Financial Analysis
Financial Statements help you determine your:
Solvency — Your balance sheet lets you know if you have sufficient assets to cover your liabilities. If the answer is yes, then your risk is low. If the answer is no, then your risk is higher. Risk is not necessarily bad. Borrowing money to fund your growth, for example, may be a smart decision, but too much risk means that if things don't work out exactly as planned, your business could collapse.
Profitability — Your income statement lets you know if you are making a sufficient profit. Profit is the key to the long-term survival of your business. You can survive without it for a while, but operating at a loss for an extended period of time will eventually catch up with you.
Liquidity — Your cash flow statement lets you know if you have enough cash available to cover your expenses and support your growth. Liquidity is the key to short-term survival. You could survive without profit for a while, but you could not survive without cash. Cash keeps the motor of your business running, without it your business would come to a grinding halt.
In order for your financial reports to be as valuable as possible, it's important you make proper use of them. Simply producing them on a monthly basis is not good enough. You need a set of tools for analyzing and monitoring those reports. Your goal will be to end up with a list of financial “vital signs” you can use to gage your progress towards your financial goals, and to identify potential problems along the way.
Review your Financial Reports as often as possible. At a minimum you should do this monthly, but there is nothing wrong with reviewing your reports daily if you can.
When reviewing your Financial Reports, focus on profits more so than gross sales. Sales mean little if your expenses are too high. Many companies have failed because not enough attention was paid to the bottom line. Creditors will only support a business for so long that doesn't make a profit. Your business needs profit to survive so maximize your margins and watch those expenses.
While most business owners don't pay enough attention to their Financial Reports, the reverse can also be a problem. A business should not be run exclusively “by the numbers” any more than it should be run without them. Your financial statements are an important reflection of a your business, but they are not your business. When you spot a number that seems out of place, look for its root cause within your business activities.
Your goal is to gather useful information from your financial reports. In order to do this, of course, you need to know what you're looking for. A great deal of information can be derived from your financial reports, so to make them truly useful, you need to ask yourself what information would be most helpful.
Review your financial reports, and then use the following questions to help focus your attention on the things that are most important. Your answers will help you design your Financial Analysis System.
To the best of your knowledge, which specific areas of your business are the most efficient and/or profitable?
- Resale of specific products — (i.e. doughnuts are our most profitable dessert item)
- Manufacturing process — (i.e. our process is designed to minimize waste)
- Purchasing — (i.e. we have an exclusive arrangement with our supplier)
- Maintenance — (i.e. our equipment is new and nearly trouble free)
- Labour — (i.e. we hardly ever need to pay for overtime)
- Promotional activities — (i.e. our location minimizes our need for advertising)
- Other
Explain:
To the best of your knowledge, which specific areas of your business are the least efficient and/or profitable?
- Resale of specific products — (i.e. fruit pies are our least profitable dessert item)
- Manufacturing process — (i.e. our process is slow and wasteful)
- Purchasing — (i.e. we rarely take advantage of quantity discounts)
- Maintenance — (i.e. our equipment is old and in frequent need of repair)
- Labour — (i.e. we overpay some of our employees)
- Promotional activities — (i.e. we do not seem to be getting a good return for our advertising dollar)
- Other
Explain:
How might you improve these areas? For example, could you rework your production schedule to reduce overtime wages or save money on purchases by buying in bulk? What impact would those improvements have on the rest of your business?
What else would you like to find out about your business from your financial reports?
Financial Analysis System
There are five basic methods of analyzing your Financial Reports. These are:
- Financial Ratio Analysis
- Industry Comparisons
- Trend Analysis
- Cost-Volume-Profit Analysis
- Common Sense
The point of analyzing your financial statements is to determine your Risk, Profitability, and liquidity in order to help you make good management decisions. All of these basic methods can give you valuable information toward that goal. Review each of these methods on the pages that follow, and then incorporate them into your Financial Analysis System.