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.
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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 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 considered. The formula for calculating operating margin is operating earnings divided by revenue.
Operating Profit Margin = Operating Earnings ÷ Revenue
Net profit margin is the percentage of revenue 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 is the percentage of growth during a given time period. To calculate this, subtract last period’s revenue from the revenue this period, and then divide 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. Take the revenue from a single client divided by total revenue. To mitigate risk, a single client shouldn’t generate the bulk of your revenue.
Revenue Concentration (%) = Revenue from one client ÷ Total Revenue
Revenue per employee can measure business productivity and determine the optimal amount of employees you need. Take your revenue divided 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
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.
Assets = (Liabilities + Equity)
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:
Liquidity ratios are portions of the company’s assets and current liabilities. They are used to measure a business’s 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 one 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 less than 1.5 usually concerns lenders.
Net working capital is the aggregate 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 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 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-term and long-term debts against total capital. To calculate this, take the company’s debt divided by its total capital.
Debt to Capital Ratio = Company’s Debt ÷ Total Capital
Debt to EBITDA (earnings before taxes, interest, depreciation, and amortization) is used to determine a business’s ability to pay debt. Debts include both short-term and longer-term debts. The EBITDA is the company’s total earnings before interest, taxes, and depreciation. Calculate this by taking your business’s interest-bearing liabilities minus cash equivalents, divided by EBITDA.
Debt to EBITDA Ratio = (Interest-Bearing Liabilities – Cash Equivalents) ÷ EBITDA
Interest coverage showcases 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, or mortgages. Calculate it by taking (earnings before interest, depreciation, and amortization minus unfunded capital expenditures and distributions) divided by total debt service (annual principal and interest payments).
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 measures how many times a business sold its total inventory over the past year, in dollar amount. A high ratio implies strong sales while a low turnover ratio implies weak sales and excess inventory. Take your cost of goods sold divided by average inventory to determine your 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’ sales relative to the value of its assets. Calculate your net asset turnover by taking your sales divided by your 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:
- Cash from operations refers to all cash flows regarding business operations. Operating activities can include production, sales, delivery of a business’s product, and payments from customers. It can also include purchasing materials, inventory costs, advertising, and shipping.
- Cash from investing arises from actions where money is being put into something with the expectation of a gain over a long period of time.
- Cash from financing results from borrowing, repaying, or raising money for the business.
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 tells you how many dollars in cash are generated for dollars 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 cash. 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
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.
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