Most small to medium-sized companies are owned and run by business leaders who are highly skilled in some key aspect of their business - such as technology, sales, or manufacturing - but are less savvy in financial matters. Financial performance measures are essential because they indicate whether a company's strategy, implementation, and execution are contributing to bottom-line results.
Whether it is your company's number one goal or not, the notion of turning a profit is sure to be in your top five short and long-term objectives. The only way to know if you are achieving your financial goals is to regularly assess your business. Are things running smoothly? If not, where are the bottlenecks? What parts of the business are acting as growth catalysts? Many of these questions can be answered by reviewing regular financial reports.
The Federal Reserve Bank of Chicago released a study on Small Business Financial Health Analysis revealing that business owners who have a higher level of knowledge about business finance tend to have companies with greater revenue and profits, as well as more long-term success. Business leaders who want to improve their financial literacy can begin by reviewing the key information contained in the financial reports from their business.
Using Financial Statements for Business Assessments
Preparing your company's financial statements is not only a good business practice, but it may also be required by law if you are a publicly-traded entity. These financial reports give you and others an overview of the financial health of the business by looking at income & expenses, assets & liabilities, and cash flow.
The Income Statement
Your company's income statement may also be referred to as its profit and loss statement. This is a report that measures your company's profitability over a certain period such as a month, quarter, or year. The income statement is produced using a step-by-step process that begins with the revenue that your business earned during the selected period. From that, your company’s expenses are subtracted, resulting in the profit or loss for the designated period.
Statement of Retained Earnings
Your company's "retained earnings" is the portion of net income that it doesn't distribute among its shareholders, but rather retains in the business for future use such as growth or servicing debt obligations. The statement begins with the balance of the retained earnings from the prior period. Then, you add the new income (or subtract the net loss), and then deduct any dividends being declared during the current period. The ending figure is the new number for retained earnings, which will be reflected on the balance sheet.
The Balance Sheet
The balance sheet, also referred to as the Statement of Financial Position, can allow you and others to assess the liquidity, solvency, and capital structure of the business. This report has three sections: assets, liabilities, and owner's equity. These figures show the position of the company on a specific date, usually the end of a quarter or year.
Both current and non-current assets are listed, this includes cash, accounts receivables, inventories, prepaid expenses, equipment, land, and investments. Liabilities are also included. These are anything that the company owes, shown as current and long-term debts. The Owner's Equity section refers to business' obligations to its owners and is often used in the case of sole proprietorships and partnerships. Otherwise, you may see the term "shareholder equity."
Statement of Cash Flows
The statement of cash flows (SCF) is a vital statement that illustrates the specifics of a company's cash flows for a stated period. It reveals how much a business both receives and pays as well as shows the sources of revenue and how cash is disbursed. The report is organized into three sections - operating, investing, and financing - to illustrate the efficient use of a company's resources.
When you review your statement of cash flows, you receive a comparison of two time periods to gauge how cash flow management has changed in the various areas over time. This gives business leaders a comprehensive picture of both the cash position of the firm and its progress from the last period.
The Role of Ratio Analysis in Assessing a Business
Ratios break down a company's financial statements into a mathematical blueprint that discloses key relationships. The formulas used for these ratios can be used to determine how a company is operating relative to its expenditures, cash flow, and industry.
While "financial ratio analysis" may sound complicated on its surface, most of these ratios are simple calculations that will provide you with a useful way to view your business. Some view these as "batting averages for your business" because they are akin to productivity measures in different aspects of your company's operations.
Revenue Ratios
If you're like most companies, revenue is your main source of cash. The volume, timing, and quality of your business' revenues can play a role in its short and long-term success.
- Revenue Growth. (Revenue this Period, less Revenue last Period) / Revenue last Period. You may or may not want to exclude large, one-time revenues, from this calculation as these can produce a distortion in your analysis.
- Revenue per Employee. (Revenue / Average Number of Company Employees). This is a revenue productivity measure for your business, so a higher ratio is more favorable. Some successful tech companies, such as Apple and Google, are producing more than $1 million in revenue per employee each year.
- Revenue Concentration. (Revenue from Client “X”/ Total Revenue). The quality of your revenue is based on how well it is diversified. If one client is responsible for revenue concentrations that are more than 10 percent of your revenue, you may be risking financial difficulty should you lose that business.
Profit Ratios
Revenue is important, but your company's bottom line results are the real determinant of whether or not you will be able to keep your doors open and facilitate growth. These profit ratios can help you measure those results.
- Gross Profit Margin. (Revenues, less Costs of Goods Sold) / Revenues. This ratio indicates how efficiently your business creates your product or provides a service to generate profit. A higher margin is better, and you can use this ratio to compare businesses within the same industry.
- Operating Profit Margin. (Revenues, less Cost of Goods Sold, less Operating Expenses) / Revenues. This is a measure of your company's profitability before you consider expenses related to financing or taxes.
- Net Profit Margin. (Revenues, less Cost of Goods Sold, less Operating Expenses, less All Other Expenses) / Revenues. This ratio indicates the amount of profit created by sales after all expenses have been paid, including interest and taxes. Again, a higher ratio is more desirable.
Operational Efficiency Ratios
How well you use your firm's resources could be a deciding factor in your company's long-term success. These ratios measure whether you have funds available to foster growth.
- Accounts Receivable Turnover. (Net Credit Sales / Average Accounts Receivable). When you extend credit to customers, you should manage those programs efficiently. A lower ratio means that your firm needs to improve its credit collection program.
- Inventory Turnover. (Cost of Goods Sold / Average Inventory). This ratio shows how effectively inventory is managed, measuring the number of times inventory is “turned” or sold during a given period against how much is purchased. To account for year-end and other inventory depletions “average inventory” is used. Average inventory is usually calculated by adding the beginning and ending inventory for the period and dividing by two. A higher ratio means you’re doing well while a lower figure indicates that you either aren't selling enough or you are carrying excess inventory.
Capital Efficiency and Solvency Ratios
Utilizing capital effectively is the sign of a successful business, but you don't want to overextend yourself and risk the solvency of your company. These ratios can help you stay on top of these vital issues.
- Return on Equity. (Net Income / Shareholder's Equity). This is the return that investors are receiving from your business over the stated period.
- Debt to Equity. (Debt / Equity). This ratio indicates how much leverage you are using to operate your business. What is reasonable will vary based on your industry. For example, capital-intensive industries often have a D/E ratio above 2, while others may have a ratio under 5.
Liquidity Ratios
Liquidity is a vital short-term measure that refers to a company's ability to quickly turn assets into cash without suffering a loss. If your business needs cash, you may have to sell some assets. When you sell receivables or equipment, there's a good chance that you will lose money in the process due to fees or depreciation. If your business is liquid, it won't have to take these drastic measures to raise cash for short-term expenses such as payroll.
- Current Ratio. (Current Assets / Current Liabilities). This is a measure of your ability to pay off short-term debt with cash or other current assets. A value lower than 1 means that your company is not liquid. A ratio of 2 or higher is best.
- Interest Coverage. (Earnings Before Interest & Taxes / Interest Expense). This measures your company's ability to pay interest expenses from your generated cash. A value of 1.5 or greater is desirable.
There are many other ratios that exist to measure the health of a business. While the above are commonly used, and relevant to most companies, you should evaluate which are meaningful for your organization.
The monitoring of your company's financial performance plays a significant role to ensure your company’s long-term success, that you are adhering to your business' strategic plan, and making strategic decisions on a timely basis. These assessments allow you to measure performance against earlier periods and see how your company stacks up against others in your industry. The detail provided in these assessments should give you the indicators you need to make necessary adjustments in a timely manner and ensure the future survival and profitability of your business.
You may need help with understanding your financial reports and assessments and would like to have more confidence as you develop a business and financial strategy. If this is the case, please reach out to us here.
Our CFOs provide part time, interim, and project-based financial expertise to small and medium-sized businesses. In general, the work they do is focused on business and financial strategy; our CFOs know how to use the tools of accounting and finance to help business owners make the best possible decisions. Contact a team leader for a complimentary consultation to discuss your needs and business challenges.
