Financial statement analysis is the process of examining the data on your financial statements and using calculations to evaluate your business’ performance. In a challenging business climate, these exercises can help uncover patterns and put numbers in context to tell you about the health of your business.
Below are three strategies for financial analysis, along with when to use each one.
Financial analysis strategy #1: Ratio analysis
Ratio analysis includes a range of different calculations which put the numbers on your financial statements into context. For example, if you hear a company has £10 million in debt, that might be excessive for a small business, but very manageable for a large corporation. A ratio analysis would calculate whether the debt load was appropriate, by measuring total debt against total assets.
There are ratio calculations for profits, liquidity, use of leverage, asset management and valuation, among other areas. Some examples of ratio analysis include:
- Gross Profit Ratio: Used to measure your profitability relative to your sales.
Formula: Gross Profit / Net Sales - Quick Ratio: Used to see whether you are in position to safely cover your short-term debt with your liquid assets.
Formula: Short-Term Liquid Assets / Short-Term Liabilities - Inventory Turnover Ratio: Used to see how quickly you’re selling goods and the demand for your products.
Formula: Cost of Goods Sold / Average Inventory Level
Once you calculate a ratio, you can compare them to snapshots of your business, as well as averages for your industry. There are a variety of free and paid resources with such benchmark information, such as Factiva.
When to use ratio analysis
In a tough economic period, ratio analysis can help you see whether it’s only your business that’s having trouble or whether it’s an industry-wide problem by comparing against the averages. Running through these calculations may also help you uncover problems you weren’t aware of.
“During turbulent social and economic times, these ratios might help inspire some creative problem solving or process innovations helping you stay out of the red,” says Jim Pendergast, SVP at Altline by The Southern Bank. For example, if your inventory turnover for a certain product is creeping up, you may need to rethink your sales approach or whether the product is worth keeping.
Ryan Maxwell, certified public accountant and director of research at FirstRate Data, also recommends prioritising cash flow statement ratios, such as the cash flow to net income ratio (cash flow from operating activities/net income). “This ratio shows the proportion of a company's profits that are actually cash profits as opposed ‘accounting profits’. Business owners often focus on profitability numbers such as net income without noticing there are serious cash flow issues developing.”
It’s a common shortfall, as 44% of small business owners who had cash flow problems said they were a surprise, according to a 2019 QuickBooks Cash Flow Survey of 3,500 companies with 0-100 employees.
Financial analysis strategy #2: DuPont analysis
DuPont analysis is a way to measure the financial performance of a company and see what’s driving its return for the shareholders and business owners. It combines three types of ratio analysis, meaning you can see what’s driving your business performance.
The DuPont analysis formula
Net Profit Margin x Asset Turnover x Equity Ratio, where…
- Net Profit Margin = Net Income / Revenue (Measures your profitability.)
- Asset Turnover = Sales / Average Total Assets (Measures your efficiency in using assets to make sales.)
- Equity Ratio: Average Total Assets / Average Shareholder’s Equity (Measures your debt level relative to equity.)
When to use DuPont analysis
“DuPont analysis is very useful for business owners to understand how to maximise the valuation of their business prior to selling or listing it via an IPO,” says Maxwell. If you’re planning to sell your business, that’s the time to focus on improving your DuPont analysis.
During tough times, however, Maxwell finds this analysis less useful. “It is not very useful for minimising the risk of corporate failure as it focuses primarily on maximising upside potential.” In other words, it's better for finding ways to increase the future value of your business rather than helping it manage through a difficult stretch today.
Financial analysis strategy #3: Common size analysis
With common size analysis, you take the information from your financial statements and recalculate as a percentage of a base amount. For example, on your income statement, you would recalculate each part as a percentage of your total revenue for the period. Here’s an example:
|
Income Statement |
Common Size Analysis |
Sales |
$500,000 |
100% |
Cost of Goods Sold |
$300,000 |
60% |
Gross Profit |
$200,000 |
40% |
Selling and Operating Expenses |
$25,000 |
5% |
General and Admin Expenses |
$25,000 |
5% |
Pre-Tax Operating Profit |
$150,000 |
30% |
When to use common size analysis
This ratio is particularly helpful when your revenue changes dramatically, such as during a recession. Whereas you can see numbers going up and down on your statements, common size analysis reveals the percentage shifts in those numbers.
Let’s say in the next period your cost of goods sold suddenly jumps from 60% to 70%. That shows you’re paying more for your inventory and you may need to renegotiate with suppliers.
Other types of financial analysis
- Horizontal analysis: draws on historical financial information and forecasted information to compare two or more time periods.
- Vertical analysis: used to identify a correlation between different line items in a financial statement.
- Profitability analysis: involves tracking profitability measures such as gross margin, EBITDA margin and net profit margin.
What should a financial analysis report include
There are five key areas when compiling a comprehensive financial analysis report:
- Revenues: to get a sense of a business’s long-term success
- Profits: reveals a business’s ability to reliably produce quality profits.
- Operational efficiency: how efficiently a company’s resources are being used.
- Capital efficiency and solvency: these are the metrics that interest lenders and investors.
- Liquidity: measures a business’s ability to generate enough capital to cover cash expenses.
Getting the right balance
Each method of financial analysis gives you a unique piece of information for your business. The best thing to do is to not stick just to one of the three methods, as that might make you blind to a lot of factors. It's okay to give more preference or weightage to a particular method, but don't refrain from using them all.
By using these strategies for financial analysis, you can pull even more insight out of your statements while giving yourself ideas on how to navigate tough times. With an American Express® Business Gold Card, you have up to 54 days to settle your payments¹, allowing more time to review business performance before investing in new ideas.
- The maximum payment period on purchases is up to 54 calendar days and is obtained only if you spend on the first day of the new statement period and repay the balance in full on the due date.