This means that the total assets should equal the combined total of your liabilities and equity. Here’s a really simple example: let’s say you buy a set of new laptops for you and your staff at a cost of £8,000. You take out a £5,000 loan (liabilities) and spend £3,000 cash (equity) to buy them. The total of your new assets is £8,000, whilst your liabilities and equity are £5,000 and £3,000 respectively — they balance.
Assets = (Liabilities + Equity)
Your balance sheet can help you determine how efficiently your small business is generating revenue and how quickly you’re selling inventory. There are three ratios that can be worked out from your balance sheet:
Liquidity ratios are based on portions of the company’s assets and current liabilities, and are used to measure its ability to pay short-term debts. A few liquidity ratios include:
- Current ratio measures the ability to cover short-term liabilities with a business’s current assets. A value of less than 1 means your business doesn’t have sufficient liquid resources.
- Current Ratio = Current Assets ÷ Current Liabilities
- Quick ratio refines current ratio by measuring the level of the most liquid current assets available to cover liabilities.
- Quick Ratio = (Cash Equivalents + Marketable Securities + Accounts Receivable) ÷ Current Liabilities
- Interest coverage measures the ability to pay interest expense from the cash you generate. A value of less than 2 may concern lenders. It’s calculated by dividing earnings before interest and taxes (EBIT) by interest expenses for the same period.
- Interest coverage = Earnings before interest and taxes (EBIT) + interest expenses
- Net working capital is the aggregated amount of all your current assets and liabilities and is calculated by subtracting current liabilities from current assets.
- Net Working Capital = Current Assets – Current Liabilities
Leverage ratios look at how much capital comes in the form of debt (or loans). Too much debt makes businesses look unattractive to investors. Some leverage ratios you can use include:
- Debt to equity measures the proportion of shareholder equity and debt used to finance a business’s assets. High debt to equity indicates that a company might not be generating enough cash for its debt obligations. It’s calculated by dividing total liabilities by shareholder equity.
- Debt to Equity Ratio = Total Liabilities ÷ Shareholder Equity
- Debt to capital assesses the ratio of all short- and long-term debts against total capital. To calculate this, divide the company’s debt by its total capital.
- Debt to Capital Ratio = Company’s Debt ÷ Total Capital
- Debt to EBITDA (earnings before taxes, interest, depreciation and amortisation) is used to determine a business’s ability to pay both its short- and longer-term debts. The EBITDA is the company’s total earnings before interest, taxes and depreciation. Calculate this by minusing your cash equivalents from your business’s interest-bearing liabilities, then dividing by EBITDA.
- Debt to EBITDA Ratio = (Interest-Bearing Liabilities – Cash Equivalents) ÷ EBITDA
- Interest coverage uncovers the ability of a business to pay its interest expenses on an outstanding debt. A higher ratio indicates better financial health since it shows the business is able to meet interest obligations from operating earnings. Calculate this ratio by dividing earnings before interest and taxes (EBIT) by your business’s interest expenses for the same period.
- Interest Coverage = EBIT ÷ Interest Expenses
- Fixed charge coverage measures a business’s ability to meet its fixed-charge obligations, which could be fixed costs like insurance, salaries, auto loans, utilities, property taxes and mortgages. You calculate it by minusing unfunded capital expenditures and distributions from earnings before interest, depreciation and amortisation minus, then dividing by total debt service (annual principal and interest payments).
- Fixed Charge Coverage = ((Earnings Before Interest + Depreciation + Amortisation) – Unfunded Capital Expenditures and Distributions) ÷ Total Debt Service
Efficiency ratios measure a company’s ability to use its assets and manage liabilities to generate income. An efficiency ratio can help determine the following:
- Inventory turnover measures how many times a business sold its total inventory over the past year in GBP. A high ratio implies strong sales while a low turnover ratio implies weak sales and excess inventory. Divide your cost of goods sold (COGS) by average inventory to determine inventory turnover.
- Inventory Turnover = COGS ÷ Average Inventory
- Account receivable days measures how efficiently a firm uses assets and is calculated by dividing the net value of credit sales by the average accounts receivable.
- Account Receivable Days = Net Value of Credit Sales ÷ Average Accounts Receivable
- Total asset turnover showcases the business’s ability to generate sales from its assets. You can determine this by dividing the net sales by the average total assets.
- Total Asset Turnover = Net Sales ÷ Average Total Assets
- Net asset turnover compares the value of a business’s sales relative to the value of its assets. Calculate your net asset turnover by dividing your sales by your average total assets.
- Net Asset Turnover = Sales ÷ Average Total Assets
3. Cash flow statement
A cash flow statement reports how much cash is generated during a given period of time, and shows how changes in the balance sheet and income statement affect cash flow for a business. It’s intended to provide information on a business’s current liquidity and solvency as well as its ability to increase cash flow in the future.
The three main components of a cash flow statement are:
Cash from operations which refers to all cash flows regarding business operations. Operating activities can include production, sales, delivery of a business’s product and payments from sales. It can also include purchasing materials, inventory costs, advertising and shipping.
Cash from investing which arises from actions where money is being put into something with the expectation of a gain over a long period of time. Investing activities include purchases or sales of assets, loans made to suppliers or customers and payments relating to mergers or acquisitions.
Cash from financing which results from borrowing, repaying or raising money for the business. Financing activities include the inflow of cash from investors and other activities that affect liabilities and equity of a company.
These three sections highlight a company’s sources of cash and how that cash is being used. Many investors consider the cash flow statement to be the most important indicator of a business’s performance.
There are a variety of ratios you can pull from your cash flow statement. Here are a couple to help you start measuring the quality of your cash flow and create a cash flow analysis:
- Operating cash flow to net sales tells you how many pounds sterling in cash are generated for pounds sterling of sales. It’s a percentage of a business’s operating cash flow to its net sales from the income statement.
- Operating Cash Flow to Net Sales (%) = Operating Cash Flow ÷ Net Sales
- Free cash flow measures how efficient a company is at generating money. To calculate free cash flow, find the net cash from operating activities and subtract capital expenditures required for current operations.
- Free Cash Flow = Cash from Operating Activities – Capital Expenditures for Current Operations
There’s a lot to be learnt from a financial statement analysis. And if you’re thinking of starting your own small business or trying to improve the financial management of your existing one, this general overview should help you get to know the ropes a little better. If you want to make sure all your calculations are correct, it’s always wise to contact a professional for their advice.