Financial Statement Analysis

1. Actual vs. Planned Performance

You did considerable business planning before you started your business (and you likely updated it for the banks, investors, or suppliers), complete with pro forma financial statements (no matter how crude). So, after your business is operating, you will need to compare your actual performance (from your financial statements) against your planned performance (from your pro forma financial statements).

This financial statement analysis should be performed line item by line item. If you had fewer sales than planned…you should know or find out why. If any costs were greater than planned…again, you should know or find out why. Ever dollar received, and every dollar spent shows up on your financial statements, and every dollar that is different than you planned should be analyzed. This could be a good thing as you may need to change your planning. This is where it becomes important to have an advisory group where you can bounce information, and ideas, around.

2. Trend Analysis

By comparing current financial statements to previous financial statements you can see which areas of your business have changed, and by how much. Then you need to determine why the change occurred, whether positive or negative. Are sales trending up? Are costs trending down (which ones aren’t)? Are profits trending up? Is your cash flow improving? These are the types of things you will want to look at in your financial statement analysis.

Like the performance analysis, you need to analyze you financial statements line item by line item to determine trends…and don't be afraid to change your planning if you see a new trend emerging.

• Balance Sheet Ratios.
  Balance Sheet ratios typically measure the strength of your business, using the following formulas:



• Current Ratio — This is one of the most widely used tests of financial strength, and is calculated by dividing Current Assets by Current Liabilities. This ratio is used to determine if your business is likely to be able to pay its bills. Obviously, a minimum acceptable ratio would be 1:1; otherwise your company would not be expected to pay its bills on time. A ratio of 2:1 is much more acceptable, and the higher, the better.


• Quick Ratio — This is sometimes called the “acid test” ratio because it concentrates on only the more liquid assets of your business. It is calculated by dividing the sum of Cash and Receivables by Current Liabilities. It excludes inventories or any other current asset that might have questionable liquidity. Depending on your history for collecting receivables, a satisfactory ratio is 1:1.


• Working Capital — Bankers especially, watch this calculation very closely as it deals more with cash flow than just a simple ratio. Working Capital equals Current Assets minus Current Liabilities. Quite often your banker will tie your loan approval amount to a minimum Working Capital requirement.


• Inventory Turnover Ratio — Not every business has an inventory that needs to be of concern, and if that is your situation you can ignore this ratio. If you are concerned about your inventory, then you definitely should watch this ratio carefully when comparing it to industry guidelines. This ratio tells you if your inventory is turning over fast enough, and is calculated by dividing Net Sales by your average Inventory (at cost).


• Leverage Ratio — This is another of the analyses used by bankers to determine if your business is credit worthy. It basically shows the extent your business relies on debt to keep operating and is calculated by dividing Total Liabilities by Net Worth (total assets minus total liabilities). Obviously, the higher the ratio is, the more risky it becomes to extend credit to your business. This is often the calculation a supplier to your business will make before extending credit to you.


• P&L Ratios
  Profit and Loss (P&L) financial statements also have some important ratio calculations for your financial statement analysis:


• Gross Profit Ratio — This is the most common calculation on your P&L—it is simply your Gross Profit divided by Net Sales. Often, different industries will have standard guidelines that you can compare your business’s numbers to. It is also desirable to watch your trends and not let this number move too far from your target.


• Net Profit Ratio — This calculation is simply Net Pre-tax Profit divided by Net Sales. Other than wanting this number to be as large as possible, I usually don’t pay too much attention to it because it includes too many non-operating costs (depreciation, amortization, etc.) to be of any real analysis value. (Your banker may be interested however.)


• Management Ratios.
  There are a couple of other ratios that interested outside parties will want to analyze:


• Return on Assets — This is calculated by dividing Net Pre-tax Profit by Total Assets. The ratio is supposed to indicate how efficiently you are utilizing your assets. To me this is a useless analysis for helping you run your business, however, bankers and investors will always calculate this ratio if you don’t.


• Return on Investment (ROI) — To a bank or investor this is the most important ratio of all. It is supposed to tell you—the business owner—if you are investing your time, and money, properly, or should you just liquidate your business and put the money into a savings account. This, of course, is pure bull…concocted by non-entrepreneurs and academics who have no idea what it means to be an entrepreneur.

  Having said that, I do realize it can be of some value to a banker or investor—they likely want to know if they could make a better return on their money by investing or loaning it to someone other than you. So, for that purpose, it can be valuable…to them. To calculate your Return on Investment, divide your Net Pre-tax Profit by your Net Worth (total assets minus total liabilities).

This is only a general guide to a simple financial statement analysis. Your business should be small enough at this early stage that it doesn’t require much more complex analyses. Should you need more, you can always use your accountant or a member of your advisory group for assistance with more in depth financial statement analysis.

The next thing you should consider, regarding your financial statements, is the auditing process, because your banker or investor(s) will likely require that. You can access the report on Auditing Financial Statements here.