Financial Analysis is the process of evaluating businesses, projects, budgets, and other finance-related transactions to determine their performance and suitability. This is an important part of managing a growing business. Doing financial analysis every month will allow you to calculate markup on products or services you need to maintain your profit margins, control your cost margin and improve your revenue margin.
A Federal Reserve study found financially healthy small businesses have four things in common: they have strong knowledge and experience with various types of credit, keep a higher level of unused credit balances, put together a budget more regularly and save cash specifically for payroll obligations. Monitoring your financial metrics and conducting an analysis each month will aid you in utilizing credit efficiently, setting attainable goals, increase your profits and allow you to have additional cash for payroll.
Getting accurate metrics starts with producing accurate and timely financial statements each month which is what you’ll receive when subscribing to one of our monthly accounting plans. Additionally there is a lot of nuance in these numbers and they must be viewed in the context of your industry which is where our business consulting team can assist you in discovering industry data, and figuring out ways to improve these metrics. Additionally if you are focused producing or selling products our team can assist you in calculating your contribution margin.
Financial Analysis first starts by analyzing your Income Statement and calculating certain common business metrics such as gross profit margin, operating profit margin, and net profit margin.
Gross Profit Margin- dividing gross profit by sales. Example- if you have a gross profit of $800 and have $1000 in revenue, that means you have a gross profit margin of 80%. That means the direct cost of product or labor is 20% of the revenue, and there is 80% left over to cover other expenses and distribute profit to shareholders. The higher gross margin the better.
Operating Profit Margin- This takes earnings before interest and taxes or EBIT (Gross Profit- Operating Expenses). Let’s say you have a gross profit of $800 ($1,000 sales – $200 of Direct Cost of Labor/Product) with operating expenses of $500, you have an EBIT of $300, out of $1,000 in revenue which means your operating profit margin is 30% and available to pay non-operating costs. Increasing operating margins can indicate better management and cost controls within a company.
Net Profit Margin- this is an indication of the overall success of the business. Higher Net Profit Margin indicates that the company is efficiently converting sales into profit. This can be compared to other businesses in your industry. Let’s say your gross profit of $800 less $500 of operating expenses, less $100 in interest and/or taxes. That leaves $200 net profit margin on $1,000 of revenue. That means for every $1 in revenue, the company earns 20 cents in profit.
After the income statement is analyzed, you can begin analyzing the Balance Sheet in conjunction with the Income Statement. By looking at both you can investigate how well your company is using its capital, why the company may be borrowing money and whether that borrowing is justified. Two metrics to watch are return on assets and the working capital ratio.
Return on Assets- This is your profit after tax divided by your total assets multiplied by 100. In the above example, we had $200 net profit margin. If your company has $5,000 in assets, that would make a return on assets of $200/$5,000 * 100 = 4%. Simply put for every dollar in assets, it earned four cents of profit. We can then compare that percentage to other companies in your industry to see how efficiently it converts money invested in assets into profit.
Working Capital Ratio- This is your current assets divided by current liabilities (current means collection or payment in less than 12 months). A ratio of less than one is a warning sign of cash flow issues. A ratio of two indicates solid short-term liquidity. Using the company example above, with $5,000 in assets, let’s say they have $2,500 in liabilities. That gives us a working capital ratio of 2.
You can also then combine some of these metrics to better understand your business. As an example, one of these metrics is Working Capital Turnover.
Working Capital Turnover- Measures how well you can use working capital to generate sales. We take the net annual sales and divide that by the average amount of working capital for the same year. For example, if there is $5,000 in assets and $2,500 in liabilities, that gives us a working capital of $2,500. Net annual sales above is $1,000. $2500/$1000 = 2.5. Lower ratios could suggest that the business isn’t running efficiently.
Conducting a financial analysis to better understand these metrics, and where every dollar you receive of sales goes, can aid in even deeper discussions as to how much you should be charging for your services, and whether or not your pricing model is even viable for you to stay in business long-term.
If you need any help regarding these issues Corridor Consulting would love to help, please schedule an individual consultation here. We’re looking forward to opening many more doors for you!
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This article is not professional tax or legal advice for your specific circumstances. Consult with your professional adviser to better understand how these items may impact you, or how they’ve changed
