After you've gotten the basics of financial record keeping down pat—and you have a good handle on your company's cash flow and other day-to-day issues—you might want to take a longer and deeper look at the financial state of your company. In some cases, you may need to undertake a fairly detailed financial analysis because you are looking for additional capital in the form of loans or investors.
Business owners who haven't been schooled in accounting often have a limited understanding of how financial analysis can help them manage their businesses effectively. Although you may be used to getting quarterly or annual financial statements from your accountant, are you sure that you're really making the best use of all the information contained in them?
Over the years, accountants and financial professionals have developed a number of systematic ways of arranging and comparing the financial facts about your business so that they can be used to make sound decisions about future actions. In this article, we'll discuss 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
- business ratios that identify key relationships between financial data and allow you to monitor your liquidity, profitability and efficiency
- cost/volume/profit analysis, a way of determining the true cost to you of providing your product or service, and the optimal operation level for your business
Common Components of Financial Statements
If you want a clear understanding of how your business is doing financially, a fairly thorough understanding of your financial statements is essential. This exercise also lays the groundwork for future business plans. A sound understanding of financial statements will help you:
- identify unfavorable trends and tendencies in your business's operations (for example, the unhealthy buildup of inventory or accounts receivable) before the situation becomes critical
- monitor your cash flow requirements on a timely basis, and identify financing needs early
- monitor important indicators of financial health (for example, liquidity ratios, efficiency ratios, profitability ratios and solvency ratios)
- monitor periodic increases and decreases in wealth (specifically, owners’ or stockholders’ equity)
- monitor your performance against your financial plan, if you have developed one
You'll want to familiarize yourself with the four basic components of financial statements:
- The income statement, also referred to as a “profit and loss statement,” “statement of incomes and losses,” or “report of earnings,” tells you or your investors:
- the income the business has earned during the accounting period
- the costs or expenses that were incurred by the business during the period
- the difference between the costs and incomes for the period, or net profit (or loss)
- The balance sheet is a statement of a company's relative wealth or financial position at a given point in time. It shows assets, liabilities and owners’ equity.
- The position statement, also known as the “statement of changes in financial position” or “sources and uses of cash,” helps to explain how a company acquired its money and how it was spent.
- The statement of changes in owners’ equity is used to bridge the gap between the amount of owners’ equity at the beginning of the period and the amount of their equity at the end of the period.
- What to do with your financial statements contains a checklist of ways to look at the data to put it in perspective.
- Common size financial statements provides an easy way to spot trends in your balance sheets and income statements over time is to convert the dollar amounts to percentages.
The Limitations of Financial Statements
Keep in mind that your financial statements are only a starting point for analysis. Individual numbers aren't good or bad in themselves—you may have to dig for the reason behind any numbers that seem out of order. For instance, if your statements shows that your accounts receivable have trended significantly downward over the last few years, it could mean that you're collecting the accounts more aggressively (which is good), or it could mean that you're writing off accounts as uncollectible too soon (which is bad). The key is to use your statements to spot trends and anomalies, and then follow these up with further investigation.
Learning the Basics of Financial Statements
Before you dive into the nuances of financial statements, you need to accept the fact that there are rules to putting these statements together. How much you need to worry about the rules, however, depends on what you want to do with the statements. If you are intending to show them to third parties such as lenders, creditors or investors, you need to be more careful than if they are intended for your eyes only.
Think of finance as a sport like, say, football. The rules of the finance game are called the generally accepted accounting principles (GAAP) and are set forth by the American Institute of Certified Public Accountants (AICPA) and the Financial Accounting Standards Board (FASB). GAAP includes numerous guidelines and conventions that help ensure that reported financial information is accurate, objective and reasonably consistent for all types of business, so that results from one business can be compared to those from another.
Most likely, your financial statements will be prepared by your accountant who will follow the GAAP rules when creating them. Some investors or banks require that financial statements be prepared by a CPA because this gives the lender an extra measure of security — CPAs have proven that they have extensive knowledge of accounting, tax and legal requirements by passing a difficult professional examination, and they must build up their knowledge with continuing education. What's more, CPAs must adhere to certain professional ethics requirements or risk losing their licenses.
Even if you're not required to use a CPA by your bank, you may decide to have a CPA prepare your statements, particularly if you're planning to seek financing or investors in the near future. However, you can also opt to have a non-CPA accountant prepare your statements, or even to prepare your own financial statements. A number of software products are available that incorporate GAAP and make this job relatively simple, provided you understand the basic concepts we're about to explain to you.
Tools to UseA trial balance spreadsheet is available in our Tools & Forms area. You can use the Excel template as a starting point for your own trial balance. You can also try our sample balance sheet and sample income statement, all of which can be used multiple times and tailored to your specifications.
Guidelines for Compiling Financial Statements
Unless your bank needs to see them more frequently, many businesses request that the statements be prepared by their accountant every quarter. Some smaller businesses find that once a year (around tax time) is enough. However, if you have financial software at your fingertips, you may find it so easy to draw up provisional statements yourself that you do it monthly, or whenever you feel the need to get precise information on how your business is doing.
Understanding the Basics of Using Financial Tools
Before you dive into the nuances of financial statements, you need to accept the fact that there are rules to putting these statements together. How much you need to worry about the rules, however, depends on what you want to do with the statements. If you are intending to show them to third parties such as lenders, creditors or investors, you need to be more careful than if they are intended for your eyes only.
Think of finance as a sport like, say, football. The rules of the finance game are called the generally accepted accounting principles (GAAP) and are set forth by the American Institute of Certified Public Accountants (AICPA) and the Financial Accounting Standards Board (FASB). GAAP includes numerous guidelines and conventions that help ensure that reported financial information is accurate, objective and reasonably consistent for all types of business, so that results from one business can be compared to those from another.
Most likely, your financial statements will be prepared by your accountant who will follow the GAAP rules when creating them. Some investors or banks require that financial statements be prepared by a CPA because this gives the lender an extra measure of security — CPAs have proven that they have extensive knowledge of accounting, tax and legal requirements by passing a difficult professional examination, and they must build up their knowledge with continuing education. What's more, CPAs must adhere to certain professional ethics requirements or risk losing their licenses.
Even if you're not required to use a CPA by your bank, you may decide to have a CPA prepare your statements, particularly if you're planning to seek financing or investors in the near future. However, you can also opt to have a non-CPA accountant prepare your statements, or even to prepare your own financial statements. A number of software products are available that incorporate GAAP and make this job relatively simple, provided you understand the basic concepts we're about to explain to you.
Guidelines for Compiling Financial Statements
Unless your bank needs to see them more frequently, many businesses request that the statements be prepared by their accountant every quarter. Some smaller businesses find that once a year (around tax time) is enough. However, if you have financial software at your fingertips, you may find it so easy to draw up provisional statements yourself that you do it monthly, or whenever you feel the need to get precise information on how your business is doing.