Lesson 6 in the Basic Accounting series:
Financial ratios and performing a financial analysis using your financial statements can help to construct a successful small business.
Financial Ratio – Comparative Analysis
Comparing your current financial statements to:
- previous years
- previous months
- previous quarters
…can tell you how your business is doing financially and if it is fulfilling its obligations.
- Are sales better or worse?
- Are costs more or less (compare each expense)
- Is your cash flow improving? What are your total current assets?
These are just a few of the things you will want to study in your financial analysis.
Pull out those previous financial statements, clear your calendar, get comfortable, and plan on spending a few hours analyzing and comparing those previous financial statements with your current ones.
Those of you with a new business can take your pro forma statements (Pro forma financial statements are forecasts of the financial position of a business at some defined point in the future) and perform your financial analysis by asking yourself the following questions:
- Do you have fewer sales than you predicted…if so, why?…possibly due to trends?
- Were any expenses greater than you predicted?…What is the total debt? Total current liabilities?
- Is there a way to lower them? Perhaps the cost of goods?
Financial Ratio – Industry Comparisons
An industry comparison analysis compares your small business’s performance to other small businesses in your industry.
These are not as easy to do simply because finding the data you need to perform these financial analyses is sometimes difficult to find.
However, if you ever need a loan or investors, you can bet they will perform some of the following financial ratio analysis or with your financial statements.
So it may be worth a little effort and/or money to get your industry average ratios. I live close to a college, and usually, I can get a copy of industry averages free from the library there.
You might be able to find the same information at your local library. The books you want to look at are the Standard and Poor Industry Averages and the Valuline Surveys.
You can also get a basic financial ratio report in your industry free online from this site: bizminer.com, but you have to pay for a more current detailed report.
Here are a few of the most common financial ratio analyses using your Profit and Loss Statement or income statement.
- Gross Profit Ratio – This is the most common ratio calculated on your Profit and Loss statement. You divide your gross profit by your net sales. Then compare your ratio to similar small businesses in your industry. Click here for a free Gross Profit Margin Ratio calculator.
- Net Profit Ratio – This formula is simply Net (pre-tax) Profit divided by Net Sales. “Net Income” is income with all expenses subtracted out, including taxes, interest expenses, and depreciation. “Net Sales” is sales revenue minus any returns and allowances. This is a good ratio to perform a comparative analysis with. Look at your data historically to see how the net profit margin is trending.
Most financial ratios are calculated using your Balance Sheet.
Here are a few of the most common financial ratio analyses: using your Balance Sheet:
- Current Ratio – This is the most common ratio calculated on your Balance Sheet. Bankers and investors use this ratio to determine if you are likely to be able to pay your bills. It is calculated by dividing Current Assets by Current Liabilities. An acceptable current ratio is at least 1:1, but a ratio of 2:1 would be much better. Click here for a free Current Ratio calculator.
- Quick Ratio – Calculated by dividing the sum of Cash and Account Receivables by Current Liabilities. This ratio is often referred to as the “Acid Test” because it concentrates mainly on your more liquid assets. An acceptable quick ratio is 1:1. Click here for a free Quick Ratio calculator.
- Debt/Assets Ratio: Total liabilities divided by total assets. The resulting ratio tells your banker, investors, and/or creditors what portion of your assets are paid for with borrowed money, so the lower, the better with this one:) Click here for a free Debt-to-Assets Ratio calculator.
- Return on Assets – This is calculated by dividing Net (pre-tax) Profit by Total Assets. Bankers and investors use this one to determine how efficiently you are using your assets. Click here for a free Return on Assets Financial Ratio calculator.
These are just some of the ratios you can use to do a simple financial statement analysis. There are more complex ratios falling in various categories, such as efficiency ratios, net profit margin ratios, operating cash flow ratio, market value ratios, fixed asset turnover ratio, working capital ratio, dividend payout ratio for dividend yield, price earnings ratio, inventory turnover ratio, leverage ratios, receivable turnover ratio, debt ratio (short-term debt and long-term debt), solvency ratios, equity ratios and liquidity ratios you can use (search financial ratios), but if you have a tiny business such as myself you really don’t need the more complex analyses just yet.
Use these and compare how you are doing now to how you were doing and how you compare to others in your industry. These are essential to any small business owner and its shareholders who own either preferred stock or common stock to measure your business’s financial health.