Financial analysis serves as a roadmap for your small business. It is a powerful tool allowing you to make better-informed decisions and avoid risk.
What is financial analysis?
Financial analysis refers to analysing a business' financial statements and calculating ratios to evaluate its stability and profitability. This helps identify good performance and areas for improvement. Understanding where a company stands in terms of profitability, liquidity, and solvency is important for stakeholders.
Key Metrics
Financial analysis involves looking at financial statements such as the balance sheet, income statement, and cash flow statement and ratios to determine a company's financial health.
Income statement
An income statement (also known as a profit and loss statement) is the most common financial statement. It shows the revenue and expenses for a particular period and indicates whether a company is profitable.
Comparing the current year's income statement to the previous years is beneficial for spotting trends such as revenue growth or increased costs to gauge how the business is doing.
If a company is making a loss, it isn't necessarily bad. They may be relatively new, still establishing their customer base and spending a lot on research and development or marketing, which they hope will pay off in the long run. On the other hand, if the cost of sales consistently exceeds the revenue, it can indicate that the business operation is not efficient and may potentially need to increase sales price or find cheaper raw materials.
Balance Sheet
A balance sheet (also known as the statement of financial position) shows the company's assets, liabilities and equity. It is a snapshot of the company's accounts at a single point in time and a handy tool for investors and lenders to assess the business's financial standing. The principal formula for the balance sheet is that Assets = Liabilities + Equity.
Cash flow Statement
A cash flow statement analysis demonstrates the ability to generate sufficient cash to cover cash expenses. Even if your revenue is great or your company is profitable, it can't compensate for poor liquidity. Sales growth is good, but if your debtors are taking a while to pay you back, it can lead to liquidity issues of not being able to pay back lenders, suppliers and staff.
A cash flow statement is usually split into three sections; operating activities, investing activities, and financing activities.
Operating activities indicate how much the company brings in from its day to day operations. This section is crucial as it will ultimately tell if the core activities of the business are generating cash. Negative operating cash flow would indicate a company can't pay its bills and would need to rely on borrowing or raising more money.
Investing activities relate to buying or selling fixed assets. This includes buying equipment and shares, and selling fixed assets. A negative investing cash flow is not necessarily a bad thing. It indicates that you are investing in your business which suggests growth and expansion.
Financing activities show how the company is funded. It includes transactions involving debt, equity and dividends. Issuing equity and borrowing money would indicate a positive cash flow from financing activities, whereas repurchasing shares and repaying loans would show negative cash flow.
Curious about automated data extraction from documents?
Ratios
Ratios are a helpful metric that measures the relationship between different components in financial statements to evaluate performance. Stand-alone ratios don't tell much of a story until they are compared over different periods and industry benchmarks or competitor results.
Profitability
Net profit margin
Net Profit / Revenue = Profit margin %
To calculate net profit margin, you would take net profit (profit after deducting tax and interest) and divide it by revenue extracted from your income statement. A high-profit margin is favourable as it suggests that most of the company's revenue is converted to profit and the cost of goods sold and expenses are low. Comparing the net profit margin to previous years will show whether overtime profit as a proportion of sales increases or decreases. This is a useful metric as it can signal to management that profitability needs to be improved by reducing costs or increasing revenue.
Gross profit margin
Gross profit / Revenue = Gross profit margin %
Gross profit margin also measures profitability; however, unlike the net profit margin, the gross profit ratio only looks at costs which directly relate to goods sold. This is another useful profitability measure which can be used in conjunction with the ratio above.
Liquidity
Current Ratio
Current assets / Current liabilities = Current ratio
To calculate the current ratio, you would derive components from the Balance sheet. A current ratio is used to assess short-term liquidity. It shows how much cash (or assets that can be turned into cash in the next 12 months) the company has to pay its current liabilities (debts due within 12 months). A value lower than 1 may indicate liquidity problems for the company, and if the current ratio is below 1 and falls over time, it may be a cause for concern. A falling current asset ratio will force management to review credit terms and how long it takes to pay back suppliers or raise extra finance, to ensure that debtors are paying back promptly. On the other hand, a high ratio can indicate a cause for concern showing inefficient use of company resources, such as stockpiling cash.
Analysing more than one liquidity or profitability ratio will give you a deeper insight into financial health. Management should look at the whole picture when making strategic decisions. A fall in the Net profit margin ratio can signal a fall in profitability; however, to further dissect this, you can look at the operating profit margin ratio or the gross profit margin specifically which has increased. This would mean that the issue lies with operating expenses such as wages, rent and marketing. Therefore it's helpful to use more than one type of profitability or liquidity ratio to determine how to act.
Why is financial analysis important?
Raising finance
Financial analysis is vital to assess the overall financial health of the business. Investors, lenders, creditors and many other stakeholders need to determine the company's health before investing or providing credit. Stakeholder decision to provide capital will depend on financial analysis of the financial statements.
Decision making
All decisions made in a business, such as purchasing supplies and setting a price, will be derived from conducting financial analysis. Companies need to know what they must charge to break even or if they want to achieve a particular margin.
Budgeting and forecasting
Budgeting is vital to ensure that departments don't over or underspend. Allocating cash without a proper budget can lead to liquidity problems. Budgeting allows you to control your finances, making sure you meet your financial goals. When setting a budget for future spending, you would generally reflect on past performance to develop a plan that works for you.
As you have learned from the article above, financial analysis is an important tool for small business owners. There are many compelling reasons why you need it. By having detailed financial information, you will be better positioned to make sound business decisions.
About Legislate
Legislate is a contracting platform where businesses, letting agents and landlords can create, sign and manage lawyer-approved contracts. Book a demo and sign up today to put the confidence back into contracting.