The financial analysis of a company examines its financial position by studying its financial statements to diagnose its actual profitability or debt. For decision-making purposes, it is a critical guide for any entrepreneur aiming for success.
A lack of resources, poor planning and a failure to pivot in time: these are some of the main reasons why companies go bust, according to a survey of more than 150 startup founders conducted by the consulting firm Wilbur Labs. Up to 37% of those surveyed felt that the main reason that startups close up shop is simply because they run out of money.
These results illustrate a potentially mortal danger lurking in the entrepreneurial ecosystem: a lack of visibility of the company’s finances, which leads to limited ability to react and plan for the future. A tool that is essential for overcoming this risk, helping founders to make the best accounting decisions, is what is known as business financial analysis: an in-depth study (and strategic interpretation) of a company’s financial data.
What is financial analysis all about?
Financial analysis examines a company’s financial position by studying its financial statements to diagnose its economic status and forecast how it will evolve in the future. Data-driven, it provides an objective view of the company’s profitability, solvency and liquidity.
The information analysed includes:
- Internal documents that relate to the company’s accounting such as financial statements, for example, which are reports that cover a given period of time, usually annual, and include documents like the balance sheet, the cash flow statement and the profit-and-loss statement (the income and expenses the company generates and its result).
- Indicators or indices related to the business and market context in which the company operates.
- Financial ratios, which provide accounting units to measure the company’s financial status. The calculation of financial ratios is particularly relevant when interpreting the company’s performance data and correlating it with the economic situation.
How is the financial analysis conducted?
Financial ratios are used to analyse and put the company’s business activity figures into perspective. Expressed as percentages or decimal values, they are the result of dividing one financial figure by another and are used to measure and compare the main indicators of financial health.
Liquidity
A company’s liquidity is its ability to convert assets to cash—without a loss in value—to pay its short-term financial obligations.
Liquidity can be assessed with indicators such as:
- Cash flow (the net cash inflows and outflows over a period of time), which will be either positive or negative depending on whether receivables are higher or lower than payables. Cash flow is also influenced by the period in which customers are charged and suppliers are paid.
- The liquidity ratio, which is the difference between current assets (total assets that can be turned into cash in less than twelve months, such as money deposited in financial institutions or the stock of goods held by the company) and current liabilities (short-term financial obligations). This ratio will give the entrepreneur an understanding of whether the company has idle resources (factors of production that are failing to generate profits) or, on the other hand, if it might struggle to pay its debts.
Solvency
Financial solvency is the company’s ability to meet all its payment obligations in the medium and long term; in short, whether it can meet its debts. It is calculated using the solvency ratio, which is calculated by dividing the company’s assets by its liabilities (debts and payment obligations). This figure is essential when it comes to pinpointing the actual state of a company’s finances, since it provides an easy way to understand whether the company could, if necessary, pay off all its debts with the assets it has at its disposal.
There are also other indicators that measure financial solvency:
- Debt ratio. This is calculated by dividing the company’s current liabilities by its equity. If non-current liabilities (long-term debts, that is, those with a maturity of more than one year) are included, the long-term debt ratio can be calculated. This gives a picture of the extent to which the company is financed by external resources.
- Financial leverage ratio. Here, assets are divided by equity. It provides an indication of whether a company is over-indebted by analysing how much of its capital is in the form of debt and whether it could meet its payment obligations out of its equity without being too dependent on external financing.
Profitability
Usually expressed as a percentage, the profitability of a startup can be understood as its ability to generate profits by comparing its return with the investment it requires. Using the profitability ratio, the profits are related to figures like the total sales figure. The following are particularly relevant when it comes to calculating profitability:
- ROE (return on equity). Also known as financial profitability, it is calculated by dividing the company’s net profit by its equity, which provides an understanding of the return the company generates for its shareholders.
- ROA (return on assets). Economic profitability is the result of dividing net profit by total assets to determine the return on its assets.
Why is financial analysis useful for entrepreneurs?
With a financial analysis, a company’s financial statements can be interpreted in a simple, clear and actionable way, in other words, they can be translated into effective business decisions.
They help entrepreneurs by reinforcing essential skills such as:
- Responsiveness. Thorough knowledge of a company’s actual profitability and solvency helps prevent unexpected developments and makes it possible to implement measures to correct economic imbalances in time.
- Foresight. Financial analyses include forward-looking forecasts of how the company’s finances will evolve, a useful roadmap for planning and risk prevention.
- Strategic decision-making. From acquiring debt to making new investments, entrepreneurs will have the context to act when and where the need (or opportunity) is greatest.
- Confidence. A financial analysis can also serve as a document that can vouch for the company’s financial standing for investors, suppliers or creditors.
There is no better asset to lead a startup or scaleup to success than relevant and current information on the state of its operations, the market and its own business decisions. Whether it means correcting course in time or moving full steam ahead with the certainty of being on the right track, the best compass for entrepreneurs to navigate the waters ahead is a financial analysis.
