Financial analysis: What is it?
Entrepreneurs – regardless of whether the business is small, medium or large – are dependent on evaluations of their business activities. For these kinds of evaluations, key figures must be set in relation to each other and a lot of different information must be collected. A financial analysis gives an overview of the current economic situation of the company. Many businesses have the report prepared by professionals, and then are faced with the question: How do I interpret the information? Others prefer to prepare the financial analysis themselves, and then need an answer to the question: How can I create a financial analysis myself?
Financial analysis: An explanation of what it is
A financial analysis is a financial accounting tool. The report bundles figures on the revenues and costs of a company. Since the financial analysis is usually prepared once a month, the evaluation provides insight into the current financial accounting. This is a voluntary report for all companies required to keep accounts.
A financial analysis is a report that presents the current economic situation of a company – on the basis of figures from the accounting department. Larger companies usually have a more comprehensive reporting system, but can benefit from this form, too. Freelancers may not have the available data to create these assessments.
Many CEOs hand over creating a financial analysis to their tax consultant. The tax consultant then prepares a monthly evaluation. But even if you create the financial analysis yourself, a monthly cycle is recommended. In this way you can see the current expenditures and proceed promptly and have an overview of the economic efficiency of your own enterprise – and not only with the annual accounts. In addition, many lenders regularly demand an economic evaluation in order to be able to better assess a company and its economic situation. For the same reason, investors are also often interested in the financial analysis.
The basis of the financial analysis is the profit and loss account (P&L) and its contents. Financial analysis therefore includes all sales revenues, other income, and expenses. As a result, decision-makers of the company and external financiers have a detailed insight into the economic performance of the business. To ensure that financial analysis also presents developments, it makes sense to include the previous year’s figures. Changes can be recognized directly at a glance.
The way a financial analysis works
The financial analysis only contains information that can be found in an income statement. At the top of the list are sales revenues, capitalized own work (for example, if the company itself has developed software that is used in the company), and changes in inventories. The total is then the total output. The material usage or the purchase of goods is deducted from this total. The result is the gross profit.
The gross profit indicates how much the company earned after deducting the cost of materials or goods purchased for all products sold. In order to obtain the correct gross profit, inventory changes must also be taken into account. If the inventory increases, this means that more was produced than sold. Expenses have therefore been incurred for products for which sales have not yet been generated. A stock increase must therefore be added when the gross profit is calculated. In this way, the material or goods usage incurred for products that have not yet been sold is neutralized. A reduction in stock must be deducted accordingly.
All operating expenses (= total costs) are deducted from gross profit. Operating expenses include, for example, personnel costs, occupancy costs, and taxes. The result is the EBIT or operating result. Neither taxes nor interest are taken into account.
Finally, interest expenses are deducted from the operating result and interest income is added. In the next step, you deduct the taxes from the pre-tax profit calculated in this way and obtain the preliminary result.
The ratio of personnel costs allows conclusions to be drawn about the productivity of employees. The personnel costs are equated with 100% and compared with the total performance. Example: With personnel costs of $100,000 (= 100%), a total output of $150,000 (= 150%) is achieved.
The values from the financial analysis can be visualized in various diagrams. The quotients are displayed in pie or ring diagrams, the temporal development is best seen in line diagrams. The visualization helps, above all, uninformed third parties to quickly grasp the economic situation of the respective company.
Creating a financial analysis
If the accounting has been outsourced to a tax consultant, the latter normally also takes over managing a financial analysis, and will send management a corresponding report once a month. However, it is also possible to create your own financial analysis. This can be done either with accounting software or a well-maintained Excel file. These tools then also allow visualization in the form of diagrams and graphs.
You would like to create a financial analysis for free? Read our simple instructions and create a financial analysis with Excel.
How do you read a financial analysis? An example
The complexity of a financial analysis varies a lot. Some are simple and straightforward to read, but others are incredibly complex, with lots of different figures which may seem daunting to the untrained eye. Here is a straightforward example, to help you get to grips with the concept:
| Year 1 | Year 2 | |
|---|---|---|
| Sales | $350,000 | $500,000 |
| COGS | $120,000 | $200,000 |
| Gross profit | $230,000 | $300,000 |
| Salaries | $50,000 | $50,000 |
| Space rental | $35,000 | $40,000 |
| Utilities | $7,000 | $7,000 |
| Other expenses | $6,000 | $8,000 |
| Total expenses | $98,000 | $105,000 |
| Net income | $132,000 | $195,000 |
This financial analysis has not included taxes, because the taxes which apply vary so greatly from state to state. Sales tax, income tax, and so on can be added into outgoing costs to give you a real net income value.
Having lots of numbers in front of you can be daunting. It is often enough to concentrate on a few key features, however:
- Sales: The revenue that the company generates is the most important factor in terms of profit. To increase profit, either sales must increase or costs must decrease. What does COGS mean? This is quite simple: it simply stands for “Cost Of Goods Sold.”
- Total expenses: In addition to sales, total expenses also include changes in outgoing costs.
- Gross profit: In operating gross profit, sales are adjusted for the cost of sales and other revenues are added. It represents the gross margin of the company.
- Total expenses: Total expenses include all operational items that reduce profits. However, this subtotal does not yet include interest and taxes. This result, also known as EBIT, gives an impression of the company’s profit without including the financing strategy or tax burdens.
- Earnings before taxes: The above example does not include information for taxes, so bear these in mind as you create your financial analysis.
In addition, there are the previous year’s figures which show the management in the above example financial analysis that the company was able to record higher sales with slightly higher costs.
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