Term
Financial analysis
Examining the accounts using liquidity, profitability, leverage and activity ratios. It reveals weak spots before they turn into a cash shortage, and banks run one on every loan application.
Updated
What it means
Financial analysis examines the financial statements and turns the figures in the balance sheet, income statement and cash flow statement into answers: is the company healthy, does it earn enough, can it pay, and where is it heading.
Its basis is ratios in four groups: liquidity, meaning the ability to pay short-term liabilities; profitability of sales and capital, such as ROE; leverage; and activity, such as days sales outstanding or days payable outstanding.
Ratios are complemented by horizontal analysis, following changes over time, and vertical analysis, showing the structure of the statements. Composite models such as the Altman Z-score combine several ratios into one number.
How it works in practice
Banks carry out financial analysis on every loan application and renewal and use it to set creditworthiness and the price of the loan. Before a meeting with the bank we prepare the same ratios for clients so that they know what the bank will see and can explain fluctuations in advance.
A business partner can be analysed from public data too, since companies’ financial statements are in the register of financial statements. Before a large order on long payment terms we therefore check for clients whether the customer is in financial difficulty.
For managing one’s own company it makes most sense to follow the ratios over time and compare them with competitors in the sector, in other words benchmarking. A single number says little on its own; a three to five-year trend says a lot.
What to watch out for
The results depend on accounting choices. A different accounting policy, for example on depreciation, inventory or impairment allowances, changes the ratios without reality changing, so comparing companies requires knowing how they account.
The balance sheet is a snapshot of one day, usually 31 December, and can be affected by seasonality or deliberately timed payments. Analysis based on averages and monthly data is more reliable than one set of annual accounts, especially for seasonal businesses.
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