In your business, a number is not just a number, it is the measurement of a result or an action measured at a point in time. Finance is game of numbers and understanding the meaning of these numbers is the basis to the success of your company.
Financial analysis refers to the process of analysing a business’ various financial results to evaluate its financial stability and future. Using financial data to assess a company’s performance is one of the key tools required by business owners and or managers to examine how their organisation is performing and make recommendations about how it can improve going forward. It is the collection, analysis and interpretation of historical financial data to determine the current financial condition and to influence future business decisions.
The financial statements of a company are used for financial analysis and financial ratio’s. The income statement analysis assists in assessing the trends, the margin’s, the operational efficiency, the company’s profitability and the overall managerial effectiveness of the company. The balance sheet analysis assists in analysing the financial strengths, weaknesses and creditworthiness of the company.
Analysing the current position of financial analysis involves accessing the types of assets owned by a company, providing information about the cash position of the company and how much debt the company has in relation to equity. The analysis will provide a benchmark measurement for your business, but it will also provide a benchmark comparison between other same type industry companies.
There are a host of analysis and ratio’s available, however there are seven key analyses:
Income statement analysis (Profit and Loss)
- Break even analysis
Break-even is where a company neither makes a profit nor loss, it is the point at which total cost and total revenue are equal (“even”). There is no net gain or loss, the company results have “broken even”. The break-even analysis is used to examine the relation between the revenue, fixed cost and variable cost. The break-even point is not a static calculation, it can be calculated at any point in your business to determine when the business will start to generate a profit or when a product will start to be profitable.
- Horizontal analysis
Horizontal analysis is a comparative analysis that compares historical data from line items and ratios over a number of accounting periods. It provides trend analysis over the months or years and assists with planning, forecasting and budgeting. The drawback however is when the financial line items per month or per year presented in the financial statements are not entirely the same or consistent.
- Profitability analysis
Gross Profit Margin
The gross profit margin is a profitability measure that indicates the percentage of gross profit in comparison to sales – it calculates the ratio of profit left of sales after deducting cost of sales.
Operating Profit Margin
Operating profit ratio analysis assists in determining the companies’ operation efficiency and is a superior measurement of the strength of a company’s management team in running the business, as compared to gross profit or net profit margin. Operating profit is the amount left after subtracting cost of goods sold and other day to day operational expenses such as electricity, rent, employee cost, transport and other costs from the revenues, it is the profit a company earns from its core operations.
Net profit
Net profit ratio is a profitability ratio that shows the relationship between net profit after tax and net sales revenue of the company and is calculated by deducting all the company expenses from its total revenue. The result of the profit margin calculation is a percentage, for example, a 10% profit margin means for each R1 of revenue the company earns R0.10 in net profit.
Balance Sheet analysis
- Solvency ratio
Debt to equity (D/E) ratio is one of the most used debt solvency ratios. A solvency ratio indicates whether a company’s cash flow is sufficient to meet its long-term liabilities and whether a company will default on its debt obligations, it is therefore a measure of a company’s financial health.
- Liquidity ratio
Liquidity ratios indicates how easily a company can pay its debts and other liabilities, it thus indicates cash flow strengths.
Current ratio
The current ratio or working capital ratio indicates how likely a company is able to meet its financial obligations for the next twelve months, thus, do the company have enough assets to pay off short-term liabilities.
Cash Ratio
The cash ratio indicates how much cash a company has on hand, in relation to its total liabilities, thus, how easy can a company pay its liabilities with cash.
- Efficiency Ratios
Asset turnover ratio
The asset turnover ratio indicates how much sales a company can generates from its assets.
Inventory Turnover ratio
The inventory turnover ratio indicates how often a company turns over its inventory, particularly, how many times inventory is sold and purchase (replaced) in a given time, for example 3.5 months.
Receivables turnover ratio
The receivables turnover ratio measures how well a company manages their credit control (debtors), in particular how long it takes to collect outstanding monies, for example 60 days.
- Coverage ratio
The asset-coverage ratio measures a company’s risk by determining how much of a company’s assets would need to be sold to cover its debts, it indicates a company’s overall financial stability.
The limitations of ratio analysis are that it is a process and not a solution in itself, however learning about the financial health of your business is critical to outsmart your competitors and achieve your business objectives.
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