What are the steps to use financial analysis for evaluating business profitability?

In order to get a complete history of financial statements, it’s best to look at the previous 5 years of P&L, BS and Cashflows. This will give us the general trend of profits, assets, liabilities and cash movements. We can then look at various ratios to determine how the next few years will pan out and what we can do to improve all metrics for the business. It’s also vital to look at the SOCE so we can see what changes have occurred in the capital of the company and if any extra money has been raised.

To evaluate business profitability using financial analysis, gather financial statements, calculate key ratios, analyze trends, compare to industry benchmarks, assess liquidity and debt levels, examine cash flow, evaluate ROI, consider non-financial factors, identify strengths and weaknesses, and use the analysis to make informed decisions, while seeking expert advice when needed.

For CXOs, understanding these financial statements is not just a routine task but a strategic necessity. Profitability ratios, such as net profit margin or return on assets (ROA), can be derived from these statements. For instance, if a company has a high ROA, it indicates efficient use of assets to generate profits. These insights can aid in making informed decisions like capital allocation or entering new markets.

For private companies, financial statements may be quite outdated as filing requirements often allow companies to finalize their accounting work several months after the end of the fiscal year. As such, always ask for pro-forma accounts as of the current or previous month and cross-check anything that stands out on the pro-formas versus the filed statements. Additionally, always ask for audited accounts, if available.

To perform a comprehensive financial analysis, it is essential to secure the company’s most recent and accurate financial statements. These statements should cover the income statement (Profit and Loss or P&L statement), the balance sheet, and the cash flow statement. These documents should ideally be sourced directly from the company’s official records or financial reports to ensure data integrity and reliability in the analysis.

Financial ratios can be divided into 4 categories:- 1) Liquidity ratio: This measures a company’s ability to pay short-term debts. 2) Leverage ratio: Measures company’s debt levels and how they compare to its assets and equity. 3) Activity ratio: Measures how efficiently a company is using its resources. 4) Profitability ratio: Measures a company’s ability to generate profits.

Financial ratios play a crucial role in assessing business profitability. Profit margin ratios, like gross, operating, and net profit margins, reveal how efficiently a company converts revenue into profit. Return ratios, such as return on assets, equity, and invested capital, measure the effectiveness of capital utilization. Efficiency ratios, like asset, inventory, and receivables turnovers, indicate how well resources are employed to generate revenue and profit. These metrics collectively provide a comprehensive picture of a business's financial health and performance.

For the C-suite, understanding these ratios is vital for strategic decision-making. For instance, a declining return on assets could indicate that it may not be the best time to invest in new capital-intensive projects. Additionally, monitoring liquidity ratios like the current ratio can provide insights into whether the company has enough resources to meet short-term obligations. These are critical data points for CFOs when considering debt financing or issuing new shares.

When it comes to the P&L, the next ratios to use are: Gross profit margin, net profit margin, cost of sales as a % of turnover, staff costs as a % of turnover, EBITDA margin, and overall profitability or not. For Balance sheet, this is where the fun really happens. We can look at changes in debtor days, creditor days, and look at things like liquidity and working capital. On the cashflow, this also shows changes in investing, financing and operating cash which is another way to look at working capital changes and can determine which aspect of the business is sucking out the most cash.

Financial ratios are crucial for assessing business profitability because they condense complex financial data into easily comparable metrics. They reveal the efficiency, solvency, and growth potential of a company, providing insights into its profitability and overall financial health. By examining ratios like return on assets (ROA), return on equity (ROE), and gross profit margin, analysts gain a quick and accurate snapshot of a business's profitability, aiding in sound decision-making and performance evaluation.

Size of the the company/organization also matters for the benchmarking period. When you evaluate the data collected, usually average ratios of the industry are taken into account and as the big companies' numbers are intense in total industry, small or medium sized companies' data may seem inaccurate.

Companies within the same sector but at different stages of growth will have different benchmarks. However as an average company, one should always see where one sits within the range of all companies when it comes to these metrics, and see how they can improve by emulating their competitors. Benchmarking is a great way not only to improve your own performance, but the sector as a whole as it could mean more growth for the whole sector and higher business valuations.

For CXOs, going beyond basic benchmark comparison to adopting predictive analytics could offer a competitive edge. Understanding seasonality effects, market trends, and consumer behavior can turn these benchmarks into dynamic metrics. For instance, if a retail business knows that its inventory turnover usually drops in Q1, it can plan sales or marketing drives accordingly. Not all benchmarks are universally applicable. For example, a start-up might not fairly be compared with an industry giant, even though they operate in the same sector.

Comparing financial ratios with benchmarks is vital because it provides context for evaluating a company's performance. Benchmarks represent industry standards or peer group averages, allowing for a meaningful assessment of how a company stacks up against its competitors.

In the M&A cycle as part of the due diligence, all these ratios and charts are populated in a data book and each line on the P&L, BS and Cashflow is analysed. Anomalies can be stripped out and earnings can be normalised as a benchmark of performance in any given year. Only by doing these charts and storytelling can we fix any issues and double down on the good things the business may be doing.

For CXOs, integrating predictive analytics with these analysis methods could be a game-changer. For example, applying machine learning models to past financial ratios could potentially forecast future performance, allowing for proactive decision-making. Data-driven approaches can also identify hidden correlations between different financial ratios and external market indicators. Horizontal analysis might not account for seasonality effects, and vertical analysis often ignores the context of market conditions.

Thinking about context is so important when interpreting and communicating results from financial analyses. Without an understanding and consideration of the context, the results of your financial analysis can contribute to wrong decisions

This part is the most crucial as all parties need to be involved and on the same page, singing from the same hymn. This is where powerful visual tools can explain things in a simple manner so all non-finance people can understand. Tableau, PowerBi, Excel and PowerPoint should be used for maximum impact.

For CXOs, it may be beneficial to incorporate interactive dashboards that can be updated in real-time, especially for internal managerial purposes. This allows for dynamic decision-making based on the most current data. For external stakeholders like investors, augmented reality (AR) presentations could make the data more engaging and easier to understand.

Interpreting and communicating financial ratio results is essential because it translates complex financial data into actionable insights. It enables stakeholders to understand a company's financial health, profitability, and performance. Effective communication fosters informed decision-making, supports strategic planning, and builds trust with investors, lenders, and internal teams.

Objective of financial analysis is to achieve Operational Excellence. Simple meaning of Op Excellence is to make the most of your available resources. Capturing business processes leads to Digitization. Digitization leads to Quality Data. Quality Data leads to Analysis. Analysis leads to Decision Making. Decision Making leads to Operational Excellence.

When doing your analysis you will bump into certain values that hold “the key” Identifying them comes with experience, but dont be afraid to go deep into the accounting and ask questions. Almost anybody can do the analysis, but if you know where it is coming from and take your time to understand the why, it is the difference. This is specially so if you are a consultant.

The biggest mistake people make when they analyze projections is that they don't understand the "how" and the "why" things will happen. Financial projections state "what" management thinks will happen. In the absence of context though, it has no meaning at all. Ask your self: "How are they going to make this happen? Why should I believe this is possible?" This will take you a step further and really help you develop insight into the business you're attempting to understand.

Financial Projections are essential to understand the potential future performance of the company being analyzed. Don't just look at current financial statements but use them to formulate a view on the future financial viability of the company by making industry-standard assumptions in terms of key value drivers such as revenues and costs, and calculate the present value of free cash flows generated by the company.