Financial statement analysis can help your business make more informed economic decisions as you will be able to determine your financial position, operating results as well as cash flow. In this article, we describe three useful techniques that can help you perform a financial statement analysis for your business. These techniques will provide visibility into trends that your business may be facing and with this knowledge, you will be better-positioned to make changes and steer your company towards greater profitability.
Before you begin, you will require the three main financial statements: the balance sheet, income statement and statement of cash flows. Each of these financial statements tells you how well you have been handling your business, and through financial statement analysis, we will be studying the details in them.
There are different types of ratios we can use to conduct a financial analysis:
Efficiency ratios show you how well your business uses its assets in generating income. For instance, an efficiency ratio may look at the time it takes for your business to collect cash from customers, or the amount of time it takes to convert inventory into cash. It may also be calculated by dividing your company’s revenue by its total assets. If the efficiency ratio is 0.25, it means that your company generates 25 cents for every dollar in assets. An improvement in efficiency ratio usually translates to improved profitability.
Liquidity ratios show you whether your company can pay off its short term debts when it converts current assets such as cash, accounts receivables and inventories into cash. To derive your company’s liquidity ratio, divide your company’s current assets by its current liabilities. If a liquidity ratio is 2, it means that a company has $2 of current assets for every dollar of current liabilities. A higher liquidity ratio would mean that your company is more liquid and has better coverage of outstanding debts.
Solvency ratios indicate whether your company’s cash flow is sufficient to pay off its short-term and long-term obligations. To derive your solvency ratio, divide your company’s net operating income (after tax) by its total debt obligations. The lower your company’s solvency ratio, the greater the probability that it will default on its liabilities.
Profitability ratios give insight on your company’s ability to turn sales into a profit, and how much is being generated. To calculate your company’s return on assets (ROA), divide your company’s net income by its total assets. A higher ROA would mean your company is earning more money on less investment. To calculate your company’s return on equity (ROE), divide your company’s net income by shareholder equity. This indicates whether assets are being used to create profit.The above ratios are especially beneficial when you compare ratios between accounting periods, or compare ratios against that of other firms in the industry. These ratios will give an accurate indication of whether your company is operating with financial efficiency.
Horizontal analysis, also known as time series analysis, is performed by comparing multiple financial periods: usually year on year (YoY) or quarter on quarter (QoQ). For instance, when you say that revenue has increased by 5% this quarter, you are performing horizontal analysis. A straightforward method is to view the difference (i.e. variance) in net profit in this year’s income statement and last year’s. If net profit for Years 1 and 2 had a variance of $50,000 and that for Years 2 and 3 had a variance of $30,000, it could indicate that something has changed.
Take for example your business’ debt to equity ratio in its balance sheet. When comparing this year’s debt to equity ratio to that of last year’s, you may note a positive or negative change. If your debt to equity ratio has gone down, it means that your debt had gone up without an increase in equity. This could signal a problem and you may wish to review the business decisions that you have made.
Vertical analysis means taking your total sales (for income statement) or assets (for balance sheet) in a one-year period as 100%, and determining how much percentage of that is represented by accounts such as “cost of goods”, “salaries”, “rent” and so on. For instance, if you had total assets of $100,000 and $20,000 in cash, your cash is 20% of total assets. If your current liabilities were $50,000, then your liabilities are 50% of your total assets.
Vertical analysis helps you review where you have put in your resources, and which areas you should take note of. For instance, if expenses over the past years have been between 40% to 50% of gross sales, but have suddenly jumped to 60%, this is something you may wish to look into. This method of vertical analysis therefore helps you spot trends for expenses that are sometimes too small to notice.
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