If someone were to ask you about your company’s financial strengths and weaknesses, could you give them a detailed answer?
As a founder, you need to know this type of information about your business. Understanding your financial performance is key to making better decisions about growth and investment plans.
The key to painting that picture lies in a process known as financial analysis.
What is financial analysis?
Financial analysis is the process of going over a company’s financial data to evaluate its performance in order to make informed business decisions. Founders and executives use financial analysis to assess performance and make strategic decisions, such as where to invest money to improve growth.
Externally, investors use financial analysis to make decisions about which companies are good investments. Potential lenders, such as banks, may also use financial analysis when they review loan applicants to assess your ability to pay back the money they lend.
Financial analysis is typically done by an external finance professional who reviews documents like the income statement, cash flow statement, and balance sheet.
How to do a financial analysis
1. Collect your company’s financial statements
Financial analysis helps you identify trends in your business’s performance. To get the best insights, compare your business performance over time.
Gather your recent financial statements, including your balance sheets, income statements, and cash flow statements. Look at the last three to five years’ worth of data, which is enough to establish a trend while still focusing on your most recent (and relevant) performance.
Once you have all your documents, arrange them in chronological order.
2. Analyze balance sheets
Your balance sheets give you a snapshot of your company’s finances at a given point in time, such as the end of a fiscal year. On this sheet, you’ll see the value of your short- and long-term assets, debts, and owner’s equity.
Look at your balance sheets and consider the following questions:
- How much debt do you have compared to equity?
- Has your debt been increasing or decreasing over time?
- How liquid is the business? (i.e., how much of the business’s assets are short term?)
- How has the liquidity of the business changed over time?
3. Analyze income statements
Also known as a profit and loss (P&L) statement, the income statement provides insight into your company’s revenue, expenses, and profits.
Evaluate your income statements and look for trends in your:
- Gross revenue: Total amount of income generated by sales.
- Operating income: Revenue minus the cost of goods sold (COGS). This tells you how much of your revenue remains after you account for operating expenses.
- Net profit (or loss): Revenue minus all expenses. This tells you how much money your company earned (or lost) after paying interest and taxes.
Startups can often take two to three years to become profitable. That’s why it’s helpful to track several financial metrics.
For example, you can have a net loss while still generating an operating profit. This means your core business is profitable, but you may still be paying off interest on the loans it took to get the business off the ground.
4. Analyze cash flow statements
Your cash flow statements give you insight into how money flows in and out of your business by looking at your expenses and which activities generate income.
Here are some steps to take in your cash flow analysis:
- Review cash flow for each activity (operating, investing, financing). Note whether cash flow is positive (the activity generates income) or negative (the activity loses money).
- Compare cash flow from each activity to see which generates the most income for your business.
- Review cash inflow and outflow over time to identify trends. Are they increasing or decreasing?
- Review total cash to see if it is increasing or decreasing over time.
5. Calculate relevant financial ratios
Calculate financial ratios to get a more detailed picture of your company’s profitability, liquidity, and overall operational efficiency. Here are some of the most common metrics to consider in a ratio analysis.
6. Summarize your findings
Put together all your findings. You can use the following prompts to help organize your analysis:
- What are my company’s financial strengths?
- What are my company’s financial weaknesses?
- How well did the company perform compared to previous financial projections?
- What are the possible explanations for my company’s strengths and weaknesses?
- What financial improvements do I want to make?
After you conduct your analysis, you’ll know where your business stands in terms of its finances and be able to have educated discussions with stakeholders and potential investors.
Furthermore, you’ll be able to use this knowledge to make more informed decisions about your business’s strategy.
Gaurav Nagani, CEO of help desk software company Desku.io, recommends conducting an analysis “before investing, at regular intervals, before making strategic decisions, and during difficult times.” This way, when you have to make impactful decisions, you’re doing so with a full picture of your company’s financial health.
Common types of financial analysis
There are several different types of financial analysis that you, or a financial professional, can use, depending on what you hope to glean.
Horizontal analysis
Horizontal analysis looks at a company’s performance over time by comparing financial statements over different periods, such as months, quarters, or years.
You can use it to identify growth trends and support financial forecasting, which is the process of using historical data to predict your company’s performance in the future.
Vertical analysis
Vertical analysis looks at a company’s financial performance relative to one metric, such as your total assets. In this case, all line items on the financial statements are expressed as a percentage of total assets. For example, you can use the debt-to-asset ratio, which looks at your total debt as a percentage of total assets.
Say your total debt is $4m and you have $10m in total assets. A vertical analysis would show your debts as 40% of total assets, which is what you get when you divide $4m by $10m.
Using vertical analysis makes it easy to see relationships between the metrics on different financial statements. It’s also helpful for comparing companies with one another for benchmarking.
Valuation
Valuation is the process of using a company’s financial information to estimate the value of the business.
Investors often compare a company’s estimated value to its stock price to see if they want to buy shares. For startups, valuations are a necessary step to take before starting a priced fundraising round.
Growth Rates
Growth rates represent the percent change in a given metric over time, such as the percent change in net sales over four quarters. Analyzing growth rates can help forecast future performance for specific metrics.
Profitability
Analysts may use profitability ratios, which provide insight into how efficiently your company turns revenue into profit. The higher your profitability ratios, the more resources you’ll have to reinvest into the company’s growth or distribute to your shareholders.
Jeff Schmidt, vice president of financial modeling at Corporate Finance Institute, reminds entrepreneurs, “The point of analysis is to not focus on one method or another but consider the analysis in total and make the proper investment decision.”
Financial analysis example
One example of a financial analysis would be if a financial analyst calculated your company’s profitability ratios, which assess your company’s ability to make money, and leverage ratios, which measure your company’s ability to pay off its debts. Based on the results of the analysis, the analyst will decide if they want to recommend your company as a good investment.
Knowing how to do a financial analysis is a key skill for entrepreneurs because it helps you understand your company’s performance. You can use the insights you gain from financial analysis to make more informed decisions about your overall strategy.
Not to mention, a financial analysis will help you understand your business from an investor’s perspective, which can inform the way you pitch your company.
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