So, you’re going to your accountant’s office tomorrow to review your company’s year-end financial statements. They have already sent to you a draft copy of the statements so that you may prepare for tomorrow’s meeting. But without going over the details in person with your accountant, you’re not sure what it all means.
A well-prepared set of financial statements, which should include comparative figures for the prior year, provides information about the company’s performance and financial position. Fundamental to understanding your financial statements is an analysis of its components by calculating certain financial ratios and comparing them to industry-wide ratios or those which are relevant to your business. These ratios will reveal important information about your company’s past, which will help you choose the path you want it to follow for the future.
Although a complete set of financial statements includes a statement of income, a balance sheet, a statement of retained earnings and a statement of changes in financial position, this article will be devoted to explaining ratios that are useful in understanding the statement of income and the balance sheet.
The Statement of Income
This is where you’ll find your company’s “bottom line”. With some simple analysis, however, there is a lot more information available.
By comparing sales from year to year, you’ll see if sales have increased more than any price increases that you implemented during the year. If they have, great! If not, it means you’re either losing customers or your customers are buying less from you. If your sales are analyzed by major categories, you may also be able to identify meaningful changes in your sales mix.
You can figure out your inventory turnover ratio by dividing the cost of sales by the average inventory for the year. The higher the ratio, the better off you are. A drop in your turnover ratio, however, may reveal an overstock situation that has yet to be corrected.
The gross profit (or gross margin) represents the excess of sales over cost of sales. A change in your gross profit ratio, which means dividing gross profit by sales, may be a symptom of many different conditions. It may mean that your sales force has maintained margins, or that you had to give in to competitive forces. On the other hand, a change may also mean that your suppliers have increased or cut their prices. If you’re a manufacturer, it may also mean using various production elements efficiently. If your sales and cost of sales figures are analyzed by major categories, you may be able to spot a trend for a type of product, rather than for the company.
For operating expenses, your primary concern should be cost control. You should focus on significant variances in the amount of expenses for any one line item, or on any changes in relationships between line items. For example, if there is a strong relationship between commission expense and sales, check to see if the commission rate on the financial statements is in line with your expectations. Furthermore, fixed expenses such as rent, insurance, and other overhead expenses, should generally be the same amount from year to year. Big variances in fixed expenses may require further investigation.
The Balance Sheet
The balance sheet gives you a financial “snapshot” at the year-end date. As you know, the balance sheet reports the company’s assets (the things that it owns), its liabilities (the things that it owes) and its shareholders equity (net worth). Using some basic balance sheet ratios will help you identify trends about your company’s finances and ability to meet its commitments.
The current ratio, being current assets divided by current liabilities, is one indicator of a company’s liquidity. The higher the ratio, the better; but a drop in the ratio may indicate trouble, such as using a demand line of credit to finance new capital equipment or other long-term assets. Another reason for a deterioration in the current ratio would be recent decreases in operating cash flow to pay your trade suppliers and other current debts as promptly as in the past. The quick assets ratio, which represents the ratio of current assets less inventory over current liabilities, is another good indicator of liquidity.
To analyze accounts receivable, you should use the accounts receivable turnover ratio, being the amount of credit sales divided by the average accounts receivable balance. When this ratio drops, it means that it’s taking longer to collect your receivables, which might be a problem that’s widespread throughout your customer base, or may be concentrated with just a few of your major customers. Although both situations require corrective action, the latter is especially dangerous. You may get hit with a big loss because of an unhappy customer or because of their own financial difficulties.
On the liability side, the most commonly used ratio is the debt-to-equity ratio, which is the sum of the liabilities divided by tangible net worth (shareholders’ equity less the book value of intangible assets). The more debt that you take on, the higher this ratio will become. Taking on too much debt means less flexibility in making business decisions or taking on new projects. This is because your lenders will have become your business partners, and that’s not the reason you went into business in the first place, is it?
To determine return on investment, which shows a shareholder’s yield on his / her investment, simply divide net income (or loss) by tangible net worth. An unusually low ratio may mean that the company’s profitability isn’t what it should be when compared to prior years or to industry standards. Alternatively, if cash balances are high, the current ratio is higher than normal and the debt to equity ratio is lower than normal, a low return on investment ratio may mean that it’s time to make either make a substantial distribution of excess company cash to shareholders or make an investment in another venture that will improve the company’s overall profitability.
Now that you’ve analyzed the statements, you will have come to certain conclusions about how well your business has fared over the past year. But was this year’s performance in line with your real expectations? Had you even set targets and goals for the year?
Planning for success, by preparing financial and operational budgets, is an important part of effectively managing your business. You should also make sure that your financial reporting system is set up in such a way that reporting actual to budgeted results is a snap. If you need help in preparing budgets or in setting up a financial reporting system, seek your accountant’s advice. He / she will be qualified to advise you on what methods and systems are best suited to you and your business.
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