As a business manager, it is your responsibility to make sure the company is operating at its optimum level. Your understanding of how to determine this level is crucial. Even with quarterly or annual financial statements supplied by your accountant, the data is meaningless without detailed financial analysis. Therefore, we created this guide is to help you understand how use your financial reports to help make critical business decisions.
The numbers in the financial statements by themselves give you a general picture of how your business is doing. For example, you will be able to see that you made more sales one year than another in comparison reports. But deeper analysis requires using the numbers in the reports to calculate ratios that will give you a better idea of how your business is doing. After a brief summary of your basic financial reports, we illustrate how to understand and use this information for making critical business decisions and increasing profitability.
The basic reports to review in your analysis are:
The income statement is a summary of the flow of transactions your business had over an entire period, usually a month, a quarter, or a year. You can determine trends in sales, expenses and profits. Gross profit margin should be closely monitored to make sure that your business is operating at the same profitability levels as it grows. Gross profit is the amount of revenue produced from the sale of inventory and is calculated by dividing your gross profit (sales minus cost of goods sold) by your sales. If your percentage is going down, you may need to either raise prices, or lower costs.
Net profit (or loss) is the difference between revenues and expenses. This figure shows the results from your operation, and is the infamous "bottom line." It is called this because the income statement is read from top to bottom, with the net operating results being the bottom line of the report.
Individual line items as a percentage of sales should also be closely monitored. This will allow you to spot trends and monitor your budget more effectively. For example, if office expenses are typically 1.5% of sales each month and one month they jump to 20%, you need to know about it. Also, if you don't closely monitor your income statement serious problems such as embezzlement can go undetected.
Your balance sheet shows your company's financial position at a given point in time. It is often referred to as a "snapshot" because it shows the financial condition of your business at a specific time, rather than over a period of time. The balance sheet is based on the outsourced accounting equation that states "assets = liabilities + owner's equity." Assets are anything the company owns, and liabilities (what the company owes) and owner's equity (the owner's share of the company) are considered claims against the company. It is called a balance sheet because the two sides of the equation must always balance: assets always equal the sum of liabilities and owner's equity. In other words, in order for your business to acquire assets you must pay for them with either liabilities (such as debt) or owner's equity (money you or other shareholders invest).
Using the data from the balance sheet such as total current assets and total current liabilities, you can calculate your current ratio and quick ratio. These two liquidity ratios show the ability of your business to generate cash to meet its short-term obligations. We will discuss these ratios in more detail later, but for now we are illustrating how the numbers in the balance sheet are used to understand your financial picture.
Once your reports are generated, you are ready to use the data to calculate a group of ratios that will tell you about the performance of your business. Banks and other creditors routinely analyze these ratios to qualify you for a loan or credit. As a business owner the understanding gained by reviewing these ratios will help keep your business on the right track.
While there are many financial ratios, the ones most commonly used to for making small business decisions are listed below. With these ratios, you can gauge your profitability, liquidity, operational efficiency and solvency.
||Whether you decide to interpret your own data, decide to use
a service like this for your business, or decide you want to hire
a professional to complete your financial analysis, by using the
information from your financial reports you will be able to
interpret what they mean and use that data for making critical
Gross profit margin
Operating profit margin
Net profit margin
Return on Assets
Return on Equity
Inventory turnover ratio
Sales to receivables ratio
Fixed asset turnover
Total asset turnover
Debt to worth ratio
Debt to assets
CCH Consumer Media Group.(2002). Start Run & Grow A Successful Small Business (4th ed). Managing Your Cash Flow and Analyzing Your Financial Position (pp. 395-439) Chicago: CCH Incorporated.