We find many of our small business clients get their financial statements and taxes filed by their accountant every year, but in many cases are not sure what their statements are telling them about their business. They do not spend the time with their accountant to explain the statements and how their business is performing as well as how they are doing versus other businesses in their industry.
Financial Analysis is not a topic that most are interested in finding out about until such time they apply for a loan or investment and find out that they are turned down. It really 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 that have been submitted to them. They want to see how you are performing year over year, which is horizontal analysis.
HORIZONTAL ANALYSIS Horizontal analysis will compare the current year to the previous year. Each item in the income statement and balance sheet will be looked at against the past year to see if there is an increase or a decrease and by what % is the change. This will help you answer underlying questions you might have. 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 could be a sign of a couple of things. Your costs have gone up, so what your business is making is less than it was 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. 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 may find out that your outstanding balances are not being collected on time, and no one is following up on this within your business. In the case of account payables, you find out that your accounts payable clerk is having to juggle who they are paying. VERTICAL ANALYSIS
Vertical analysis, instead of looking across, is looking up and down the income statement and balance sheet. In many cases, this type of analysis is looked at to compare a business to competitors/other firms in the same industry. On the income statement, you can 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. Also, you can 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 are seen 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. Some of this information for Canadian businesses can be found on the Industry Canada website under Financial Performance. In other cases, this information can be provided by industry associations, and the worst case can be purchased.
Unfortunately for those who are not fond of math, ratio analysis uses information from your income statement and balance sheet to calculate different ratios within your business which helps you measure the financial performance of your business. You may have heard your banker talk about your Debt to Equity Ratio or your Current Ratio. These are two of the ratios that they look at to determine whether you are a credit risk, along with a set of other ratios sometimes depending on your specific industry and how your business compares.
What is essential is to understand what ratios that your lender or investor may be looking at for your business and determine what they are before you turn in your business plan and financials. Financial ratio calculations can be found online and there are even calculators that can help you if you are not a math wizard.
COMBINE HORIZONTAL, VERTICAL, AND RATIO ANALYSIS
While horizontal analysis, which compares the current year to the previous year, coupled with Vertical analysis, that is looking up and down the income statement and balance sheet, can yield interesting insights and trends. Ratios can let you know whether you are becoming a better or worse credit risk for your banker.
On the income statement, you can 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. Also, you can look at individual operating expenses as a percentage of the total of all operating costs. What you are looking for are 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 are covering 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, and this can take cash out of your business.
Reductions in Long Term Loans plus Interest Expense all divide by your Net Income can let bankers know how well you can service your loans with your Net Income. Increases in this ratio can become very problematic later on if not addressed soon enough
TOOLS TO HELP
One of the first things we do when we work with a business is do analysis on their financials in many of our engagements, as this helps us understand what is going on in the company from a financial perspective which can also help in finding out where some of the major issues lie that they are having.
We had developed a tool that we use to do a lot of the calculations for us, and have now developed it further so a small business owner who wants to analyze their own financials can do so. The tool we have looks at Horizontal Analysis, Vertical Analysis and Ratio Analysis. The Ratio Analysis looks at 14 different calculations and provides you with an understanding of what the ratio is measuring, the importance, and notes on what is a good ratio or whether it should be compared to other businesses in your industry.
You can find this tool available in our store where we are now developing more tools to help businesses help themselves during this pandemic while revenues are tight or non-existent depending on where you are with respect to opening.
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 do not have 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 2 years. If you would like to be able to look at additional years, the tool can be modified for your business.
SUMMARY Understanding what your financial statements are telling you is very important for a business owner to know. It is how anyone that is lending or investing money in your business or plans sell / lease you equipment or other assets 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?