For a financial strategy to work, there first must be organization in the form of an accounting system, which classifies, arranges, and summarizes data.
The output becomes income statements, balance sheets, and cash flow statements. These are key informational tools for the leadership/management team, investors, and lenders.
There are two primary types of accounting methods used to generate financial reports—cash method and accrual method. With the cash method, transactions are only recorded when cash is received or paid out. The method is easy to maintain, and there is no account receivables or payables. The report equals the cash. The problem with the cash method is that it doesn’t always match expenses to income. This method is typically chosen by small cash-type businesses.
On the other hand, the accrual method reports income and expenses as they are incurred—even if no money has changed hands. Most businesses use the accrual method because it accurately reflects activity in each month’s report.
There is also a modified cash basis method, which tracks payables and receivables. Ask your accountant which method is best for your company.
Here are some helpful terms for your Financial Analysis:
Income Statement Analysis
Income from the sale of a company’s products or services. Also, known as revenues or your top line.
These are all of the costs of doing business that are directly proportional to your sales or the costs involved with making the parts. Also known as the costs of goods sold.
Cost of Material Sold:
The amount you paid for the material you shipped. This doesn’t include the cost of material you purchased during the period unless you shipped it during the same period.
The amount of money available to cover fixed expenses and generate profits. Also known as gross profit margin.
Expenditures that don’t vary with levels of production.
This is the pretax profit earned by the company, what is left after you subtract the variable costs and fixed expenses. Also, known as net income from operations.
Operating Profit = Revenues – Variable Costs – Fixed Expenses
This is what is left of your sales and non-operating income after
all operating and non-operating expenses have been subtracted
from your sales. Also, know as net income or your bottom line.
Net Profit = Revenues + Other Income – Variable Costs – Fixed Expenses – Non-Operating Expenses
Balance Sheet Analysis
The total of anything of value that is owned or legally due to the business.
Cash and other resources that can be converted into cash within 12 months of the date of the balance sheet.
Inventory – Material
The purchased price of the material held in inventory. This does include the cost of material you purchased during the period unless you shipped it during the same period.
The amount due but not yet paid from customers in payment or products or services.
The total of your cash in checking, savings, money market and petty cash.
The total of your stocks and bonds.
The amount of resources your business owns for use in operations, such as building, machinery, and equipment. Except for land, fixed assets are listed at their purchased price minus depreciation.
The amount of debts and obligations payable within one year (accounts payable, current portion of long term debt, accrued pension, etc.)
Long Term Liabilities
The amount of debts and obligations payable over a period exceeding one year (machinery notes, mortgages, etc.)
The total amount of current and long term liabilities.
Total Liabilities = Current Liabilities + Long Term Liabilities
The amount represents the owners’ interest in the company.
Owners Equity = Total Assets - Total Liabilities
Key Financial Ratios
Return on Revenues
This ratio shows how much net income is derived from every dollar of net revenues. Many people would like a very high number here, but most numbers earn a net profit of less than 10% and are quite successful.
Return on Revenues = Net Profit ÷ Net Revenues
Return on Equity
This ratio shows the relationship between your net profit and owners’ equity. The higher the risk, the higher the return should be. If your return is less than 5%, you could get a better rate saving with your local bank.
Return on Equity = Net Profit + Owners’ Equity
Contribution Margin Ratio
A percentage of net revenues, tells you how well you are generating funds to cover fixed expenses and make a profit.
Contribution Margin Ratio = Contribution Margin ÷ Net Revenues
Tells you at what point your business “breaks even.” It is the dollar amount of revenues that exactly covers all of your variable costs and all your fixed costs, with nothing left over for profit.
Break-even Revenues = Fixed Expenses ÷ Contribution Margin Ratio
How quickly you collect your accounts receivable. How many “times” net sales “covers” your receivables. The bigger the number, the faster you collect cash from those who owe you money.
Receivables Turnover = Net Revenues ÷ Accounts Receivable
This ratio represents the number of times in the period that inventory is sold, or “turns over.”
Inventory Turnover = Cost of Goods Sold ÷ Total Inventory
Represents the short-term resources that you have available to maintain normal business operations. The more working capital you have, the more reliable your operation is.
Working Capital = Current Assets - Current Liabilities
Working Capital Turnover
The company’s effectiveness in using working capital to generate revenues. The higher the number, the more effective you are using your money to make sales.
Working Capital Turnover = Net Revenues ÷ Average Working Capital
How much the owners’ equity is leveraged. How much the owners have at stake in the company compared with how much, the bank has at stake. A high ratio is considered a sign of a “risky” company. A low ratio is a sign of a “conservative” business.
Debt-to-Equity Ratio = Total Liabilities ÷ Owners’ Equity
Tells you about your liquidity, whether you’ll have enough cash to run your business. It tells you if you have enough current assets to meet the payment schedule of current liabilities. A strong ratio will be 2:1 or better, you have twice as much current resources to cover your current obligations.
Current Ratio = Total Current Assets ÷ Total Current Liabilities
Is a more rigorous measure of your liquidity, whether you’ll have enough cash to run your business. It tells you if you have enough “quick” assets (cash, accounts receivable, stocks) to meet the payment schedule of current liabilities. A strong ratio will be 1:1 or better. You have enough money to cover your current obligations. Also known as the acid test ratio.
Quick Ratio = (Cash + Accounts Receivables + Liquid Assets) ÷ Total Current Liabilities