Financial statement analysis is the process of examining the data on your financial statements and using calculations to evaluate your business’s performance. In a challenging business climate, these exercises can help uncover patterns and put numbers in context to tell you about the health of your business.
Below are three strategies for financial analysis, along with when to use each one.
Financial Analysis Strategy #1: Ratio Analysis
Ratio analysis includes a wide range of different calculations which put the numbers on your financial statements in context. For example, if you hear a company has $10 million in debt, that might be excessive for a small business, but very manageable for a large corporation. A ratio analysis would calculate whether the debt load was appropriate, say by measuring total debt against total assets.
There are ratio calculations for profits, liquidity, use of leverage, asset management and valuation, among other areas. Some examples of ratio analysis include:
- Gross Profit Ratio: Used to measure your profitability relative to your sales.
Gross Profit / Net Sales
- Quick Ratio: Used to see whether you are in position to safely cover your short-term debt with your liquid assets.
Short-Term Liquid Assets / Short-Term Liabilities
- Inventory Turnover Ratio: Used to see how quickly you’re selling goods and the demand for your products.
Cost of Goods Sold / Average Inventory Level
Once you calculate a ratio, you can compare them to snapshots of your business, as well as averages for your industry, which you can find on the web. There are a variety of free and paid resources with such benchmark information, including websites like CSIMarket and Factiva.
When to Use Ratio Analysis
In a tough economic period, ratio analysis can help you see whether it’s only your business that’s having trouble or whether it’s an industry-wide problem by comparing against the averages. Running through these calculations may also help you uncover problems you weren’t aware of.
“During turbulent social and economic times, these ratios might help inspire some creative problem solving or process innovations helping you stay out of the red,” says Jim Pendergast, SVP at Altline by The Southern Bank. For example, if your inventory turnover for a certain product is creeping up, you may need to rethink your sales approach or whether the product is worth keeping.
My number one tip would be to not just stick to one of the three methods. It's okay to give more preference or weightage to [one], but don't refrain from using them all.
—Zach Reece, former CPA, owner, Colony Roofers
Ryan Maxwell, CPA and director of research at FirstRate Data, also recommends prioritizing cash-flow statement ratios, such as the cash flow to net income ratio (cash flow from operating activities/net income). “This ratio shows the proportion of a company's profits that are actually cash profits as opposed 'accounting profits.' Business owners often focus on profitability numbers such as net income without noticing there are serious cash-flow issues developing.”
It’s a common shortfall, as 44% of small business owners who had cash-flow problems said they were a surprise, according to a 2019 QuickBooks Cash Flow Survey of 3,500 companies with 0-100 employees.
Financial Analysis Strategy #2: DuPont Analysis
DuPont analysis, first used by the DuPont Corporation in the 1920s, is a way to measure the financial performance of a company and see what’s driving its return for the shareholders and business owners. It combines three types of ratio analysis.
By breaking the calculation into three parts, you can see what’s driving your business performance, whether it’s earning larger profits, selling inventory more quickly or taking on more debt.
The DuPont analysis formula
Net Profit Margin x Asset Turnover x Equity Ratio, where…
- Net Profit Margin = Net Income / Revenue (Measures your profitability.)
- Asset Turnover = Sales / Average Total Assets (Measures your efficiency in using assets to make sales.)
- Equity Ratio: Average Total Assets / Average Shareholder’s Equity (Measures your debt level relative to equity.)
When to Use DuPont Analysis
“DuPont analysis is very useful for business owners to understand how to maximize the valuation of their business prior to selling or listing it via an IPO,” says Maxwell.
If you’re planning to sell your business, that’s the time to focus on improving your DuPont analysis. For example, you could reduce short-term expenses in order to boost your net income and profit margin, to make your company look as efficient as possible before the sale. On the other hand, boosting return by adding more debt is not as impressive for future buyers.
During tough times, however, Maxwell finds this analysis less useful. “It is not very useful for minimizing the risk of corporate failure as it focuses primarily on maximizing upside potential.” In other words, it's better for finding ways to increase the future value of your business rather than helping it manage through a difficult stretch today.
Financial Analysis Strategy #3: Common Size Analysis
With common size analysis, you take the information from your financial statements and recalculate as a percentage of a base amount. For example, on your income statement (which shows your profit/loss), you would recalculate each part as a percentage of your total revenue for the period. Here’s an example:
|
Income Statement |
Common Size Analysis |
Sales |
$500,000 |
100% |
Cost of Goods Sold |
$300,000 |
60% |
Gross Profit |
$200,000 |
40% |
Selling and Operating Expenses |
$25,000 |
5% |
General and Admin Expenses |
$25,000 |
5% |
Pre-Tax Operating Profit |
$150,000 |
30% |
You can see everything was a percentage of the total sales such as Gross Profit = $200,000/$500,000 = 40%.
When to Use Common Size Analysis
This ratio is particularly helpful when your revenue changes dramatically, like during a recession. Whereas you can see numbers going up and down on your statements, common size analysis actually measures the percentage shifts in those numbers.
Let’s say if in the next period your cost of goods sold suddenly jumps from 60% to 70%. That shows you’re paying more for your inventory and you may need to renegotiate with suppliers. You could more easily catch that using the common size analysis.
“A common size financial statement is the best to use during the COVID situation,” says Zach Reece, former CPA and owner of Colony Roofers. “In this method, all factors are represented as a percentage of the same base figure. Thus, when the market is down, this is the best way to see how your company is doing compared to last year,” he says.
The Balance
Each method of financial analysis gives you a unique piece of information for your business. That’s why Reece likes to use all of them. “My number one tip would be to not just stick to one of the three methods. This might make you blind to a lot of factors. It's okay to give more preference or weightage to a particular method, but don't refrain from using them all,” he says.
By using these strategies for financial analysis, you can pull even more insight out of your statements while giving yourself ideas on how to navigate tough times.
Photo: Getty Images
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