Why should a business conduct a financial analysis?
Financial Analysis involves using financial data (income statement, balance sheet, and cash flow statement) of an entity to assess a company’s performance and make recommendations about how it can improve going forward. Some organizations are reluctant or hesitant to look into the numbers of their books because they either might have improper records or generally lack the expertise to analyze their data or they simply don’t see the need to carry out analysis of their financial information.
However, once you realize the importance of financial analysis, you will never turn back no matter the reason.
Usually, financial analysis is carried out to either assess the current performance of an entity to enable comparison with past periods, or to compare an organization’s performance to similar entities within the same industry, or to give recommendations about how to improve going forward.
To carry out financial analysis, one needs the financial data of the organization. These financial data include the income statement, balance sheet, and cash flow statement. These data can be obtained from the financial records of the organization. Some of the analysis that can be performed are:
1. Profitability analysis (analyzing revenue, expense and profit trends from year to year)
2. Liquidity analysis (analysis of cash flow and turnover of receivables, payables, and inventory)
3. Financial analysis (looking out to see if there are significant changes to assets, liabilities, and equity)
You can also look at key performance indicators of the organization if there are any significant changes over time and this might enable you to identify what needs to be done to improve upon the performance of the business.
Benefits of Financial Analysis
After the analysis has been done, we expect to gain something from going through the trouble of making the analysis. Some of these benefits are explained below.
1. Identifying low performing products or divisions: analyzing various revenue lines, products, and geographic areas can indicate where sales or profits or low. This helps the organization to make the necessary adjustments to improve upon its performance. For example, if you have two product lines and profits seem to be in decline, a revenue and expense trend analysis of the various product lines or divisions can indicate where sales are low or where an expense is high. Once this is established, you can act on the results to improve performance.
2. Identifying growth opportunities: proper analysis of the market can easily assist an entity to identify key growth opportunities to the entity. For example, a low sales product or division may be because of poor marketing, if this is identified and necessary measures are taken, the product can easily penetrate the market with the right marketing strategy.
3. Identifying profit and revenue trends: the income statement should be able to indicate the different classifications of revenue and expense as a percentage of net sales. For example, if the direct cost of sales was 30% of sales a year ago and now it is closer to 50%. It’s probably eating into profits and needs to be investigated. However, if the cost is reducing, it might indicate how efficient you are in the current year.
4. Tracking payables and receivables: this tells you whether the sales you are making reflect in your cash flow or whether you are enjoying better payment terms from your suppliers. This will also help you to identify whether your debtors pay their debt on time which will enable you to have a favorable cash flow to embark on your projects or not. It also enables you to put yourself in a position to re-negotiate with your suppliers for better and favorable payment terms.
5. Planning for the future: using a long-term cash flow analysis can give you a better idea when you are going to have enough funds to invest in your capital expenditures. If you are also looking to enter for credit and investment opportunities to facilitate your growth, the various financial data of your entity can provide potential investors or lenders the necessary tools to assess your financial health and level of risk.
It is important to understand that the longer you wait to analyze your financial data, the longer you are missing out on tools that can help you improve upon your performance, growth, increasing profits, expansion, etc. Built Accounting professionals are more than capable of helping you out if you do not have the expertise to carry out a financial analysis.