How well is your company really doing financially? Do you truly know the answer to that question? Do you know how to conduct the right financial analysis tests to get an accurate answer?
Don’t worry. Many business owners don’t know the full story of the financial health of their companies. The problem with not knowing is that disaster could be looming. If you don’t understand your numbers, not only will you lose opportunities to grow, but you’ll also lose profits and possibly, your entire company!
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Following is an introduction to some financial analysis methods that can help you get an understanding of your company’s financial position at any time. Some of the financial analysis ratios discussed at the end of the article are used only by companies with shareholders, but I included them so even if you don’t own a corporation or public company, you’ll have some tools to evaluate other companies for your future business and investing decisions.
Horizontal analysis is a technique used to evaluate financial data by comparing results and identifying year-over-year changes to each line item on the balance sheet or income statement. By analyzing the percent change for each line item, you can identify the financial strengths and weaknesses of your company, which could affect the company’s ability to be profitable, attract investors, secure loans, and grow.
A vertical analysis of financial statements is conducted to measure the performance of your company over a period of time. Also referred to as a common-size analysis, a vertical analysis compares each item in the financial statements (usually the income statement and balance sheet) to a base that is set to 100%.
For the balance sheet, total assets, total liabilities, and equity are set to 100% while revenue is set to 100% on the income statement. A vertical analysis provides a high-level view of strengths and weaknesses when the percentages for each line item are compared between two years or against an industry benchmark.
A trend analysis is used to spot trends in increases or decreases over a period of time in financial statements. A trend analysis can be performed using historical data as well as for forecasting future sales and performance. By reviewing the percent change in each line item on the balance sheet and income statement over a period of years, you can identify decreases or increases that are expected to continue in the future so appropriate strategies can be put in place to maximize or minimize those trends as appropriate.
Ratio analysis is a technique used to measure a company’s ability to pay current liabilities, sell inventory, collect receivables, and pay short-term and long-term debt. Ratios can also help a company measure its profitability and analyze its stock as a viable investment choice. Using data from the financial statements, a series of ratios offers a perspective that a horizontal analysis or vertical analysis cannot provide. Ratios give a picture of how the company is positioned financially. Some of the most commonly analyzed ratios are discussed below.
The current ratio is calculated by dividing total current assets by total current liabilities. It measures your company’s ability to pay its current liabilities with its current assets. In other words, the current ratio tells you whether or not your company has enough money on a daily basis to pay the bills.
The acid-test ratio is calculated by adding cash, short-term investments, and net receivables and then dividing the sum by total current liabilities. It’s similar to the current ratio, but it only measures a company’s most liquid assets. In other words, this ratio measures your company’s ability to pay all of its current liabilities if they became due immediately. Is your company liquid enough? The acid-ratio test provides the answer to that question.
Average Collection Period
The average collection period ratio measures your company’s ability to collect money from its credit customers. In other words, the ratio tells you how long it takes for customers to pay. It is calculated by dividing net credit sales by average accounts receivable.
To determine if your company’s average collection period is a strength or weakness, it must be compared to an industry average or benchmark. An average collection period ratio that is lower than the industry average is a sign of strength and tells you that your company is collecting money from customers faster than the industry average. A higher average collection period ratio is a sign of weakness because your company is collecting money slower than the industry average.
The debt ratio is calculated by dividing total liabilities by total assets. It measures the proportion of the company’s assets that are financed with debt. If the ratio is high, then the company has too much debt. For example, if the debt ratio hits 50%, you should use caution, because too much debt, particularly when the economy weakens, puts your company in a risky position. If your company cannot pay its debt, it might have to file bankruptcy.
Gross Profit Margin
Gross profit margin is a measurement of management’s efficiency in using labor and supplies to manufacture goods. It’s calculated by subtracting cost of goods sold from sales and then dividing the result by sales. The gross profit margin tells little without a benchmark to compare it to. Your company’s gross profit margin should be higher than the benchmark to be considered a strength.
Operating Profit Margin
Operating profit margin is a measurement of your company’s ability to generate an income from its operations. The operating profit margin reports how much earnings before income taxes is generated from each sales dollar and is calculated by dividing earnings before income taxes by sales. A company’s operating profit margin should be evaluated against a benchmark and is considered a strength when the company’s ratio is higher than the benchmark.
Net Profit Margin
Net profit margin measures the percentage of each dollar in sales that is earned as net income. It is calculated by dividing net income by net sales. Your company’s net profit margin cannot be evaluated without a benchmark to compare it to. Your company’s profit margin must be equal to or higher than the benchmark for it to be a sign of strength.
Times Interest Earned
Times interest earned measures your company’s ability to pay the interest on its debt. In other words, it measures the number of times operating income can cover interest expense and is calculated by dividing income from operations by interest expense. A high ratio (over the industry average of 1.0 is good) means your company will have no problems paying the interest it owes on its debt, but a low ratio (below 1.0) means the company is in big trouble.
Earnings per Share
Earnings per share evaluates a company’s profit by measuring the portion of a company’s profit that is allocated to each outstanding share of the company’s common stock. Said another way, earnings per share represents the dollar value of earnings for each outstanding share of common stock. Investors want earnings per share to go up. There isn’t an industry benchmark for earnings per share, so comparisons are only done on internal metrics with the goal to increase earnings per share so shareholder value increases.
Return on Total Assets
Return on total assets measures how profitably your company uses its assets. The ratio must be compared to a benchmark. To calculate return on total assets, the sum of net income and interest expense is divided by average total assets.
Return on Common Equity
Return on common equity measures how profitably your company uses its common equity, including additional paid-in capital on common stock and retained earnings. It is calculated by subtracting preferred dividends from net income and then dividing the result by average common stockholders’ equity. It must be compared to an industry average. If your company’s return on common equity is higher than the industry average, then the company is more profitable.
Price/earnings ratio (P/E ratio) is a measurement of your company’s current share price (i.e., the market price per share) to its earnings per share. In other words, the price/earnings ratio shows how much shareholders are willing to pay for every $1 your company earns. It is calculated by dividing market value per share by earnings per share. If your company’s price/earnings ratio declines, stockholders will not find the stock as attractive as it was before the drop.
Your Next Steps
Talk to your accountant and finance professional to gather the numbers you need for your financial analysis evaluations. Once you crunch the numbers, you’ll know if you have any financial problems that need to be addressed. The entire story of your company’s chances for success is written in your numbers. You just need to know how to read and use them!