How to perform a financial analysis

Financial analysis is the key to making informed strategic decisions and managing your business proactively. Here’s what you should know about it, including what it involves, why it matters, and how some common techniques work. 

We’ll also provide a step-by-step framework you can use to keep the process organized.

What is financial analysis? And why it matters

Financial analysis is the practice of studying a business’s financial information to better understand the strength of its position, performance, or potential. In addition to reviewing historical records, it often involves techniques like:

• Calculating ratios between key line items
• Identifying and interpreting long-term trends
• Estimating future outcomes under various assumptions
• Comparing results against competitor or industry benchmarks

These processes help transform a company’s raw financial data into actionable insights that can be valuable for both internal and external stakeholders.

Internally, founders and managers primarily engage in financial analysis to inform strategic decision-making. For example, you may use it to determine whether your business can support new hires or identify underperforming product lines.

When analysis becomes a regular part of your financial management, it can also help you become more proactive. Instead of reacting to potential disruptions as they emerge, you can begin to anticipate them and implement solutions in advance.

Meanwhile, external stakeholders typically engage in financial analysis before they work with you. For example, creating a financial analysis report is a large part of the due diligence lenders and investors conduct before offering capital.

Key financial statements used in analysis

Financial analysis primarily revolves around three core financial statements, each of which summarizes a different aspect of a company's finances. These include:

• Balance sheet: Also known as the statement of financial position, this details a company’s assets, liabilities, and equity at a specific point in time. Analysis usually reveals insights into financial stability, liquidity, leverage, and efficiency.
• Income statement: Commonly referred to as the profit and loss statement (P&L), this breaks down a business’s revenue, expenses, gains, and losses over a period. Analysis usually provides insight into the subject’s profitability.
• Cash flow statement: This financial report explains your company’s cash inflows and outflows from operating, investing, and financing activities. Cash flow analysis helps you gain insight into your liquidity on a more granular level.

Historical versions of these documents are the typical starting point for financial analysis. Reviewing them can help you understand where your business stands today and exactly how it got there. 

However, forward-looking versions of these statements are often more valuable for guiding future decisions. 

For example, financial forecasts estimate what will happen if current trends continue. They’re often used in combination with financial projections—which estimate what will happen under hypothetical conditions—to evaluate potential strategic adjustments.

For more insight into the specifics of financial statement analysis, you can read our article, How to Analyze Financial Statements.

Common financial analysis methods and techniques

Financial analysis is a broad term that encompasses a variety of techniques, each designed to extract different types of insights. Here are some of the most important methods to be aware of and how they work:

• Benchmarking: Benchmarking compares your financial metrics against competitor or industry averages. It provides context for performance and highlights areas of relative strength or weakness.
• Vertical analysis: This involves expressing each line item as a percentage of a base figure, such as revenue or total assets. This makes it easier to compare financial statement results across periods or companies of different sizes.
• Horizontal analysis: Horizontal analysis evaluates changes in financial data over time. By comparing year-over-year or period-over-period results, it helps you identify trends in areas like revenue, costs, and runway.
• Financial modeling: Financial modeling involves building a numerical representation of your business based on historical financial results. These models allow you to project future performance, financial position, and cash flows under specific assumptions.
• Scenario analysis: This involves adjusting multiple independent variables in your financial models, often to estimate base-case, best-case, and worst-case scenarios. For example, you might use it to project your financial performance if market trends remain constant, improve, or worsen.
• Sensitivity analysis: Sensitivity analysis tests how sensitive your financial model is to changes in a single independent variable. It can help you identify your unique key performance indicators (KPIs) and model the impact of strategic decisions, like pricing changes.
• Ratio analysis: This involves comparing the ratios between related line items, providing a pulse check on specific aspects of your financial health. For example, the current ratio compares current assets to current liabilities, revealing whether your short-term assets are enough to cover your short-term debts.

Essential financial ratios and metrics

Financial ratios and metrics can be very efficient tools for financial analysis. By highlighting relationships between key line items, they make it easy to evaluate your strengths and weaknesses at a glance.

However, there are so many ratios that it can be hard to know which matter most for your business. To help you get started, here’s an overview of the primary categories and some important metrics from each one:

• Liquidity ratios: These measure your company’s ability to meet its short-term obligations. The primary example is the current ratio, which compares current assets to current liabilities. Another example is the quick ratio, which takes a more conservative view by excluding less liquid current assets, like inventory.
• Solvency ratios: Solvency ratios assess your company’s ability to meet its long-term obligations. One of the main examples is the debt-to-asset ratio, which compares total debts to total assets, like an expanded version of the quick ratio. Another is the interest coverage ratio, which divides earnings before interest and taxes (EBIT) by interest expense to show how easily it covers borrowing costs.
• Profitability ratios: These evaluate how efficiently your business generates profit through its operations. For example, gross profit margin shows how much revenue remains after the cost of sales. Meanwhile, net profit margin reflects overall profitability after all expenses by comparing net income to revenue.
• Efficiency ratios: Efficiency ratios measure how well your business uses its assets. Notable examples include accounts receivable turnover, which measures how long it takes you to collect from customers, and inventory turnover, which shows how often you sell and replace your inventory.

Step-by-step process for performing financial analysis

A financial analysis framework is essential for keeping the process organized and repeatable. Here’s a step-by-step approach you can implement in your business:

1. Define your goals and scope: Start by clarifying what you want to learn from the analysis, such as evaluating profitability or planning for future cash needs. This helps inform which metrics and techniques deserve the most attention.
2. Gather and prepare financial data: Collect historical income statements, balance sheets, and cash flow statements. Review them for accuracy and completeness so your financial planning is based on reliable inputs.
3. Perform ratio analysis: Use liquidity, solvency, efficiency, and profitability analysis ratios to evaluate your company’s finances. This provides an initial overview of strengths, weaknesses, risks, and opportunities.
4. Analyze trends and benchmarks: Apply horizontal and vertical analysis to identify trends and KPIs. Then, compare them to competitor or industry benchmarks to gain context for your results.
5. Build a financial model and test assumptions: Create a financial model to project your performance, position, and cash flows. Use scenario and sensitivity analysis to understand how changes in key assumptions could affect outcomes.
6. Interpret findings and incorporate insights into strategy: Translate your ultimate results into key takeaways and actionable next steps that tie back to your original goals.

Financial analysis software and tools

Many businesses perform financial analysis in spreadsheets at first, especially when operations are straightforward and transaction volume is manageable. These tools are readily available and capable of supporting many different techniques.

However, spreadsheet-based data analysis becomes harder to maintain as your business grows. At a certain point, manually updating formulas and keeping financial models in sync can balloon into a full-time job.

This is when a dedicated financial analysis tool becomes a more efficient solution. These platforms connect directly to accounting systems and automate much of the underlying work, freeing your financial analysts to focus on interpreting the results.

Zeni can help streamline your financial analysis in many ways, starting with automated bookkeeping. When your financial reporting is continuously updated, your financial models will always have accurate, real-time data to work with.

Our AI-powered CFO agent takes things to the next level, reducing complex analytical techniques to just a few keystrokes. 

Instead of manually adjusting spreadsheets, you can ask questions like, “What happens to cash flow if operating expenses increase by 8%?” and receive instant insights.

In addition, all Zeni subscribers gain access to our full suite of financial tools, including bill payment and employee reimbursement software. Schedule a demo today to see how Zeni can enhance your financial analysis.