The complete guide to financial analysis for small business owners

Conducting financial analysis and effectively managing cash flow is a common challenge faced by many small business owners.

According to a survey by the Federation of Small Businesses, 46% of small businesses applied for finance as a way to manage challenges with cash flow, with only a quarter using the same recourse for business expansion.

Having a detailed, up-to-date view of your working capital, debts, and small business expenses is important when making well-informed investment decisions, minimising deficits, and ensuring your business' long-term profitability.

In this guide, we’ll take a more detailed look at what a financial analysis is, how to write a financial analysis, and how to use your financial analysis to ensure greater stability for your business.

What is financial analysis?

A financial analysis is used to assess your business' financial stability, based on data sources such as the business' profit & loss (P&L) statement, cash flow statements, and balance sheet.

When properly analysed, the metrics from these sources help merchants to understand their current financial stability, how any recent projects have affected their cash flow, and the long-term viability of the business.

This distinguishes it from a technical analysis of the financial markets, which is used for publicly-traded companies, examines movements in share price, and is used to help identify viable investment decisions.

Financial analysis is important for giving you a real-time view of your cash flow, as the dynamic nature of managing a business means it’s common for merchants to move through different grades of financial health.

With so much diversity in financial health between UK businesses, creating an effective financial analysis report and closely monitoring your business's cash flow is essential for comparing your performance against competitors with industry benchmarks and staying on-track to reach your long-term business goals.

Why is financial analysis important for small businesses? 

Financial analysis is crucial as it helps you stay informed of your business's day-to-day financial health and the performance of new projects and business opportunities.

This will help you make more informed decisions when determining your small business budget, planning for the future, and ensuring the long-term sustainability of your business model.

Some common small business decisions that should be informed by a small business financial analysis include:

• Pricing strategies: where merchants can determine the optimal price of a product based on cost analysis and profit margins.

• Expansion plans: such as opening a new branch or launching a new product.

• Investment decisions: specifically assessing the potential return on investment (ROI) and discounted cash flow for actions such as outsourcing your small business marketing strategy.

• Risk management: for example evaluating financial risks through a SWOT analysis and supporting your cash flow management by opening new income streams or insuring against crises.

• Hiring decisions: informed by cash flow forecasts and payroll analysis, that will determine the budget for new hires or whether the business needs to downsize to stay profitable.

Through effective financial planning and analysis, you can build a more comprehensive view of your business's financial health, and ensure that any of these key decisions are made based on objective data, rather than assumptions or intuition.

3 main financial analysis reports for small business owners

Your exact approach to financial analysis will depend on the complexity of your business model, and the number of different variables that can affect your key financial metrics.

There are 3 core financial analysis reports that all small business owners should be familiar with:

Profit and loss analysis

Profit and loss financial analysis collates a business' revenues and costs to determine its overall profitability, typically quarterly or as part of your year-end accounts. The key metrics in a profit and loss analysis include: 

• Revenue.

• COGS (cost of goods sold).

• Gross profit (revenue minus COGS).

• Operating expenses.

• Net profit (revenue minus all expenses).

Balance sheet analysis

A balance sheet analysis is used to evaluate a business' financial health at a specific point in time, providing a snapshot view of your business' assets and debts at a particular moment.

For limited companies, balance sheets are also used to show shareholders’ equity, and to help shareholders or potential investors understand the business' capital structure.

A balance sheet analysis’s key metrics include the business' current assets, such as cash and accounts receivable, non-current assets, such as its property and equipment, and liabilities such as short-term expenses and long-term debts.

Cash flow statement analysis

A cash flow statement analysis is used to assess the real movement of cash in and out of a business.

This distinguishes it from a profit and loss statement, which is focused on the business' accounting profit, and not necessarily the movement of cash.

The three metrics of this kind of financial statement analysis are: 

• Operating activities refer to cash generated through your normal business activities. For example, payments to suppliers, payroll expenses and cash paid for business-related taxes, such as VAT or income tax.

• Investing activities which cover cash generated from buying or selling financial assets.

• Financing activities refer to cash generated through issuing debt from small business loans.

Additional types of financial analysis

Aside from these core reports, there are several other approaches to financial analysis that as a merchant you should be aware of in case they apply to your business model and goals.

These additional types of financial analysis include:

Growth analysis

A growth analysis looks at a business' growth trajectory, rather than just its financial performance over a given period.

Depending on the exact aims, a growth analysis might include looking at the growth of revenue year-on-year, your business' market share compared to competitors, or the rate of customer acquisition over a given period.

Profitability analysis

Profitability analysis is used to look at your business' profit margin from different business activities, comparing the cost of goods or services to your revenue.

This can be especially useful for merchants who maintain multiple revenue streams and want to have a more detailed understanding of how each one is impacting their business' financial health.

Operational efficiency analysis

An operational efficiency analysis is used to assess your business' resources, and how efficiently you’ve used them to generate revenue.

This involves comparing the cost of stock, labour, and overhead expenses to the level of activity as part of running a business that’s resulted in generating revenue.

Variance analysis

Variance analysis focuses on comparing the financial results of your business activities with amounts that you’ve forecasted while budgeting, then finding the cause of the gap (variance) between them.

This analysis format is useful for highlighting activities where your spending is going over budget (ie. your small business marketing strategy), or your revenue is falling short of what you’ve forecasted, then taking any necessary corrective steps.

Solvency analysis

Solvency analysis is focused on assessing your business' financial obligations, through the analysis of metrics like your interest coverage ratio (your business' earnings divided by interest obligations) and debt-to-equity ratio.

A solvency analysis helps merchants to stay aware of their business' risk of defaulting on debts, and can inform decisions that will help avoid this scenario.

Liquidity analysis

Liquidity analysis is used to assess your business' ability to pay its short-term debts when due by comparing assets to financial obligations.

The key metrics making up a liquidity analysis include current ratio, which compares any assets that can be used to cover your business’s short-term obligations, and quick ratio, which is more conservative and excludes harder-to-sell assets like your business' inventory.

While a current ratio accounts for all assets that can be used to cover liabilities, quick ratio is more stringent and doesn't allow you to count stock and prepaid expenses as part of your current assets. This is because these assets can't be liquidated into cash quickly, hence the term quick ratio.

Like a solvency analysis, this kind of financial analysis is useful for reducing the risk of defaulting and budgeting for all your financial obligations.

As a small business owner, you should regularly monitor your current ratio and take proactive steps if it drops below 1.0. This might include reducing expenses, improving your cash flow management or seeking professional financial advice to address potential issues before they become irreversible.

Trend analysis and benchmarking

Unlike the other kinds of analysis in this list, trend analysis doesn’t have a specific set of metrics that are considered to be essential, and can be adapted based on the unique requirements of each business.

So, what is trend analysis in financial statement analysis?

Trend analyses are usually combined with both internal and external benchmarking. 

• Internal benchmarking is the process of comparing your business' recent performance with its own historical performance.

• External benchmarking, on the other hand, focuses on market and competitor analysis through methods such as SWOT analysis, allowing you to measure your performance against that of your competitors or industry averages.

Through trend analysis and benchmarking, merchants can better understand their financial health within the context of the wider industry, and determine whether they need to make adjustments to stay competitive.

How to conduct a financial analysis for your business in 5 steps

Now that you understand the role that financial analysis plays for merchants, it’s time to leverage financial analyses’ benefits for your own side hustle or established small business.

Here’s how to perform financial analysis for your business in 5 steps.

Decide on the type of financial analysis you’ll conduct

As different types of financial analysis require you to harvest different datasets, the first step in any financial analysis is to decide which type of analysis you’ll be carrying out.

A good way of deciding which kind of analysis to focus on first is thinking about the specific questions you want to answer about your small business finances.

If you’re aiming for a general overview of your business' financial health, then a simple profitability and break even analysis could give you all you need.

However, if you’re concerned that your business activities are taking you over budget, then a variance analysis may be more appropriate.

The current stage of your business can also be an effective way to determine which kind of financial analysis is going to give you the most value.

If you’re only just becoming your own boss or starting an online business, you’re likely to see value from looking at profitability and cash flow analyses. This is because you may be in a more flexible period of business growth and in a better position to make big adjustments to improve profit.

Larger and more developed businesses (such as a franchise business), on the other hand, may have stabilised their profit margins comfortably and be more interested in fine-tuning processes through an efficiency analysis.

By considering the information you’re trying to gather by carrying out your analysis, and the most pressing needs of your business, you’ll be able to settle on a type of analysis that has the most intrinsic value for your situation as a merchant.

Collect financial statements

Now that you’ve determined the financial analysis format you’re focusing on, you can gather the financial statements with the data you’ll need to carry it out.

The key financial statements you’ll need to organise include:

• Balance sheets.

• Profit and loss statements.

• Cash flow statements.

Assuming you’re going to be looking for both the long-term trends of your small business finances alongside a more up-to-date overview of your business' financial health, it’s important to gather statements covering the longest time frame possible.

If you’re slightly behind on your bookkeeping or you’ve never generated financial statements in the past, you can still use your past data to create up-to-date statements retroactively, by looking at records such as your:

• Bank statements.

• Bills, invoices, and receipts.

• Sales records.

• Tax returns.

If you don’t have financial records covering all the data sets you’ll need to fill your financial statements, you can still make educated estimates.

Just make sure that these estimates are informed by the data you do have, and that you’re highlighting any estimated figures to keep your process as transparent as possible.

Review your statements

With all your financial data organised, you can start to review these statements and calculate the key metrics that are most pertinent to your financial analysis.

Here’s a quick breakdown of the metrics and findings you can draw from each of the key financial statements:

Balance sheet

The outstanding debt your business has compared to its equity, whether your debt has increased or decreased over time, how many short-term assets your business has and how the proportion has changed over time.

Profit and loss statements

The total amount generated by your core business activities (gross revenue), your revenue minus COGS (operating income), and your net profit or loss.

Cash flow statements

Positive and negative net cash flow for all business activities, the difference in cash flow from each income stream, level of operating cash flow, the overall inflow and outflow, and whether this has increased or decreased over time.

Conduct ratio analysis and benchmark comparisons

The next stage in your financial information analysis is to carry out financial accounting ratio analysis.

This allows you to measure your performance against relevant benchmarks, rather than analysing data from a single period through a vertical analysis or observing trends through a horizontal analysis.

The two main phases required when you’re looking into how to do financial ratio analysis are:

Select the most relevant ratios

Depending on the questions you’re hoping to answer through your analysis, you can look at various ratios such as:

• Liquidity ratios (current and quick) which will calculate your business' ability to meet financial obligations.

• Profitability ratios, such as net profit margin and return on equity

• Solvency ratios like debt-to-equity, which gauge your ability to pay long-term debts.

• Efficiency ratios, such as accounts receivable and inventory turnover, which will reveal how efficiently you’re using your resources.

Calculate your ratios

Each of the above ratios has a specific formula that uses different figures from your financial statements.

The net profit margin formula, for example, is:

If you’re unfamiliar with making these calculations yourself, there are many online tools you can use to enter figures from your financial statements and automatically calculate the relevant ratio.

Another effective approach is finding Excel or Google Sheets tutorials that show you how to set up the relevant formulas in a spreadsheet.

This will allow you to enter the data from your financial statements and automatically generate the relevant ratios, while allowing you to observe all your figures from one place rather than jumping from one tool to the next.

Interpret results and act on the insights gathered

Once you’ve assessed your financial statements and calculated the relevant ratios, you’ll have everything you need to carry out the final stage of your financial analysis.

This can be divided into 4 distinct phases:

Interpretation

Look at your financial metrics and calculated ratios in the context of your analysis type, and whether or not they’re indicating strong financial health compared to relevant benchmarks.

Imagine, for example, that your hand-crafted gifts online store has a profit margin of 5%, while the UK average for similar businesses is 10%.

This could indicate an issue with your business' cost efficiency, caused by issues such as overly generous product pricing, or a higher COGS.

Trend identification

Next, look for patterns in your business' financial data that indicate the trajectory of your financial health.

Variables such as whether your profit margin is increasing or decreasing, or if your debt-equity ratio is getting higher or lower. These can be useful indicators to determine if your business is moving in a positive or negative direction.

If, for example, you’re running a bar or restaurant and your current ratio has been decreasing over the past year, this will indicate that you have progressively less liquid cash available to pay off short-term debts.

In this scenario, you may need to delay more non-essential purchases or exercise stricter policies when using business credit to improve your cash flow.

Prediction

Once you’ve identified clear trends, the next step is to use these to make informed decisions about your business' performance in the future.

Using historic cash flow data to create a cash flow forecast, revenue trends to forecast your future sales and seasonal fluctuations, past spending patterns to forecast expenses, are all useful methods to make informed estimates about how your business will perform in the future.

Taking action

Based on your forecasting, you can engage in more effective decision-making.

This will involve allocating resources to your best-performing areas, and planning to address your business' most prominent weaknesses to build healthier financial ratios.

This can take the form of many different projects, such as looking for new sources of small business finance, developing new products, or adjusting your pricing strategy.

By strategising over the next few years based on the findings from your financial analysis, you can maximise the chances of sustainable success for your small business.

Financial analysis best practices for small business owners

Now that you know how to conduct a financial analysis, here are some important best practices to bear in mind in order to make sure your future financial analysis are as effective as possible.

Regularly review your financial statements and reports

Financial analysis isn’t a one-off project. To maintain a thorough understanding of your business' financial health, it’s important to revisit your statements and reports at least quarterly, and check what’s changed since your last analysis.

Regular reviews of your financial statements and reports will empower you to monitor your real-time performance and make informed decisions for the future.

It will also help ensure you can identify any potential issues early, and take preventative measures before financial problems become unmanageable.

Find and use effective accounting software

As a small merchant, you may struggle to find the time for managing your finances alongside all your other responsibilities.

Finding effective small business accounting software can help you automate many tasks involved in financial analysis, removing the need to gather your own data or carry out your own calculations.

The question of how to use AI for financial analysis has become a popular topic since the proliferation of AI business tools in 2023.

Prioritising accounting tools that use AI for financial tasks can help to remove the risk of human error, while making it easier to analyse historical trends and making predictions about your business' future performance.

Just be aware that many AI tools for financial analysis are in the early stages of development, and may make mistakes. It’s always a good idea to check key figures manually before integrating AI-generated results in your reports.

Speak to a financial advisor

Consistently revisiting your financial reports and using effective accounting tools and software to simplify the analytical processes will help you build a clearer picture of your business' financial health.

However, there may still be some terms or concepts that are hard to understand if you don’t have a financial background.

Consulting a financial advisor or accountant about your approach to analysis can provide expert guidance that’s tailored to your unique needs as a business. Helping you learn new approaches to analysis, long-term planning, and risk management.

Financial advisors can also help by auditing your current approach to financial analysis, identifying shortcomings or areas where your analysis could be more thorough, and helping you plan to remedy these issues.

Disclaimer: The contents of this page are intended for informational purposes only and should not be construed as professional advice. For matters requiring legal or financial expertise, it’s recommended to seek guidance from qualified professionals.