Using Financial Analysis Techniques to Understand Your Business
At the beginning of a new year it is always important to review and reflect on the year just passed and how well you, your staff, and your business performed. What could have been improved? What did you do well? All as evidenced by results, many of those results being financial in nature. To help plan for your focus during the next year, financial analysis can help you uncover what can be improved upon in the next period.
There are a number of techniques you can use to perform financial statement analysis for your business, depending on what you are trying to find out. The financial statements you want to use in your analysis are the balance sheet and income statement. Here are some techniques to use to analyze your financial statements:
1. Trend Analysis
Trend analysis is also called time-series analysis. Trend analysis helps determine how the business is likely to perform over time. Trend analysis is based on historical data from the financial statements and forecasted data from the businesses pro forma, or forward-looking, financial statements.
One popular way of doing trend analysis is by using financial ratio analysis. If you calculate financial ratios for a business, you have to calculate at least two years of ratios in order for them to mean anything. Ratios are meaningless unless you have something to compare them to, in this case the previous year’s data. For example an important ratio is the Current Ratio which is the ratio of current or short term, assets to current liabilities on your financial statement. Ideally your ratio is higher than 1.0 which would mean that for every dollar of short-term liability you have a dollar of short-term asset. Short term assets are cash, accounts receivable, inventory and other highly liquid accounts. Short term liabilities are those that are due in one year or less such as accounts payable, etc. Microsoft has a great Excel template available free which can help you calculate your ratios and can be found here: http://office.microsoft.com/en-us/templates/comprehensive-ratio-analysis-TC101877349.aspx
2. Common Size Financial Statement Analysis
Common size financial statement analysis is analyzing the balance sheet and income statement using percentages. All income statement line items are stated as a percentage of sales. All balance sheet line items are stated as a percentage of total assets. For example, on the income statement, every line item is divided by sales and on the balance sheet, every line item is divided by total assets. This type of analysis enables you to view the income statement and balance sheet in a percentage format which is easy to interpret.
If you look at this income statement, for example, you can develop a common size income statement. If you calculate the percentage that net income is of total sales, the formula is $64,000/$1,000,000 = 6.4%. You can apply that formula to every line item on the income statement to develop your common size income statement. As with financial ratio analysis, you can compare the common size income statement from one year to other years of data to see how your firm is doing. It is generally easier to make that comparison using percentages rather than absolute numbers.
3. Percentage Change Financial Statement Analysis
Percentage change financial statement analysis gets a little more complicated. When you use this form of analysis, you calculate growth rates for all income statement items and balance sheet accounts relative to a base year. This is a very powerful form of financial statement analysis. You can actually see how different income statement items and balance sheet accounts grew or declined relative to grows or declines in sales and total assets.
Here is an example of percentage change analysis. Let’s say that XYZ, Inc. has $500 in inventory on its balance sheet in 2011 and $700 in inventory on its balance sheet in 2012. How much has inventory grown in 2012? The formula to calculate the growth rate in inventory is the following: Change in inventory/Beginning inventory Balance = $200/$500 = 0.40 = 40%. The change in inventory for XYZ, Inc. in 2012 is 40%.
Benchmarking is also called industry analysis. Benchmarking involves comparing a company to other companies in the same industry in order to see how one company is doing financially compared to the industry. This type of analysis is very helpful to the financial manager as it helps to see if any financial adjustments need to be made.
Here is a tool at the Small Business Administration website called SizeUp that helps you compare your business to competitors. http://www.sba.gov/sizeup
Compiling, analyzing, and understanding financial statements provides business owners one of the most important tools for reducing the considerable risk involved in starting and growing a business. The comparison of financial ratios to industry standards is, perhaps, one of the best uses of financial information, as it allows the business owner to compare the performance of his or her business with other like businesses.
The ISBDC Business Advisors have a tool available to them to perform an analysis and if you would like assistance at no cost to you take our business survey.