You’ll need to fully understand how a company works to get the most out of your investment. One good way to know how a business is doing is to carry out a thorough financial analysis.
So, what do you need to make this happen?
The most important thing you need is a solid understanding of what financial analyses are and how you can create one. This is why, in this article, we’ll be going over the key elements of financial analysis. But, before we get into that, I would like to first explain what a financial report & analysis is.
What is Financial Analysis
According to Wikipedia, financial analysis is “an assessment of the viability, stability, and profitability of a business, sub-business or project”.
In simple words, a financial analysis is an assessment of a company’s performance over a period. This assessment reveals the company’s strengths, weaknesses, growth patterns and financial worth.
As you’d ask a friend you haven’t seen in a while, ask yourself the following questions:
- How is X Company doing?
- What pleasant changes have occurred in their operations?
- What are their plans for growth?
- What are the best investment tools they use to give real-time financial reports?
To find answers to these questions you’d need a detailed financial analysis.
Once you have this, the next decisions you’d have to make on your finances would be a walk in the park.
Now, let’s get down to business…
What Are The Key Elements of Financial Analysis
This, simply, is the income of the company. They are what determine the performance of a company over time.
How much has the company’s revenue grown, from when it started until now?
To know this, you’ll need to get hard data of how they started and how they’re currently doing in the business.
FORMULA: (latest revenue generated – old revenue generated) / old revenue generated
This refers to the measure of how a company’s revenue is shared among its customers.
As Marc J Marin point’s out, a company with too many “high-end customers” stands a risk of getting knocked over. High-end customers are those that can make a big difference in the profit a company makes.
According to financial analysts, only less than 10% of your revenue should come from each client. Anything from 10, and above, means you have a high revenue concentration.
FORMULA: (revenue raised from client / total revenue generated)
Revenue Per Employee
This covers the productivity of each employee as well as the company’s workforce as a whole.
- How much does an employee bring in?
- How does the performance of the company’s workforce affect its cash flow?
FORMULA: (total revenue generated / average number of employees)
A company that cannot continually generate returns may fail in the long run.
- Gross Profit Ratio/Margin
This, according to Investopedia, is the percentage of sales a company makes.
A company with a healthy gross profit will always be able to handle all its revenue costs. They’d also find it very easy to settle their current and/or outstanding expenses as well.
FORMULA: (revenues – the cost of goods sold) / revenues
3. Operating Profit Margin
This shows the ability of a company to continually make profits even with the expenses they incur.
FORMULA: (revenues – the cost of goods sold – operating expenses) / revenues
Net Profit Margin
This accounts for the profits the company can reinvest as well as that it can share amongst its shareholders.
FORMULA: (revenues – the cost of goods sold – operating expenses – additional expenses) / revenues
This assesses the way a business effectively manages all its capitals and assets.
Operational flexibility also covers how the business generally responds well to changes.
Account Receivable Returns
This is an assessment of how the company successfully manages its customers’ credit. Higher credit is a sign of a healthy account receivable turnover.
A low one signifies you have to improve demand if you must continue to survive.
FORMULA: (net credit sales / minimum account receivable)
This answers the question; “how do you manage your existing assets and resources?”
FORMULA: (cost of goods sold / average inventory)
4. Capital Efficiency and Solvency
This measures the company’s capacity to achieve its long-term financial goals.
Return Equity Ratio
This accounts for the returns your investors gain from your company. It shows to your prospective clients that you’re reliable.
FORMULA: (net income / shareholder equity)
This is the ratio of shareholders’ equity to the debt the company incurs with its expenses.
FORMULA: (debt incurred / total shareholder equity)
This is a measure of a company’s ability to meet its short-term financial obligations.
A low liquidity ratio indicates that a company’s operational flexibility is low.
This covers the company’s ability to easily settle its short-term obligations.
FORMULA: (current assets / current liabilities) CV
This is the ability of a company to settle its short-term expenses with its returns.
FORMULA: (gross profits ÷ interest expense)
Now that you know what the key elements of financial analysis are, you should have no problem doing a thorough financial analysis on your business. What each of these elements do is to reveal how each component of your business is doing. They also show you your areas of strength and weakness and invariably make your decision-making processes easier for you.
Visit our shortlist of the best financial statement analysis books to discover more about this intriguing subject.