Understanding how to do financial analysis is critical to the smooth operation of any business. One of the most common mistakes that small businessmen make is to neglect the financial side of running a business. This is quite understandable, because it is easy to get caught up in developing and marketing your product or service to the public, especially if it is one that you are very passionate about. As long as orders or clients are coming in, it is very easy for a small businessman to think that his business is doing well.
But as many successful businessmen know, keeping an eye on the financial aspect of your business is critical to having a thriving, if not a highly profitable business. It is thus imperative for any small businessman to have a clear understanding of accounting concepts and principles, and a few accounting skills too. Such knowledge and skills will be vital to conducting a financial analysis of the business.
Simply put, financial analysis is the assessment of the viability, stability and profitability of a business. The first step of conducting a financial analysis of your business is to gather and look at the financial statements of your business. The three most important financial statements you will need are the Income Statement, the Balance Sheet, and the Statement of Cash Flows. The Income Statement, also called the Profit and Loss Statement, indicates the profitability of your business for a certain accounting period. The Balance Sheet, or Statement of Financial Position, lets you in on the status of your business’ assets, liabilities, and ownership equity. The Statement of Cash Flows presents an overview of the movement of cash and cash equivalents in and out of the business.
These financial statements will let you see if your assets have grown during the accounting period under study. Similarly, it will let you see if your business is in a liquid financial position, and whether it will have the cash necessary to maintain operations in the coming months. You could also look for trends in sales, in your company’s operating expenses.
You can go a further in your financial analysis by using financial ratios. Common financial ratios are liquidity ratios, leverage or debt ratios, profitability ratios, efficiency ratios, and value ratios. Liquidity ratio, also known as Acid-test or quick ratio is computed by adding you cash, marketable securities, and account receivables and dividing the sum by current liabilities. This is used to determine whether your business can pay or retire its current liabilities.
The debt ratio measures what percentage of the total assets is unpaid for. This is computed by dividing your total debt—the sum of current liabilities and long-term liabilities—by your total assets, which is the sum of your current assets, fixed assets and other assets).
Profitability ratios use margin analysis to show return on sales and capital employed. Efficiency ratios show how your assets are being managed and how fast the inventory is produced and sold. Value ratios measure the embedded value of stocks.
A clear grasp of these ratios will help you gauge the performance of your business. Use them as frequently as possible to keep your business in good financial health. For more information on how to do accurate financial analyses, consider enrolling in a few online finance courses to keep your skills sharp.