With increasing competition and rising costs on all fronts, management of many companies spend substantial amounts of their time fire-fighting and thinking of ways to remain relevant and competitive. As a result, financial analysis and its application to strategic planning is often neglected as having smooth operations is top priority. To worsen the problem, financial analysis is commonly viewed as difficult, time-consuming and extremely technical thus frowned upon. This article aims to simplify the perceived complexity of financial analysis, educating management on how to make sense of their numbers.
Financial analysis involves the examination of historical and current financial information to gain insights on the company’s historical and future financial performance. This information can be obtained from the Financial Statements, particularly Income Statement, Balance Sheet and Cash Flow Statement. Financial analysis helps management understand their strengths and weaknesses, more accurately evaluate potential opportunities thus resulting in better decision-making.
The four main methods of financial analysis and their application are explained below:
- Horizontal analysis
Horizontal analysis involves the comparison of historical financial information over a certain time period. It measures both the absolute and percentage change of the ratio or line item between time periods and can be used for all three main components of the financial statements. For example, one can calculate the year-on-year absolute and percentage change in revenue to gain insights on revenue performance over a particular time horizon. This analysis is important as management can understand the trend of the line items, comparing it with the industry, their operations and the strategic direction to determine whether it is aligned. In addition, large variances can be easily identified to allow management to focus their resources on investigating substantial or anomalous variances.
- Vertical analysis
Vertical analysis involves the comparison of historical financial information as a percentage of a line item for a particular time period. It measures the line item in proportion to a designated base and can also be used for both the Income Statement and Balance Sheet. For example, one can calculate the percentage of cash and equivalents to total current assets to know the strength of their cash reserves or the percentage of staff expenses to total operating expenses to grasp the extent of the burden on revenue. The main benefit of this analysis is that results from companies of different sizes can be easily compared. Management can also compare percentages from different time periods to determine whether composition of account types e.g. asset, liabilities, expenses has changed with time.
- Ratio analysis
Ratio analysis is the quantitative analysis of information in the financial statements. It evaluates the company in various aspects e.g. financial sustainability, liquidity and profitability using different ratios. This allows management to understand their strengths and weaknesses in the different aspects, providing early warning signs on potential issues so that management can improve their weaknesses.
Benchmarking is the comparison of your own performance against competitors and best practices. This method is the most critical and should be used in conjunction with the abovementioned to allow management to determine their “true” performance. When formulating the benchmark, it is especially crucial that the right competitors are identified and recent data is prioritised to ensure a fair and accurate comparison.
As shown above, a lot of insights can be gathered from the “sea of numbers” in the financial statements that many shy away from. With a little patience and the existence of data, management can definitely make sense of their own numbers!