Financial health is one of the best indicators of your business's potential for long-term growth. The first step toward improving financial literacy is to conduct a financial analysis of your business. A proper analysis consists of five key areas, each containing its own set of data points and ratios.
Financial analysis is the process of evaluating a business or individual's financial situation. This can be done by reviewing their financial statements, such as their income statement or balance sheet.
Revenues are probably your business's main source of cash. The quantity, quality and timing of revenues can determine long-term success.
- Revenue growth (revenue this period - revenue last period) ÷ revenue last period. When calculating revenue growth, omit one-time revenues, which can distort the analysis.
- Revenue concentration (revenue from client ÷ total revenue). If a single customer generates a high percentage of your revenues, you could face financial difficulty if that customer stops buying. In ideal cases, no client represents more than 10 percent of total revenues.
- Revenue per employee (revenue ÷ average number of employees). This ratio measures your business's productivity. The higher the ratio, the better. Many highly successful companies achieve over $1 million in annual revenue per employee, but a good number for your business depends on many factors like your industry, your competitors' performance, and other variables.
If you can't produce quality profits consistently, your business may not survive in the long run.
- Gross profit margin (revenues – cost of goods sold) ÷ revenues. A healthy gross profit margin allows you to absorb shocks to revenues or cost of goods sold without losing the ability to pay for ongoing expenses.
- Operating profit margin (revenues – cost of goods sold – operating expenses) ÷ revenues. Operating expenses don't include interest or taxes. This determines your company’s ability to make a profit regardless of how you finance operations (debt or equity). The higher, the better.
- Net profit margin (revenues – cost of goods sold – operating expenses – all other expenses) ÷ revenues. This is what remains for reinvestment into your business and for distribution to owners in the form of dividends.
3. Operational Efficiency
Operational efficiency measures how well you're using the company’s resources. A lack of operational efficiency leads to smaller profits and weaker growth.
- Accounts receivables turnover (net credit sales ÷ average accounts receivable). This measures how efficiently you manage the credit you extend to customers. A higher number means your company is managing credit well; a lower number is a warning sign you should improve how you collect from customers.
- Inventory turnover (cost of goods sold ÷ average inventory). This measures how efficiently you manage inventory. A higher number is a good sign; a lower number means you either aren't selling well or are producing too much for your current level of sales.
4. Capital Efficiency and Solvency
Capital efficiency and solvency are of interest to lenders and investors.
- Return on equity (net income ÷ shareholder’s equity). This represents the return investors are generating from your business.
- Debt to equity (debt ÷ equity). The definitions of debt and equity can vary, but generally this indicates how much leverage you're using to operate. Leverage should not exceed what's reasonable for your business.
Liquidity analysis addresses your ability to generate sufficient cash to cover cash expenses. No amount of revenue growth or profits can compensate for poor liquidity.
- Current ratio (current assets ÷ current liabilities). This measures your ability to pay off short-term obligations from cash and other current assets. A value less than 1 means your company doesn't have sufficient liquid resources to do this. A ratio above 2 is best.
- Interest coverage (earnings before interest and taxes ÷ interest expense). This measures your ability to pay interest expense from the cash you generate. A value less than 1.5 is cause for concern to lenders.
Basis for Comparison
The final part of the financial analysis is to establish a proper basis for comparison, so you can determine if performance is aligned with appropriate benchmarks. This works for each data point individually as well as for your overall financial condition.
The first basis is your company’s past, to determine if your financial condition is improving or worsening. Typically, the past three years of performance is sufficient, but if access to older data is available, you should consider including that as well. Looking at your past and present financial condition may also help you spot trends. If, for example, liquidity has decreased consistently, you can make changes.
The second basis is your direct competitors. This can provide an important reality check. Having revenue growth of 10 percent annually may sound good, but if competitors are growing at 25 percent, you may be underperforming.
Frequently Asked Questions About Financial Analysis:
1. What is financial analysis?
Financial analysis is the process of evaluating a business or individual's financial situation. This can be done by reviewing their financial statements, such as their income statement or balance sheet. Financial analysis can also involve looking at economic trends to determine how they may impact the financial health of a company.
2. What are the types of financial analysis?
Fundamental analysis: This approach looks at a company's financial statements and other key indicators to determine its intrinsic value.
Technical analysis: This approach uses past market data to identify trends and predict future price movements.
3. What is the importance of financial analysis?
Financial analysis can help you make informed decisions about where to invest your money. It can also help you assess the financial health of a company and make decisions about whether to do business with them.
4. What are the steps in financial analysis?
There are different steps involved in financial analysis depending on the type of analysis you are doing. However, some common steps include the following:
Gathering Financial Data: Financial data can be collected from various sources, such as financial statements, annual reports, and government records.
Analyzing the data: Financial data can be gathered from several sources, such as financial statements, annual reports, and government records.
Interpreting the results: You can interpret the results of your analysis to make conclusions about a company's financial health.
A version of this article was originally published on June 25, 2019.
The information contained herein is for generalized informational and educational purposes only and does not constitute investment, financial, tax, legal or other professional advice on any subject matter. THIS IS NOT A SUBSTITUTE FOR PROFESSIONAL BUSINESS ADVICE. Therefore, seek such advice in connection with any specific situation, as necessary. The views and opinions of third parties expressed herein represent the opinion of the author, speaker or participant (as the case may be) and do not necessarily represent the views, opinions and/or judgments of American Express Company or any of its affiliates, subsidiaries or divisions. American Express makes no representation as to, and is not responsible for, the accuracy, timeliness, completeness or reliability of any such opinion, advice or statement made herein.
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