No matter how big or small a business is, they need to conduct regular financial statement analysis to both understand a company’s current standing as well as predict the future financial outcome. There are several different techniques when approaching financial analysis, each which focus on a slightly different area to examine, helping businesses identify any possible financial problems and gain a better understanding of their financial position.
The Most Commonly Used Financial Analysis Techniques
Luckily, you don’t have to be a financial analyst to grasp the basics of financial statement analysis techniques. Here are some of the most common techniques used, what they’re best used for, and what they can reveal about your business.
Trend analysis helps a business understand their performance over time, based on historical trends. Using a series of past financial statements, as well as forecasted data, a business can potentially make better predictions by identifying trends and the catalyst of those trends. To conduct financial trend analysis, you need at least two years of financial statement data, though most businesses benefit from several years of consistent data to compare.
Common-size financial analysis:
Common-size financial statement analyzes two parts of a business’s financial statement, the balance sheet, and income statement. In this technique, all income statement items are represented as a percentage of sales, while the balance sheet items are expressed as a percentage of a business’s total assets. One of the benefits of this technique is that percentages make it easier to understand both performance and expense of a business year over year when comparing financial documents, as well as compare your business to another.
Financial ratio analysis:
A ratio analysis allows for meaningful comparison and understanding of relationships between the different parts of a financial statement. Using financial ratios to examine different parts of a business is a quick way to get an overview of financial health. Using financial ratio analysis can help a business understand key areas of business such as debt vs. equity, price vs. earnings, profit areas like margin and return on assets, as well as liability areas like employee and inventory turnover.
Cost volume profit analysis:
This analysis technique helps businesses better under the relationship between sales, costs, and business profit. It examines the fixed cost and variable cost and establishes the relationship between sales and variable cost to help business leaders better plan and project profit.
Benchmarking (industry) analysis:
This is the analysis technique to use to compare your business to a competitor business or to businesses in the industry at large. It can help answer questions like, “Does our business have a competitive advantage? Are there weaknesses or inefficiencies that we can address and close the gap between ourselves and competitors?” The one challenge in this technique is ensuring that competitor or industry data is presented or formulated in the same way that your company compiles and records your financial transactions.
Because of the different things that financial statement analysis can tell you about including profits, liquidity, debt, and which areas of the business generate the most revenue or loss, you will want to choose the financial statement analysis technique that can fit your purposes and help you answer the questions specific to your business. No matter what technique you use to approach financial statement analysis, to get the most comprehensive results, you’ll want to make sure that your financial statements cover more than one reporting period and that the statements have been prepared the same way so that data can be read and analyzed across statements.
Financial analysis is one of the best tools that business leaders and internal stakeholders have in understanding the financial state of the company, as well as understanding their place in the industry.