Friday, November 11, 2005

Making Sense of your Financial Statements

Financial statements provide an overview of the economic situation of a business or individual. While many small business owners often keep themselves busy well beyond an eight- or 10-hour workday and "live and breathe" their business, the nuts and bolts facts of their financial condition are often overlooked.

With increased scrutiny of financial documents for even closely held companies, financial statement analysis and forecasting programs are an excellent resource for owners of businesses. Use of such tools will help the owners gain a better understanding of their present and potential financial condition and can ease the process of acquiring additional funding, whether through loans or private investors or provide insight to how well the company is performing against its industry peers.

Several ratios can give insight to a companies performance. In the following article we can explain the liquidity, efficiency, operating, financing, and profitability ratios.

Liquidity Ratios

Liquidity is a company's ability to meet its maturing short-term obligations. Liquidity is essential to a business when confronted with unforeseen events, such as a strike, recession, supply interruption, and so forth. Favorable liquidity is also necessary for taking advantage of certain business opportunities that may develop. Determining the liquidity of a company is particularly important to creditors, since it may affect timely payment of principal and interest payments, and payment of trade debt, as well as overall solvency.

From the firm's perspective, the liquidity ratios measure the management of working capital, which includes activities with current assets and current liabilities.

Working Capital to Sales Ratio is computed by subtracting current liabilities from current assets (equivalent to calculating working capital), and then dividing the result by net sales. This measures the working capital a company is carrying relative to its sales volume, and is an indicator into how much working capital is required for a certain sales level. It also provides insight into the degree of protection afforded current creditors.

Although there are differences of opinion, it is generally accepted that the higher this value the better, because it means that the company is doing a good job of creating working capital for day-to-day operations and to guard against any sudden downturns in business. Extremely high values, however, may indicate that the company could be generating higher sales with the available working capital.

Efficiency Ratios

Efficiency ratios usually indicate how well a firm is managing its accounts receivable, accounts payable, inventory and operating cycle. Because these ratios are based upon a snapshot of certain balance sheet accounts (to total annual sales), they will not reflect seasonal fluctuations.

Days in Accounts Receivable is defined as the average number of days required to collect an account receivable. The ratio is calculated by dividing (Trade) Accounts Receivable by average Daily Net Sales and is expressed in days. Firms should strive for a low number of days in accounts receivable, because it means receiving payments quicker and enhancing cash flow.

Accounts receivable turnover is sometimes used as another benchmark in this area, and is defined as Annual Net Sales divided by Accounts Receivable.

Operating Ratios

Operating ratios are designed to assist in the evaluation of management performance and its effectiveness in utilizing the resources available.

Asset Turnover is calculated from Net Sales divided by Total Assets. This ratio measures a firm's ability to generate sales from the total asset base. Higher ratios suggest a greater capacity to create sales with given assets. This ratio is particularly helpful in conjunction with other asset utilization measurements.

Financing Ratios

Financing ratios analyze the relationship between a firm's debt load, its fixed asset base and net worth. Essentially, they explore the financial structure of a company.

A high level of debt can make a firm vulnerable to business downturns for reasons beyond the firm's control. Two ratios are commonly used for this analysis: Debt to equity and cash flow to current maturities of long-term debt.

Cash Flow to Current LT Debt Ratio is computed by dividing Cash Flow (as measured by net income before taxes plus depreciation, amortization, and depletion) by Current Maturities of Long-Term Debt. This ratio provides insight into how well the company is able to meet its current obligations on long-term debt through its cash flow. The higher the value, the better.

Profitability Ratios

Profitability ratios are useful in expressing the company's earnings relative to what created them, whether it is sales, owners' equity, or total asset base.

Return on Sales (Net Profit %) measures a company's ability to generate profits relative to the sales volume. It is definitely one of the key indicators of the success of a business. Return on Sales is calculated by dividing Net Income before Taxes by Net Sales, and expressing the result as a percentage. Obviously, the higher the value, the more successful the company is at generating profits from its sales.

In short, business owners need to be able to identify negative and positive trends. They need to know not only if cash flow is dropping, but why, and how to increase it before it dries up completely. We can help you with a complete review of your financial structure to give you ideas of were your company stands against the industry and what actions plans could be taken to improve performance in some areas. As always, if you have any questions or concerns please contact our office.