What can you learn from a business’s financial statements?

When examined critically, financial statements enable business owners to gain an understanding of the performance and value of their business. The three basic financial statements are:

  1. Income statement
  2. Balance sheet
  3. Cash flow statement

The best business managers use operating budgets, projections, and forecasts to help guide the business. 

A well put together budget will help a business owner stay on the best path. The actual and expected volume of sales and the expected cost of sales and overhead expenses will yield your projected profit for the period. Analyzing this information against a series of reporting periods allows business owners to identify important trends with respect to revenues, gross margins and net profits, and build projections with respect to future revenues and expenses.

Gross Margin

Do you understand your gross margin backward and forward? The gross margin is the amount a business earns from the sale of products and services before the deduction of  selling and administration expenses. The gross margin percentage is useful when analyzed over a trend line to see what the current trend is telling us.

Gross margins can be forecast if the business owner understands the factors that make up the cost of goods sold and the market environment for its products or services. For example, if a company utilizes a large amount of oil in its production process, a significant decrease in the price of a barrel of oil will have large implications and will lead to positive effects in the gross margin assuming all other factors remain constant. Gross margin is closely linked to contribution margin. The difference is that gross margin can include an allocation of factory overhead costs, some of which may be fixed.

Break Even Analysis

Do you know the break-even sales number for your business today? A break-even analysis will identify the minimum sales required to reach zero profit based on known factors, including an analysis of the contribution margin of the product sold. The contribution margin ratio is the contribution margin per unit (selling price per unit subtracted by variable cost per unit) divided by selling price per unit. For example, let’s say a product sells for $100 per unit and the variable cost is $70 per unit. The contribution margin is $30 per unit ($100-$70) and the contribution margin ratio is 30% ($30/$100). If total fixed costs are $30,000, the break-even point in sales dollars is $100,000 ($30,000/30%), or 1,000 units.

Return on Equity

One of the most important financial ratios to understand is return on equity. The return on equity shows the company’s net profit (earnings) as a percentage of equity. A high return on equity will attract more capital into the business, which will allow business owners to allocate this capital into its most productive use. The earnings will flow to the balance sheet statement and increase or decrease owner’s equity.

A few other valuable ratios…

More valuable ratios can be found on the balance sheet.  Since the balance sheet presents a snapshot of the financial position at a certain point in time, we can find useful historical data and measure the company’s performance against financial ratios such as the current ratio, quick ratio, inventory turnover, AR turnover, and many others.

  • Current Ratio & Quick Ratio: To identify the liquidity of a business we look at the current ratio and the quick ratio. The current ratio measures the amount of liquidity available to pay current liabilities. The quick ratio excludes the slower moving items, notably inventory. The reason for this exclusion is that it may not be possible to convert inventory into cash so quickly. Creditors rely on the Quick Ratio before making any investments in your business.
  • Efficiency Ratios: How efficient is your business when it comes to inventory and accounts receivable? The inventory turnover is an indicator of how many times a company’s inventory is sold and replaced over a period of time. The higher the turnover the better! The accounts receivable turnover is a ratio which measures how quickly the Company is transferring credit sales to cash collections. A low number can cause a serious cash crunch!

A few words on cash flow…

The cash flow statement tells us where cash was deployed and how the business financed operations and investing activities. The cash flow statement begins with net profit reported on the income statement and adjusts this balance for non-cash transactions such as depreciation and year-over-year changes in the balance sheet accounts to arrive at cash from operating activities. Savvy investors and creditors will determine the quality of a business’ earnings by comparing earnings from operations to cash flows from operating activities.

In conclusion

Investors and business owners will be more willing to take risks if the projections are based on empirical evidence. Financial projections for revenue and operating expenses are important because they will encourage management to develop strategies for different business scenarios. For example, if sales decrease slightly or significantly year-over-year, what are the plans in place to ensure that the company remains viable? A thoughtful management team will have plans in place to mitigate the effects of a sales decrease and potentially discover business opportunities in times of uncertainty.

On the other end, what if sales increase slightly or significantly year-over-year? Has the management team identified the true drivers of growth and encouraged its expansion? To what strategies does management attribute this success? Is there any room for improvement? An attentive management team will base business strategy on empirical evidence of past success.

What are your financial reports saying about you?

Written by Jack Campbell, CPA