Financial statement analysis is, of course, the underlying purpose of preparing financial statements. Everyone who looks at your financial statements will be automatically performing some form of analysis.
Your banker will quickly analyze them to determine your capability for paying back a loan.
Your investor(s) will always perform a financial statement analysis to determine if your business is a good investment, or whether you have been performing according to plan.
Your suppliers will analyze your financial statements to determine your credit worthiness—and so on.
To see a typical financial statement analysis you may want to check out my book, Small Business Financial Statements: What They Are, How to Understand Them, and How to Use Them. For more information--click here.
The important thing to remember is: everyone who looks at your financial statements will conduct a financial statement analysis, in one form or another. That is why your statements need to be as accurate and truthful as possible.
You, as well as your business, will be judged according to your financial statements.
But the most important aspect of financial statement analysis is the analysis you perform yourself.
There are three major analyses you need to make. There are many
others as well, but we’ll stick to the three major ones here, as
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 current 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 what you planned should be analyzed. This is extremely important since you may need to change your planning.
This is where an advisory group becomes important, as it gives you a place where you can discuss information, ideas, and possible changes in your planning.
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:
These are the types of things you will want to look at in your financial statement analysis of trends.
Like the prior "performance analysis", you need to analyze your 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.
3. Industry Comparisons
This analysis is not only a comparison of your business’s performance to others in your industry, but also to standards set by your banker, your investor(s), your advisory group, or even yourself.
These comparisons are usually made in the form of financial “ratios.”
Here are a few of the more common financial ratio analyses:
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. This ratio tells you if your inventory is turning over fast enough, and is calculated by dividing Net Sales by your average Inventory.
If you are concerned about your inventory, then you definitely should watch this ratio carefully when comparing it to industry guidelines.
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.
This ratio 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.
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.
EBITDA — This analysis is of the "Earnings Before Interest, Taxes, Depreciation, and Amortization" (EBITDA). This ratio is calculated by dividing EBITDA by Net Sales, and indicates how well the business is actually "operating," without the inclusion of non-operating costs.
This ratio should be looked at as one of the most important ratios of your business operations.
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 usually includes too many non-operating costs (depreciation, amortization, etc.) to be of any real analysis value. (Your banker may be interested however.)
There are a couple of other ratios that interested outside parties may want to analyze:
Return on Assets — This is calculated by dividing Net Pre-tax Profit by Total Assets. This 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) — This ratio is supposed to tell you 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. This ratio rarely helps you better run your business.
Having said that, I do realize this ratio is of considerable value to a banker or investor—they certainly 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).
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Don’t worry about needing to learn all the technicalities of financial statement analysis. There are many sources of expert help, including your accountant, a member of your advisory group, or one of your industry organizations.
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.
For more detailed information about financial statements, and an example of how a financial statement analysis is conducted, you may want to check out my book, Small Business Financial Statements: What They Are, How to Understand Them, and How to Use Them. For more information--click here.
The next thing you should consider, regarding your financial statements, is the auditing process, because your banker or investor(s) my very well require some sort of financial Audit from time to time. You can access the report on Auditing Financial Statements here.
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