We find many of our small business clients get their financial statements and taxes filed by their accountants every year but need to figure out what their financials are telling them about their business. They do not spend the time or money with their accountant to explain the statements or how their business is performing with respect to others in their industry. They, in most cases, see their accountant once a year to drop off the information needed to compile the statements to file their taxes.
Financial Analysis is a topic most are only interested in finding out about when the business needs to apply for a loan or investment. If you require help understanding your financials, there is a good chance you could be turned down without understanding why. It would have been more advantageous for the business to understand the results before applying for a loan or providing their financials to an investor. A lender or investor will do their financial due diligence on the statements submitted to them. They want to see how you are performing year over year, within the year, with respect to spending versus revenue, assets versus liabilities, and specific financial ratios that tell a story about the risk of the business to the lender/investor.
HORIZONTAL ANALYSIS
Horizontal analysis compares the current year to the performance of the previous year. It analyzes each item in the income statement and balance sheet against the past year to determine increases and decreases and by what percentage. The horizontal analysis will help you answer underlying questions you might have in the following situations.
Situation 1
In the case of your Income Statement, you notice that your margins (or the profit you make) are becoming lower and lower each year. This situation could be a sign of a couple of things.
Your costs have gone up, so what your business is making overall is less than before.
You might investigate other suppliers for lower costs, or you might have to increase your price if you want to make the same margin.
Situation 2
In the case of your Balance Sheet, you notice that your accounts receivables and accounts payables increased significantly from the previous year.
For your account receivables, you uncover that your bookkeeper needs to collect outstanding balances on time, and no one is following up on this within your business.
In the case of account payables, you uncover that your accounts payable clerk has to juggle whom they are paying.
VERTICAL ANALYSIS
Vertical analysis is often used to compare a business to competitors/other firms in the same industry. The vertical analysis looks at the year's income statement and balance sheet. On the income statement, you look at each revenue item, cost of sales/cost of goods item, operating expenses, income tax, and profit as a percentage of the overall revenue. You can also look at individual operating expenses as a percentage of the total of all operating costs.
In the case of the balance sheet, asset items are viewed as a percentage of total assets and liabilities, and shareholder's equity is viewed as a percentage of the total liabilities and equity.
Vertical analysis needs information from others in your industry in most cases to compare it to make it relevant. The information for Canadian businesses can be found on the Industry Canada website under Financial Performance for most industries. In other cases, industry associations can provide this information, and in the worst case, the information can be purchased.
RATIO ANALYSIS
Ratio analysis helps you measure the financial performance of your business. Unfortunately, for those not fond of math, ratio analysis uses information from your income statement and balance sheet to calculate different ratios within your business. You may have heard your banker talk about your Debt to Equity Ratio or your Current Ratio in the past. These are two ratios that banks look at to determine whether you are a credit risk. They will also use other ratios depending on your specific industry.
Understanding what ratios your lender or investor may be looking at for your business is essential, along with determining what they are before you give them your business plan and financial statements. Financial ratio calculations can be found online, and there are even calculators that can help you if you are not a math wizard. Here is a link to several.
USE ALL THREE ANALYSIS TOOLS
If you are looking for financing or investment, it is critical that you know how you are performing before your lender or investor tells you. Using horizontal, vertical, and ratio analysis can help you understand what your financials are telling you about your business. It can help you determine if you are improving or if areas need work.
With horizontal analysis, you look for improvements and growth year over year. If there are no improvements, you can see where there are potential issues. Suppose your expenses are rising exponentially, and you make less profit each year. In that case, you should look at what expenses can be eliminated and still have revenue growth. On the balance sheet, you look for trends such as reducing liabilities and increasing your assets.
In the case of vertical analysis on the income statement, you are looking for trends of improvement or deterioration. Realizing your cost of sales as a percentage of sales is rising by 1 to 2 percent per year can forecast future financial stress. Looking at Interest Expense as a ratio of your Net Income can let you know how much of your earnings cover interest payments to the bank. In the case of the balance sheet reviewing fixed assets as a total percentage of assets might show that equipment purchases are on the rise, which can take cash out of your business.
Reductions in Long Term Loans plus Interest Expenses divided by your Net Income lets bankers know how well you can service your loans with your Net Income. Increases in this ratio can become problematic later on if not addressed.
TOOLS TO HELP
One of the first things we do when we work with a business is perform an analysis on their financials. This helps us understand what is going on in the company from a financial perspective. In addition, it can also help in finding out where some of the major issues lie that they are having.
We had developed a tool to help us perform the calculations and are now offering it as a tool for business owners who wants to analyze their financials. The tool looks at Horizontal Analysis, Vertical Analysis and Ratio Analysis. The Ratio Analysis looks at 14 different calculations and explains what the ratio measures. It also notes a good ratio number/percentage or whether you need to compare it to other businesses in your industry.
This tool is available in our store, where we are now developing more tools to help businesses help themselves. There are detailed instructions available on the tool. In addition to the analysis above, the tool will generate a cash flow statement for you if you still need one from your accountant. The information generated by this tool could be very beneficial to provide to a lender or an investor. The tool currently only looks at two years. The tool could be modified for your business under a consulting engagement if you want to look at additional years.
SUMMARY
Understanding what your financial statements tell you is very important for business owners. It is how anyone lending or investing money in your business determines whether you are worth the risk. Before you approach them, wouldn't it be advantageous to know ahead of time whether your financials are at a point for consideration?
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