Financial Analysis: A Simple Overview for Small Businesses
There’s a possible link between business owners actively monitoring their company’s financial health and its success.
A study by the Federal Reserve Bank of Chicago found that 78% of companies with above-average financial health and 92% of those with excellent financial health had an annual income of at least $1 million. Among companies with excellent financial health, 50% were earning more than $10 million yearly.
Meanwhile, 70% of businesses with below-average financial health and 88% of those with poor financial health had annual revenues below $1 million. Of the latter, 40% had less than $100,000 in revenues.
Business owners need to monitor and examine their finances regularly to have an accurate view of the stability and profitability of the company. Conducting a financial analysis allows owners to get a bird’s-eye view of the business’s financial status.
This article discusses the basics of financial analysis, the key elements involved, and why it’s important for a business.
The Purpose of Financial Analysis
Financial analysis helps business owners and managers make smart decisions or review historical trends based on past successes. An internal financial analysis informs you of whether your business is stable and profitable. An external one helps an investor choose the best investment opportunities.
Financial analysis can also determine:
- If a business or an asset is solvent – This means a business has more assets than liabilities. An example of this is a company that’s making a profit and has enough money to pay its debts.
- If a business or asset is liquid – You may easily convert a business or asset into cash. Money is considered a liquid asset, whether it’s in a savings account or on hand. Meanwhile, cars or real estate are not considered liquid because they are not easily convertible to cash without losing their value.
In short, a financial analysis may be used to test the profitability and financial health of assets or businesses. A good financial analysis allows owners or managers to answer all the questions about a company’s financial standing and provide a reliable foundation for future strategies.
The Key Elements of Financial Analysis
Accurate financial statements are the key to a reliable financial analysis. These statements provide information that can be used to analyze a business’s financial standing.
Financial statements needed for analysis may vary according to purpose, industry, or asset type. We’ll cover three important statements that are suitable for a variety of business purposes.
1. Income Statement
An income statement illustrates the net income or net loss of a business. It reports the financial performance over a chosen period to highlight a company’s profitability. An income statement can also help predict future performance and cash flow.
An income statement may include:
- Gross Profit Margin – A percentage of the revenue minus the cost of goods sold.
How to calculate: Divide earnings by revenue
- Net Profit Margin – The percentage of revenue minus the expenses from sales.
How to calculate: Divide the net profit by the revenue.
- Operating Profit Margin – The remaining revenue after operations costs and the cost of goods sold.
How to calculate: Divide the operating profit by the revenue.
- Revenue Growth – Growth percentage of a given period.
How to calculate: Subtract your last period’s revenue from the current period’s revenue and divide the subtotal by the previous revenue.
- Revenue Concentration – An assessment of which clients generate the most revenue.
How to calculate: Divide the revenue from one client by your total revenue.
- Revenue Per Employee – An assessment of the business’ productivity and required employees.
How to calculate: Divide the revenue by the number of current employees.
2. Balance Sheet
A balance sheet provides detailed information about a business or a company’s assets, liabilities, and shareholders’ equity. Analyzing the balance sheet helps indicate how well the business is using its capital. If the company borrowed money, balance sheets could show whether borrowing that money is justified.
The balance sheet adheres to the following accounting equation:
Assets = Liabilities + Shareholder’s Equity
To pay for all that it owns (assets), a business may borrow money (liabilities) or take the amount from investors (issuing shareholder’ equity). Both sides of the equation must balance themselves out.
For example, if your business took a $5,000 loan from the bank to buy equipment, your assets will increase by $5,000, and your liabilities will also increase by $5,000. This balances both sides.
$5,000 (Asset) = $5,000 (Liabilities) + 0 (Shareholder’s Equity)
If you borrowed half of the $5,000 from the bank and half was given by investors, your asset side would increase by $5,000, your liabilities by $2,500, and shareholder’s equity by $2,500.
$5,000 (Asset) = $2,500 (Liabilities) + $2,500 (Shareholder’s Equity)
If the statement shows an unbalanced equation, it’s a good reason to investigate. There are several reasons this could happen, like misplaced data or omitted transactions.
3. Cash Flow Statement A cash flow statement summarizes the amount of cash entering and leaving a business. It also measures how well a business or company manages its cash positions. It translates to how well the business generates cash to pay its debt obligations and fund operating expenses.
A cash flow statement includes:
- Inventory Turnover: This is how many times the company sold its inventory (in dollar amount) over the past year. Divide the cost of goods sold by the average inventory.
- Accounts Receivable Days: This is how efficiently the company used its assets. Divide the net value of credit sales by the average accounts receivable.
- Total Asset Turnover: This is the business’s ability to generate sales from assets. Divide your annual sales by total assets.
- Net Asset Turnover: This is the value of your sales compared to the asset’s value. Divide sales during a period by total asset value in the same period.
The Need to Understand Financial Analysis
Business analytics company CB Insights cites cash problems and the lack of investor interest as some of the main causes of business failures. Possible cash problems can be detected through proper financial analysis, while having a solid, detailed report can help convince investors to take an interest in your business.
There is more to financial analysis than what is provided in this article. However, the information here should help you understand and do a quick review of an analysis report or provide meaningful insights to your finance team.
For a growing business, it might be difficult for you or your team to keep up with the financial aspects of your company, especially if other important issues require your attention.
Quadrant Advisory offers bookkeeping and accounting management services for businesses like yours. We help you focus on your company’s core product while enabling your growth.