Financial analysis is an aspect of the overall business finance function that involves examining historical data to gain information about the current and future financial health of a company. Financial analysis can be applied in a wide variety of situations to give business managers the information they need to make critical decisions. "The inability to understand and deal with financial data is a severe handicap in the corporate world," Alan S. Donnahoe wrote in his book What Every Manager Should Know about Financial Analysis. "In a very real sense, finance is the language of business. Goals are set and performance is measured in financial terms. Plants are built, equipment ordered, and new projects undertaken based on clear investment return criteria. Financial analysis is required in every such case."
The finance function in business organizations involves evaluating economic trends, setting financial policy, and creating long-range plans for business activities. It also involves applying a system of internal controls for the handling of cash, the recognition of sales, the disbursement of expenses, the valuation of inventory, and the approval of capital expenditures. In addition, the finance function reports on these internal control systems through the preparation of financial statements, such as income statements, balance sheets, and cash flow statements.
Finally, finance involves analyzing the data contained in financial statements in order to provide valuable information for management decisions. In this way, financial analysis is only one part of the overall function of finance, but a very important one. "The mathematical tools produce data, not explanations; information, not interpretation; measurement, not meaning," according to James E. Kristy and Susan Z. Diamond in their book Finance without Fear. "To these tools you must add judgment, which develops slowly—mostly out of experience."
The two main sources of data for financial analysis are a company's balance sheet and income statement. The balance sheet outlines the financial and physical resources that a company has available for business activities in the future. It is important to note, however, that the balance sheet only lists these resources, and makes no judgment about how well they will be used by management. For this reason, the balance sheet is more useful in analyzing a company's current financial position than its expected performance.
The main elements of the balance sheet are assets and liabilities. Assets generally include both current assets (cash or equivalents that will be converted to cash within one year, such as accounts receivable, inventory, and prepaid expenses) and noncurrent assets (assets that are held for more than one year and are used in running the business, including fixed assets like property, plant, and equipment; long-term investments; and intangible assets like patents, copyrights, and goodwill). Both the total amount of assets and the makeup of asset accounts are of interest to financial analysts.
The balance sheet also includes two categories of liabilities, current liabilities (debts that will come due within one year, such as accounts payable, short-term loans, and taxes) and long-term debts (debts that are due more than one year from the date of the statement). Liabilities are important to financial analysts because businesses have same obligation to pay their bills regularly as individuals, while business income tends to be less certain. Long-term liabilities are less important to analysts, since they lack the urgency of short-term debts, though their presence does indicate that a company is strong enough to be allowed to borrow money.
The balance sheet also commonly includes stock-holders' equity accounts, which detail the permanent capital of the business. The total equity usually consists of two parts: the money that has been invested by shareholders, and the money that has been retained from profits and reinvested in the business. In general, the more equity that is held by a business, the better the ability of the business to borrow additional funds.
In contrast to the balance sheet, the income statement provides information about a company's performance over a certain period of time. Although it does not reveal much about the company's current financial condition, it does provide indications of its future viability. The main elements of the income statement are revenues earned, expenses incurred, and net profit or loss. Revenues consist mainly of sales, though financial analysts may also note the inclusion of royalties, interest, and extraordinary items. Likewise, operating expenses usually consist primarily of the cost of goods sold, but can also include some unusual items. Net income is the "bottom line" of the income statement. This figure is the main indicator of a company's accomplishments over the statement period.
As Kristy and Diamond noted, a company's over-all financial health can be assessed by examining three major factors: its liquidity, leverage, and profitability. All three of these factors are internal measures that are largely within the control of a company's management. It is important to note, however, that they may also be affected by other conditions—such as overall trends in the economy—that are beyond management's control.
LIQUIDITY Liquidity refers to a company's ability to pay its current bills and expenses. In other words, liquidity relates to the availability of cash and other assets to cover accounts payable, short-term debt, and other liabilities. All small businesses require a certain degree of liquidity in order to pay their bills on time, though start-up and very young companies are often not very liquid. In mature companies, low levels of liquidity can indicate poor management or a need for additional capital. Of course, any company's liquidity may vary due to seasonality, the timing of sales, and the state of the economy.
Companies tend to run into problems with liquidity because cash outflows are not flexible, while income is often uncertain. "Creditors expect their money when promised, just as employees expect regular paychecks. However, the cash being generated does not follow a set schedule. Sales of inventory vary, as do collections from customers," Kristy and Diamond explained. "Because of this difference between cash generation and cash payments, businesses must maintain a certain ratio of current assets to current liabilities in order to ensure adequate liquidity."
LEVERAGE Leverage refers to the proportion of a company's capital that has been contributed by investors as compared to creditors. In other words, leverage is the extent to which a company has depended upon borrowing to finance its operations A company that has a high proportion of debt in relation to its equity would be considered highly leveraged. Leverage is an important aspect of financial analysis because it is reviewed closely by both bankers and investors. A high leverage ratio may increase a company's exposure to risk and business downturns, but along with this higher risk also comes the potential for higher returns.
PROFITABILITY Profitability refers to management's performance in using the resources of a business. Many measures of profitability involve calculating the financial return that the company earns on the money that has been invested. As James O. Gill stated in his book Financial Basics of Small Business Success, most entrepreneurs decide to start their own businesses in order to earn a better return on their money than would be available through a bank or other low-risk investments. If profitability measures demonstrate that this is not occurring—particularly once a small business has moved beyond the start-up phase—then the entrepreneur should consider selling the business and reinvesting his or her money elsewhere. However, it is important to note that many factors can influence profitability measures, including changes in price, volume, or expenses, as well the purchase of assets or the borrowing of money.
"Measuring the liquidity, leverage, and profitability of a company is not a matter of how many dollars in assets, liabilities, and equity it has, but of the proportions in which such items occur in relation to one another," Kristy and Diamond wrote. "We analyze a company, therefore, by looking at ratios rather than just dollar amounts." Financial ratios are determined by dividing one number by another, and are usually expressed as a percentage. They enable business owners to examine the relationships between seemingly unrelated items and thus gain useful information for decision-making. "They are simple to calculate, easy to use, and provide a wealth of information that cannot be gotten anywhere else," Gill noted. But, he added, "Ratios are aids to judgment and cannot take the place of experience. They will not replace good management, but they will make a good manager better. They help to pinpoint areas that need investigation and assist in developing an operating strategy for the future."
Virtually any financial statistics can be compared using a ratio. In fact, Kristy and Diamond claimed that there are over 150 recognized financial ratios that can be computed in a financial analysis. In reality, however, small business owners and managers only need to be concerned with a small set of ratios in order to identify where improvements are needed. Determining which ratios to compute depends on the type of business, the age of the business, the point in the business cycle, and any specific information sought. For example, if a small business depends on a large number of fixed assets, ratios that measure how efficiently these assets are being used may be the most significant.
There are a few general ratios that can be very useful in an overall financial analysis, however. To assess a company's liquidity, Kristy and Diamond recommend using the current, quick, and liquidity ratios. The current ratio can be defined as Current Assets / Current Liabilities. It measures the ability of an entity to pay its near-term obligations. Though the ideal current ratio depends to some extent on the type of business, a general rule of thumb is that it should be at least 2:1. A lower current ratio means that the company may not be able to pay its bills on time, while a higher ratio means that the company has money in cash or safe investments that could be put to better use in the business.
The quick ratio, also known as the "acid test," can be defined as Quick Assets (cash, marketable securities, and receivables) / Current Liabilities. This ratio provides a stricter definition of the company's ability to make payments on current obligations. Ideally, this ratio should be 1:1. If it is higher, the company may keep too much cash on hand or have a poor collection program for accounts receivable. If it is lower, it may indicate that the company relies too heavily on inventory to meet its obligations. The liquidity ratio, also known as the cash ratio, can be defined as Cash / Current Liabilities. This measure eliminates all current assets except cash from the calculation of liquidity. Ideally, the ratio should be approximately .40:1.
To measure a company's leverage, Kristy and Diamond recommend using the debt/equity ratio. Defined as Debt / Owners' Equity, this ratio indicates the relative mix of the company's investor-supplied capital. A company is generally considered safer if it has a low debt to equity ratio—that is, a higher proportion of owner-supplied capital—though a very low ratio can indicate excessive caution. In general, debt should be between 50 and 80 percent of equity.
Finally, to measure a company's level of profitability, Kristy and Diamond recommend using the return on equity (ROE) ratio, which can be defined as Net Income / Owners' Equity. This ratio indicates how well the company is utilizing its equity investment. ROE is considered to be one of the best indicators of profitability. It is also a good figure to compare against competitors or an industry average. Experts suggest that companies usually need at least 10-14 percent ROE in order to fund future growth. If this ratio is too low, it can indicate poor management performance or a highly conservative business approach. On the other hand, a high ROE can mean that management is doing a good job, or that the firm is undercapitalized.
In conclusion, financial analysis can be an important tool for small business owners and managers to measure their progress toward reaching company goals, as well as toward competing with larger companies within an industry. When performed regularly over time, financial analysis can also help small businesses recognize and adapt to trends affecting their operations. It is also important for small business owners to understand and use financial analysis because it provides one of the main measures of a company's success from the perspective of bankers, investors, and outside analysts.
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