With talks of a recession on the horizon, is your small business in a position to succeed regardless of what the future has in store? Understanding and monitoring the current state of your business’s financial health is key to navigating an economic downturn. But when it comes to assessing your financial health, the influx of financial data can be overwhelming. Let’s explore which financial statements and ratios are worth analyzing, how to read them, and how your small business can gain value from them.
Is Your Business in Good Financial Health?
The foundation of a strong financial analysis is having access to accurate data and consistent reporting. While an accountant can do a lot of the legwork for you, it’s important for small business owners to learn the basics of bookkeeping. If you don’t have an accountant, we suggest investing in accounting software to manage the day-to-day financial transactions of your business and compile reports for you. That said, what’s even more important is having the financial acumen to understand what the numbers represent and what they’re trying to tell you. Let’s explore three financial statements and eight ratios that can measure your financial health and tell you what actions to take.
3 Financial Statements you Should Understand
Financial statements can be defined as reports that summarize important financial information about your business. There are three types of financial statements:
1) Balance Sheet
2) Income Statement
3) Cash Flow Statement
Each statement has its place and together with the others gives you a full picture of your financial health. Financial statements can be compiled on a monthly, quarterly or yearly basis.
Balance Sheet Analysis
The balance sheet provides a snapshot of your business’s finances as they currently stand. It reports what your business owns (assets), owes (liabilities), and its shareholder equity. As the name implies, a balance sheet will always balance out since every asset that a business owns was either supplied by creditors or its owners. At the core of a balance sheet is the accounting equation:
Total assets = Total Liabilities + Total Equity
1) Assets: Anything valuable that your business owns such as cash, accounts receivable, inventory, office furniture, etc. Usually, assets are broken up into current assets and fixed assets. Current assets represent cash or anything that can be converted into cash within a year. Fixed assets are long-term tangible assets (e.g., property or equipment) that are subject to depreciation and can’t be converted into cash within a year.
2) Liabilities: Debt that you owe to other people. This can include accounts payable, credit card debt, mortgages, loans and accrued expenses (utilities, wages owed, taxes, etc.). Like assets, liabilities are split into current liabilities and long-term debt. Current liabilities represent anything that needs to be repaid within 12 months. Long-term liabilities are financial obligations that need to be paid beyond 12 months.
3) Shareholder Equity: The remaining value of a business once all debts (liabilities) has been paid off. Simply put, it’s your business’s net worth and can be a great indicator of your financial health.
Using a Balance Sheet to Analyze Your Financial Health
Balance sheets reflect important financial data that can be used to make informed business decisions. Analyzing a balance sheet will help you answer the following questions:
- How much debt have I accumulated? Is this debt justified?
- How much liquidity do I have to cover my debts? Which assets can I quickly convert into cash in the short term?
- How long does it take to receive payments from my customers and to repay suppliers?
- How long does it take for me to sell my inventory that’s currently in stock?
Income Statement Analysis
The income statement provides a detailed breakdown of a businesses’ revenue, expenses and profits or losses over a reporting period. Think of it as a set of stairs. Your business begins at the top of the staircase with all the money it made during that period. As you start walking down, you subtract costs and expenses until you arrive at the bottom (net profit). Income statements are a huge help when it comes to managing your business strategy, budgeting and financial forecasting.
An income statement contains six sections:
1) Revenue: How much money you earned during the period.
2) Cost of Revenue (Cost of Goods Sold): How much it cost to make & distribute your products or services.
3) Gross Profit: How profitable your products and services are. Calculated by subtracting the cost of revenue from revenue.
4) Operating Expenses (Overhead): Other costs of running your business (utilities, rent, support staff, etc.).
5) Operating Income or Loss: How profitable and efficient your business is overall. Calculated by subtracting operating expenses from gross profit.
6) Net Income: How much money you walked away with during the period. Calculated by subtracting taxes from operating income or loss.
Using Income Statements to Analyze Your Financial Health
Income statements provide you with insights on your revenue, profit and everything in between. Analyzing an income statement will help you answer the following questions:
- Is my business making money?
- How much revenue is growing over specific accounting periods?
- How much am I spending on producing products or services?
- How much am I spending on overhead or the cost of running my business?
- Can my business cover its interest repayments on debt?
Cash Flow Statement Analysis
Cash flow is a common challenge for small businesses, and the pandemic only exacerbated that problem. A cash flow statement can help you track how much cash entered and left your business over a specific period. The cash flow statement is based on cash basis accounting, which recognizes revenue and expenses only when cash is truly exchanged. Cash basis accounting provides business owners a clearer picture of their cash movement and is key to understanding a business’s financial health.
Cashflow statements are categorized into operating, investing and financing activities:
1. Operating Activities: Reports on all the core business activities related to buying and selling goods or services.
2. Investing Activities: Reports on the result of investment gains or losses and cash spent on property, vehicles, equipment, etc.
3. Financing Activities: Reports on cash invested by the owner in the business as well as taking out and repaying loans.
Using a Cash Flow statement to analyze your financial health
Unlike an income statement, a cash flow statement shows you the reality of your cash situation within your business. Analyzing a cash flow statement will help you answer the following questions:
- What is my liquidity situation like?
- Where is my cash coming from?
- Has cash increased or decreased?
- How much free cash flow was generated to be used to further invest?
8 Financial Ratios you Should Know
Although financial statements can be helpful, they offer somewhat limited insight. Using financial ratios in conjunction helps you make sense of the numbers in financial statements and can be easily compared against competitors. As a small business owner, it’s important to calculate ratios which point to liquidity, leverage, profitability and asset management.
Liquidity refers to cash that a company has on hand and that can be immediately used to purchase an item or pay an invoice. The better a business’s liquidity, the easier it is to overcome cash flow challenges, to secure loans, and to capitalize on opportunities. Use these two ratios to determine your liquidity:
1. Current ratio (working capital ratio): Determines a business’s ability to pay short-term obligations with its current assets. It compares a firm’s current assets (e.g., cash, receivables and inventory) with its current liabilities.
Current Ratio = Current Assets/Current Liabilities
2. Quick ratio: It’s the current ratio without inventory added in (e.g., cash and receivables versus current liabilities). This ratio shows whether a company has enough money on hand to pay for unexpected events, such as maintenance costs.
Quick Ratio = (Current Assets – Current Inventory)/Current Liabilities
In most cases, current and quick ratios lower than 1.0 are a red flag as it indicates that a business’s current liabilities exceed its current assets. With both ratios, you want to find yourself at a ratio of 2 to 1 to be in a healthy position to pay off your debts.
Leverage helps you determine your debt levels compared to things like assets or equity. Leverage ratios are often used to determine a businesses’ ability to pay long-term debt.
3. Debt to Equity Ratio: This ratio measures your total debt to total equity which measures the risk level of your financial structure. Lenders pay special attention to this ratio since it tells them if you’re taking on too much debt.
Debt to Equity Ratio = Total Debt/Equity
4. Debt to Total Assets: This ratio compares a company’s debt obligations to a business’s total assets. If your business has a debt to total assets ratio higher than one, you have more debt than assets. As a result, you may suffer from less financial flexibility.
Debt to Total Assets = Total Debt/Total Assets
Profitability ratios measure how much income your business can generate after accounting for factors such as operating costs, taxes and debt payments. These ratios can be calculated using an income statement.
5. Gross Profit Margin: Determines how much money your business is making as a percentage of sales compared to the cost of producing goods. It’s the amount of profit before deducting operating, overhead costs and taxes. At face value, a gross margin between 50 and 70% is considered healthy for most small businesses.
Gross Profit Margin = Net sales – Cost of Goods Sold/Net sales
6. Net Profit Margin: This ratio shows how much profit was generated from every dollar in sales, after accounting for all business expenses. The higher the net profit margin, the better your business is doing. Anything between 7 and 10% is healthy, but that will largely depend on your industry.
Net Profit Margin = Net profit/Revenue
This category analyzes how efficiently your business uses its assets to generate sales.
7. Receivables Turnover: This ratio measures how long it takes to be paid once a sale has been made. Being paid quickly is extremely important for cash flow. If your turnover is high, you should spend time working on your receivable process.
Receivables Turnover = Net Annual Credit Sales/Average Accounts Receivable
8. Inventory Turnover: This ratio measures how well you’re managing your inventory. Lower turnover may indicate that your sales are poor or that you might be carrying too much inventory. It’s a great way to determine if you are wasting resources on storage costs or tying up cash on inventory that doesn’t sell.
Cost of Goods Sold/Average Inventory = Inventory Turnover Ratio
Improve Your Financial Health
Financial statements and financial ratios are essential analysis tools that small business owners should measure consistently. By tracking these metrics over time, you will be able to identify risks before they become potential problems and make changes to improve your bottom line.