What is Financial Analysis?
What is Financial Analysis?
As technology proliferates and global companies multiply, competition is becoming increasingly tough across all sectors. What used to be a practice confined to publicly traded and large-scale companies—data-driven business management—is now virtually unavoidable for almost any business in today's competitive environment.
Financial analysis is one of the most critical tools that allow your company to make data-driven decisions concerning projects, budgets, strategic plans, and business models. It enables company managers and decision-makers to objectively assess the current status of the company and future projections.
Why Conduct Financial Analysis?
Proper financial analysis can give you a clear picture of your business’s financial health and sustainability, allowing you to plan effectively. You can set long-term plans for your commercial activities and make accurate decisions about projects, products, customers, and investments. The primary source of financial analysis is the financial data resulting from your business’s sales and expenses. These data feed essential records such as the balance sheet, profit/loss statement, and cash flow statement, forming the basis for financial analysis.
Moreover, no company operates in isolation in its market. Businesses are in a race with their competitors and sectors. Therefore, to stay a step ahead in competition, businesses should compare their own momentum and financial status with their competitors. One of the most efficient ways to analyze and interpret financial data is to make comparative analyses with other companies or to track specific ratios within trends. For example, Gross Profit Margin is considered crucial data for many companies. While it might give you information about your products' profitability, there are also sector-specific average values. In the software industry, a Gross Profit Margin of 70% and above is considered good, whereas, in the agricultural sector, even figures in the 20s can be considered satisfactory.
What are the Methods of Financial Analysis?
There are more than ten methods of financial analysis, depending on the goals. In this blog by Nuvio Academy, we'll discuss four basic methods of financial analysis. If you ask, “Which method is the most suitable for me?” the answer is: All of them! These methods collectively turn into a powerful resource for analyzing your business’s financial health.
- Percentage Method (Vertical Analysis): The aim of this method is to find the proportion of a specific financial data within the total revenue. The source is the income statement (profit/loss statement). The most critical figures derived through vertical analysis include Gross Profit Margin, Net Profit Margin, and Operational Profitability. For instance, if a company's Gross Profit is $6,584,263 and the total revenue is $14,953,224, the Gross Profit Margin would be calculated as 44%.
- Comparative Table Analysis (Horizontal Analysis): Companies, like individuals, have unique characteristics. Just as we learn, grow, and strengthen by drawing lessons from our past, companies need to do the same. This method serves precisely this purpose. Horizontal analysis is a method based on comparing a business's financial data over a few years to analyze the rate of change. It allows you to plan for the next 3 to 5 years based on the past 4-5 years of data.
- Ratio Analysis: Ratio analysis involves comparing various financial figures from a company's financial statements. A multitude of ratios can be calculated to gain insights into a company's liquidity, efficiency, profitability, and debt standing. These ratios are foundational data points for investors and lending institutions. However, ratios alone are not sufficient to draw a full picture of a company’s financial health. Therefore, these ratios are usually compared with past years, industry averages, and widely-accepted benchmarks to evaluate the company's financial standing comprehensively. Commonly known financial ratios include the Current Ratio, which shows the company's ability to cover short-term debts; the Cash Ratio, which compares current cash assets to liabilities; and Gross Profit Margin, which indicates profitability after the cost of goods sold. Stay tuned for our upcoming content at Nuvio Academy where we'll delve into the details and formulas behind these financial ratios.
- Cash Flow Analysis: Just as important as financial ratios and horizontal or vertical analysis, cash flow analysis is another method to quickly identify possible operational issues within a company. Following the maxim "Cash is King," we can deduce that the greater a company's ability to generate cash, the more resilient it will be against challenges. One of the most important figures in cash flow analysis is Free Cash Flow, calculated using the Cash Flow Statement. This represents the cash remaining in a company's coffers after all expenses have been paid, which can be used for dividend distribution or future investments, pleasing both investors and company partners.
This All Sounds Complicated, How Do We Conduct Our Financial Analysis?
Every company needs to carry out financial analysis to keep tabs on its financial health. But for many companies, especially SMEs, financial analysis seems to consist of complex Excel spreadsheets or expensive consultations, making it a daunting task. With Nuvio, you can quickly track your company’s income, expenses, and cash flow, and have immediate access to a range of financial analyses through specialized dashboards—all without grappling with any Excel sheets or complicated calculations. Feel free to try Nuvio for free to ensure you’re keeping your business financially healthy.