Three Essential Components of a Financial Analysis

Three Essential Components of a Financial Analysis
Understanding the framework of a financial analysis can help you determine profitability and future earnings potential for your business. Here’s a rundown of what to know as well as the calculations needed to conduct a financial analysis.
by Square Jun 11, 2018 — 6 min read
Three Essential Components of a Financial Analysis

A financial analysis helps business owners determine their company’s performance, sustainability, and growth by reviewing various financial statements like their income statement, balance sheet, and cash flow statement.

Here’s a deep dive on what you need to know about each of these statements, along with specific ratios and calculations to help you conduct a financial analysis:

The framework of a financial analysis

1. Income statement

An income statement reports the company’s financial performance over a given period of time and showcases a business’s profitability. It can be used to predict future performance and assess the capability of future cash flow. You might also hear people refer to this as the profit and loss statement (P&L), statement of operations, or statement of earnings.

The “top line” of the income statement 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 important analysis ratios to compute when reviewing your income statement:

Gross Profit Margin = Gross Profit ÷ Revenue from Sales

Operating Profit Margin = Operating Earnings ÷ Revenue

Net Profit Margin = Net Profit ÷ Revenue

Revenue Growth (%) = (Revenue from Current Period – Revenue from Previous Period) ÷ Revenue from Previous Period

Revenue Concentration (%) = Revenue from one client ÷ Total Revenue

Revenue per Employee = Revenue ÷ Number of Employees

2. Balance sheet

A balance sheet reports the company’s assets, liabilities, and shareholder equity at a specific point in time. In every balance sheet, assets must equal the total of your liabilities and equity, meaning the dollar amount must zero out.

Your balance sheet can help you determine how efficiently you’re generating revenue and how quickly you’re selling inventory. There are three types of ratios that can be computed from your balance sheet:

Current Ratio = Current Assets ÷ Current Liabilities

Quick Ratio = (Cash Equivalents + Marketable Securities + Accounts Receivable) ÷ Current Liabilities

 

Leverage ratios look at how much capital comes in the form of a debt (or loan). Too much debt can be dangerous for a business and turn off investors. Some leverage ratios you can use include:

Debt to Equity Ratio = Total Liabilities ÷ Shareholder Equity

Debt to Capital Ratio = Company’s Debt ÷ Total Capital

Debt to EBITDA Ratio = (Interest-Bearing Liabilities – Cash Equivalents) ÷ EBITDA

Interest Coverage = EBIT ÷ Interest Expenses

Fixed Charge Coverage = ([Earnings Before Interest + Depreciation + Amortization] – 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 = COGS ÷ Average Inventory

Account Receivable Days = Net Value of Credit Sales ÷ Average Accounts Receivable

Total Asset Turnover = Net Sales ÷ Average Total Assets

Net Asset Turnover = Sales ÷ Average Total Assets

3. Cash flow statement

A cash flow statement reports the amount of cash generated during a given period of time. It’s intended to provide information on a business’s current liquidity and solvency as well as its ability to change cash flows in the future.

The three main components of a cash flow statement are:

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 in your cash flow statement. Here are a few to help you start measuring the quality of your cash flow and create a cash flow analysis:

Operating Cash Flow to Net Sales (%) = Operating Cash Flow ÷ Net Sales

Free Cash Flow = Cash from Operating Activities – Capital Expenditures for Current Operations

This is a general overview of what goes into a financial analysis. If you want to put together one for your business, don’t hesitate to contact a professional to get their advice and expertise.

Running a business is no easy feat, but Square is here to help. We have all the tools you need to start, run, and grow your business, whether you’re selling in person, online, or both. And we’ve made all our tools to work together as one system, saving you time and money — and making decisions easier. So you can get back to doing the work you love and focusing on whatever’s next. See how Square works.

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