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The Fundamentals of Financial Analysis

Running a business successfully requires agile decision-making based on the right data. This is a skill that small business owners need to master pretty quickly. Being able to collect, analyse and interpret financial data can illuminate a path to success. Without learning these skills, your operational strategy will always be a roll of the dice, no matter how great you are at what you do.

This is the essence of financial analysis. While gut instinct may play a part in business decision-making, it needs to be backed by data. But what kind of data?  

Let’s start at the very beginning...

What is financial analysis?

Financial analysis is the collection, analysis and interpretation of historical financial data to influence business decisions. It is crucial for business owners in making operational decisions. However, it is also very important for investors. Before investing in a company, external investors will look at historical and projected cash flow, profitability and potential risk factors. 

The primary source of data for financial analysis is a company’s financial statements. From these, analysts (whether internal or external) can predict trends, determine ratios and compare the company’s financial health with that of its competitors. 

What are the fundamentals of financial analysis? 

We’ve looked at the function and importance of financial analysis, and where the data comes from. But what do internal and external financial analysts look at when determining the health of a company? Some of the fundamentals include the following:

Revenue

Revenue is the clay from which profits are sculpted. Revenue tracks how much money is coming into the company, when it’s coming in, and the quality of that revenue (i.e. how predictable and diverse it is). 

Revenue can also be a vanity metric. A business can have a lot of money coming in yet still be in poor financial health, which brings us to...

Profit margin

There are many key performance indicators in financial analysis. But profit margin is arguably the “one metric to rule them all”. Financial analysts will track:

  • Gross profit margins

  • Net profit margins

  • Operating profit margins

Of course, a business can still be healthy and have modest profit margins, especially if it's investing heavily in its own growth. Amazon is a prime example of this. 

Solvency

A company’s solvency (or capital efficiency) is its ability to pay its operational debts. This is measured by two metrics. First, the company’s debt-to-equity ratio is used to gauge the company’s leverage. Second, there’s the return on equity. This is how much return investors generate from your business. 

Liquidity

Liquidity is very similar to solvency. It’s your ability to cover short-term obligations and maintain healthy cash flow. Even if your revenue and profits are high, your business cannot be considered financially healthy if it has poor cash flow. As well as assessing your assets-to-liability ratio, your ability to pay interest expense from the cash you generate should also be considered. 

Operational efficiency

Finally, your business's operational efficiency also needs to be measured as part of a comprehensive financial analysis. This demonstrates how well you’re using the resources at your disposal. Poor operational efficiency can bottleneck or even hobble growth and profitability.

Operational efficiency is measured by tracking inventory and accounts receivable turnover. 

We can help

If you’re interested in finding out more about financial analysis, Key Performance Indicators and other aspects of business finance then get in touch with our financial experts. Find out how GoCardless can help you with ad hoc payments or recurring payments.

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