Financial Analysis Techniques for Evaluating Business Performance
Tools used in financial analysis are very useful in evaluating the company’s performance and the trends of the organisation’s performance. Essentially, a financial analyst transforms the data into financial metrics, which ultimately helps in making the decision. These financial analysts also seek to respond to several questions like How well did the organisation perform as compared with the past performance of the organisation and its rivals in the market? How is the company going to perform in the coming years? Depending on the company’s performance in the future, what value is issued by the security or the organisation?
The annual report of the company is the key source of data which includes the notes and financial statements and commentary of management, which shows the financial and operating review or the analysis and discussion of the management as the financial statements do not provide data for the past performance of the company and also for future performance. So, according to this, a financial analyst has to gather information and data from the company’s financial reports along with other data, which includes the information and data related to the country, company, comparable companies, and industries.
A financial statement is the procedure of the external and internal parties of the companies to have a better knowledge of the organisation’s performance. This procedure involves evaluating four important aspects of financial statements in an organisation. These are the balance sheet, income statement, annual report and cash flow statement.
- Balance Sheet – An organisation’s balance sheet is analysed to identify the functional efficacy of the company. At the initial stage, the analysis of the asset is conducted and mainly focuses on several critical assets like cash and the equivalents of cash, PP&E, and inventory which will assist in predicting the growth of the future. The next stage involves the examination of short-term and long-term liabilities to identify any problems regarding the future predictability of the organisation or the debt repayment which the organisation cannot cover. And the last stage shows the inspection of the equity section of the organisation’s owner, allowing the user to identify the shared capital distributed outside and inside the company.
- Income Statement – In the analysis of the financial statement, the company’s income statement is examined to identify the profitability of the current as well as the future. Investigating the previous and present fiscal year’s income statement of the organisation helps enable the user to figure out any trend in the expenses and revenue, which ultimately indicates the possibility of enhancing the organisation’s profitability in the future.
- Cash Flow Statement – This is also the most important in the financial statement analysis to determine where the money is generated and where it is being spent within the company. If a single segment of the organisation has large outflows to remain viable, then the organisation has to generate inflows with the help of sales of assets or financing.
- Annual Report – Annual report is the last statement which offers information based on the quality and is helpful for the further evaluation of the financing and operational activities of the organisation altogether. It includes all the statements discussed above yet provides narratives and additional insights on the crucial figures of the company. The narrative and additional insights under the annual report involve the overall growth and the extensive breakdown of different business benchmarks and segments. The financial performance analysis is significant if the company conducts for external and internal usage. This is so because it aids in determining the possible future growth, effectiveness, structure as well as performance of the company.
Methods of Analysis of Financial Statements
Certain techniques and tools are utilised by financial analysts so that they can develop a better knowledge and understanding of the financial performance of the organisation over some time. The most common techniques financial organisations use to analyse the financial statement are vertical, horizontal, trend, liquidity, profitability, variance, sensitivity, and scenario and ratio analysis.
- Vertical analysis – This financial statement analysis method helps establish a relation between the various items listed in the ledger. It gives the financial analyst an enhanced knowledge of the total performance following the expenses and revenue. And the results are shown as the ratio.
- Horizontal analysis – The comparison between the performances of two or more periods is made to understand the company’s progress for some time. Each ledger element is differentiated from past periods to collect the understanding and knowledge of the trends. For instance, if the price of the manufactured products rises by 10 per cent but is not shown in the earned revenue, then certain elements must cost the organisation more.
- Trend analysis – This financial statement analysis helps analyse the trends for over three periods or more than that. It mainly considers the pattern change, taking the previous year as the base year. This analysis will indicate a negative and a positive trend if the data shows any change in the organisation’s financial statement.
- Ratio analysis – This analysis of financial statements is utilised to figure out the comparison between one financial element against the other element and reveals an upward or downward trend. After evaluating the ratio analysis method, the ratio is differentiated from the previous data to determine if the organisation’s performance is according to the expectations set. It also aids the management in highlighting any deviation from the expectations set and thus takes appropriate measures to rectify it.
- Liquidity – This financial statement analysis technique mainly works on the balance sheet. In this, the financial analyst has to calculate the accounts payable, accounts receivable, inventory and turnover rates. Several liquidity analysis types involve the current ratio, net working capital, acid test and cash ratio.
- Variance – This method of financial statement analysis measures the difference between the estimated budget of the company and the exact amount of money it spent. If the calculator shows the difference between the budget of the organisation and the exact amount spent, then there exists variance. For instance, if the company’s budget is $300000 and it spends $325000. The example shows that the organisation has a variance of $25000. Once the variance is calculated, the financial analyst can investigate to identify the reason behind this and how it can be prevented.
- Profitability – The main purpose of bringing in investments and assets is to gain profits for the organisation. This method of analysis helps the company understand how the revenue is generated. This method assists the financial analyst in evaluating the feasibility of the decisions depending on the investment by measuring the return rate in the given time. Certain tools can be utilised to run the profitability analysis, which involves calculating the profit margins, paying before taxes, interest, amortisation margins, calculator of profit margins and depreciation.
- Sensitivity and Scenario – The analysis of sensitivity and scenario will evaluate the modifications in the performance of the business depending on the present scenario and various components. Several factors that impact these modifications involve the economic outlook, modifications in the structure of the tax as well as the rates of the bank. This analysis technique uses data and information from past experiences to determine how these modifications impact the organisation’s financial performance. This method of analysis aids the analysts in making informed decisions so that they can safeguard the unfavourable results.
Metrics of Financial Performance
While examining the organisation’s financial performance, several metrics indicate the performance. These are discussed below –
- Gross Profit Margins – This shows the revenue percentage left after the difference in the direct production cost. This does not involve the calculation of taxes, interest and operating expenses. The formula for the gross profit margin is – Gross profit margin = [(Difference between cost of sales and revenue) / Revenue] * 100
- Working Capital – This financial performance metric assesses the business’s available liquidity to fund everyday events. These evaluations can aid the financial analyst in determining if the organisation acquires resources which can be transformed into cash promptly when required. The formula for the working capital is – Working capital = difference between current liabilities and current assets
- Current Ratio – This financial analysis metric helps determine if the company’s assets counterbalance its current liabilities. A current ratio of not over one means that the organisation needs more current assets adequately to pay the company’s current liabilities. The formula for the current ratio is – Current ratio = Current assets / Current liabilities
- Inventory Turnover ratio – This metric of the financial performance is referred to as an efficiency ratio which assesses the number of how many times the company sells its overall inventory in a financial year. This inventory ratio helps determine if the company’s inventory is obsolete or in demand. This information can also be utilised to make smart decisions about marketing, pricing, warehouse management and manufacturing. The formula for the inventory turnover ratio is – Inventory Turnover Ratio = Cost of sales / [(addition of beginning inventory and ending inventory) / 2]
- Leverage – This metric of financial performance calculates the company’s debt to buy the company’s assets. This equity multiplier stays at one if the company only utilises equity to finance the organisation’s assets. When the debt of the organisation increase, the leverage also goes up. The formula for leverage is – Leverage = total assets / total equity
- Profitability Ratio – This metric is also called Return on Assets or ROA. It evaluates the company’s performance by utilising the resources to earn benefits. The sum of the profitability ratio comes low when the organisation needs to use its resources more efficiently. The formula for the profitability ratio is – Profitability ratio = Total profit / [(difference of beginning assets and ending assets) / 2]
- Return on equity – It is also a type of profitability ratio which identifies the company’s performance by utilising the equity to acquire the investors’ profits. The formula for the return on equity is – Return on equity = Net profit / [(addition of beginning equity and ending equity) /2]
- Debt-to-equity ratio – This metric is the ratio of the proportion of the shareholder’s equity and the organisation’s debt which finances the company’s assets. It gives insights into the company’s solvency by identifying the capability of the organisation’s equity to balance the overall debt if the company faces a downturn. The formula for the debt-to-equity ratio is :Debt-to-equity ratio = total debt / total equity
Advantages Of Performance Analysis
The analysis of performance provides certain advantages to the company. It also helps determine the areas required for improvement to enhance profitability. Several advantages are –
- Enhancing debt management by offering transparency in the data related to debt.
- Enhancing the financial performance by determining the exact areas to enhance and improve.
- Boosting collaboration and communication within the organisation.
- Reducing the exposure of risk.
- Enhancing the management of supplier relationships.
- Determining the trends of the company to identify the strategies that are profitable to give better outcomes.
- Motivating the shareholders to make investments in the organisations.
Analysing financial performance refers to the systematic investigation of the financial statements, ratios, and other important information and data of the company to assess the financial performance, determine the weaknesses and strengths and also make appropriate decisions regarding the business operations, financing activities and investments. This plays an important part in the decision-making process, assisting management, investors and the company’s stakeholders to determine the trends so that the company’s financial stability can be assessed to figure out the company’s growth potential. The stakeholders who benefit from the financial analysis involve the creditors, investors, regulatory authorities, employees and management. Various financial analysis types involve vertical analysis, horizontal analysis, ratio analysis, trend analysis, profitability, liquidity and variance, etc. Financial analysis is also useful in different contexts like evaluating business performance, decision-making on investment, mergers and acquisitions, lending decisions and credit analysis, budgeting and financial planning. Yet, it has several limitations, but learning continuously and staying updated with the organisation’s trends is very important and analysing the financial conditions of a business.
Author Bio: Mark Edmonds is a recognized financial master and creator prestigious for his skill in business performance evaluation and analysis strategies. With a rich foundation in the financial business, Mark’s sagacious commitments have demonstrated instrumental in directing businesses towards progress. As an esteemed individual from Academic Assignments, a top-quality business management assignment help supplier, Mark has consistently engaged students to understand complex financial ideas effortlessly. His energy for giving information and devotion to the scholarly world make him a priceless financial analysis and training resource.