A common misconception in business is that financial analysis is only for financial analysts. The reality is that all managers should have at least a basic understanding of financial analysis to assess their organizations’ past, current, and future performance.
Business leadership relies on using financial statements to inform decisions and effectively communicate with stakeholders and investors. Here's an overview of what financial analysis is and four skills all managers need.
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Financial analysis is making sense of the numbers associated with a business's finances, which are gleaned from cash flow statements, balance sheets, ratios, income statements, and statements of shareholders’ equity. This data is essential when determining how a business is performing and recommending future improvements.
Types of Financial Analysis
There are many types of financial analysis, but these three methods are the most common:
- Horizontal analysis, also called "trend analysis," compares a business's financial documents to the previous period and evaluates changes over time. It involves determining whether numbers have increased or decreased and why.
- Vertical analysis is an examination of a company's finances that involves analyzing a single column of a financial document to determine how different numbers interact during a specific reporting period.
- Ratio analysis investigates the relationship between different pieces of financial information in the same report. It helps professionals make sense of a company's health and performance.
Individuals should familiarize themselves with each type of analysis to fully understand their organization's financial performance. Otherwise, it's difficult to determine whether a company is struggling or succeeding.
Managers need financial analysis skills to review a company's finances and make informed decisions. Here are four that all managers should learn.
Financial Analysis Skills
1. Reading Financial Statements
Effective leaders need to read and understand fundamental financial documents. The three most important are the balance sheet, income statement, and statement of cash flows.
- Balance sheets communicate a company's worth and list assets, liabilities, and equity for a reporting period. Managers can use this data to understand their business's financial position.
- Income statements, also known as "profit and loss (P&L) statements," summarize a company's income and expenses to demonstrate its performance over a given period.
- Cash flow statements record what happens to a company's cash over an accounting period. They help managers understand how well it can operate in the short- and long-term, given the cash flow it’s experiencing.
Together, these statements provide an account of a company's financial performance. Managers should know how to reference the data in these documents before making any organizational recommendations.
2. Calculating and Understanding Key Ratios
Thoroughly comprehending financial ratios is critical to understanding a company's financial status. Managers should be familiar with the following ratios:
- Profitability ratios: These determine an organization’s profitability and include profit margin; return on assets; return on equity; and earnings before interest, taxes, depreciation, and amortization (EBITDA).
- Liquidity ratios: Liquidity refers to a company's ability to convert assets into cash quickly. Key liquidity ratios include the current ratio and quick ratio.
- Leverage ratios: These calculate a company's dependency on debt to finance its endeavors. Important ratios include total debt to total assets, long-term debt to capitalization, total assets to net worth, and EBIT to interest expense.
- Productivity ratios: Also known as "activity ratios," these reflect how effectively a company uses its assets. Key ratios include asset turnover, inventory turnover, and receivables collection period.
Assessing a company's financial condition with ratio analysis is crucial for managers to learn. When leveraged correctly, comparing and contrasting ratios against previous periods can uncover whether a company is under- or overperforming.
3. Finding Meaning in Numbers
Numbers provide information, not comprehension, because everyone looks at numbers differently. Furthermore, companies across industries have different priorities.
In addition to financial literacy, managers need an in-depth understanding of how numbers should be applied to their businesses. High ratios can be problematic for one company and encouraging for another because financial data and numbers aren’t inherently universal.
To find meaning in your numbers, you must:
- Understand your business: What are your company’s goals? What inventory do you hold? In some cases, inventory value quickly depreciates.
- Compare your numbers to competitors in your industry: The same ratios don’t apply to every industry. For example, service industries don’t have as much inventory as product-based companies, so the ratios are inherently different.
In most cases, return on equity is the most important ratio, but this isn’t always true. Most business success is measured by the value companies provide to shareholders and owners, but managers should be aware, and have a clear understanding, of other possible profit metrics.
4. Thinking Beyond Numbers
Numbers are important but don't tell the entire story. Some of the most valuable company assets can't be assigned a number, such as:
- Brand: A company's brand is one of its most valuable assets, yet it's not reported on a balance sheet. Brand value is typically based on estimates and changes dramatically year over year. Unless your brand is sold to a parent company, it's difficult to calculate its value.
- Word of mouth: Referrals and recommendations are highly valuable because 90 percent of consumers are likely to trust a person’s company recommendation, even if it’s from a stranger. Similar to brand, it's possible to estimate the value of word of mouth, but it isn't reportable on financial statements. This is because it’s difficult to assign return on investment (ROI) to word-of-mouth campaigns.
Managers shouldn’t be discouraged by this. Even though these assets are difficult to report and track on financial statements, they’re still valuable and key factors in your company’s success.
How to Develop Financial Analysis Skills
If you're not yet proficient in finance, try not to get overwhelmed. Financial analysis skills aren’t only attainable but can be mastered with the right tools. Here are three ways you can start developing these skills:
- Conduct research: Researching independently can provide a surface-level understanding of financial concepts. While this doesn’t sufficiently inform you of the financial intricacies needed for decision-making, it's an excellent starting point.
- Learn from others: Consulting with others is an often-overlooked learning method. Reach out to your company’s accountants or finance experts and ask questions. Industry-specific knowledge can be useful when making financial decisions.
- Take a finance course: Taking a course is one of the best ways to obtain demonstrable proficiency in financial analysis. Consider Harvard Business School Online's course Leading with Finance, which can equip you with a comprehensive understanding of financial principles and how to leverage them for your business.
Learning the Skills to Make Financially Viable Decisions
Whether for personal interest or to inform your company's financial decisions, a business finance course can teach valuable financial skills.
If you're already a manager or aspiring to be one, understanding your organization’s financial landscape can take your decision-making abilities to the next level and provide valuable networking opportunities.
Do you want to improve your confidence and knowledge of finance? Explore Leading with Finance, one of our online finance and accounting courses. If you aren't sure which course is the right fit, download our free course flowchart to determine which best aligns with your goals.
