If you are looking for additional capital from financial institutions or investors, you may need to undertake a fairly detailed financial analysis.
How can financial analysis help you manage your business more effectively? Are you sure that you're making the best use of all the information contained in quarterly or annual financial statements from your accountant?
Accountants and financial professionals have developed a systematic way of arranging and comparing the numbers on your financial statements to make sound business decisions. The following sections are some of the most commonly used tools for financial analysis:
Financial statements, including the income statement, balance sheet, statement of changes in financial position, and statement of changes in owners' equity, identify unfavorable trends and tendencies in your business' operations (e.g., the unhealthy buildup of inventory or accounts receivable), before the situation becomes critical. The statements will help you:
- Monitor your cash flow requirements on a timely basis, and identify financing needs early.
- Monitor important indicators of financial health such as liquidity ratios, efficiency ratios, profitability ratios, and solvency ratios.
- Monitor periodic increases and decreases in company wealth - owners' and/or stockholders' equity.
- Monitor your performance against your financial plan, if you have developed one.
Business ratios identify key relationships between financial data and allow you to monitor your liquidity, profitability, and efficiency. These ratios are simple to calculate; however, the ratios are powerful tools that allow you to immediately seize the relationship, such as debt over equity or inventory turnover.
In addition, you can assess the performance of your business over time, compare your business to others in the same industry, or compare your business to others of a similar size when you calculate a group of ratios at the end of every accounting period. Banks use business ratios to evaluate businesses that apply for loans by comparing the businesses' numbers with that of their industries and business sizes. Creditors, to determine whether or not to extend credit to you, could also use business ratios.