Most businesses produce regular financial statements and comply with recordkeeping requirements of their own or the bank they borrow money from. But, financial statement analysis is often overlooked or not performed on a systematic and timely basis to obtain insight into the financial performance of a company. Believe it or not, your bank really does look at the financial statements you provide them, and they do a comprehensive analysis of your balance sheet, income statement, and your cash flow while looking at some key financial ratios. They ask for three years worth of statements to also do some trend analysis on these statements also. The bank is doing it to protect the credit risk they have in a company. Shouldn't you be doing it too to protect the investment you've made in your company too? Here are some examples:
Financial ratios can measure different things in your business: / means "divided by"
Profitability Ratios can measure your gross and net profit margins, gross profit or net profit after tax/sales
Liquidity Ratios can measure how much current assets you have in excess of your current liabilities, current assets/current liabilities
Debt Ratios can measure how leveraged your company is, total debt/total net worth
Activity Ratios can tell you how quickly you're collecting your receivables, paying your vendors or turning your inventory, sales/accounts receivable, cost of sales/inventory or accounts payable
Business owners can use ratio analysis to quickly spot problems especially if there is a negative trend over time. If you're having cash flow problems, it may be due a slow down in your collection period on accounts receivable. If your gross profit margin has changed you may have decreased prices to stimulate sales or your costs may have increased.
There are different ratios to measure different aspects of your business. Ratios reveal relationships that can help you evaluate the performance of your company.
Some business owners struggle to know how much of a line of credit they need for their company. There is a formula that exists called the trade gap or financing gap.
If you take the collection period on receivables plus the number of days it takes to turn inventory (delete this if you don't have inventory) and subtract the payment period on accounts payable (delete this if you don't have accounts payable) you come up with the trade gap or financing gap. For example,
Accounts Receivable Turn in days (45 days) plus Inventory Turn in days (35 days) = 80 days minus Accounts Payable Turn in days (-45 days) equals Trade Gap or Financing Gap of 35 days.
Using this formula, you can predict that the line of credit need will be about 35 days of sales because that is the gap that is not covered by your accounts payable financing. Obviously, this gap can change based on any changes in any of the variables, but it is a good place to start.
Financial analysis using ratios between key values can help you cope with the massive amount of numbers in company financial statements. If using these ratios will help you spot problems faster and enhance the potential long term success of your company, wouldn't that be a good thing?
