Clues to Analyze Financial Statements
by by Marty Schulz, Albany BizCenter

Of the 18 million small businesses in the US, 98% of them are privately owned and will fail within 10 years largely due to a lack of monitoring or understanding how to read their financial statements. Most small business owners are excellent technicians who love doing their trade, but hate to do the "bookwork" necessary to run a long term, profitable business. The goal of this article is simply to introduce you to some basic analysis techniques that can easily be done to check the financial "health" of your business.

Imagine that you are a doctor, working at Good Samaritan hospital. Patients will arrive with varying degrees of illnesses, some serious, some not. Medical school has taught you to a make careful, fact based diagnosis, using certain standardized tests. In cases that are serious, you check the patients vital signs such as blood pressure, temperature, respiration and heart condition.

You can check the financial health of a company in much the same way using financial statements for our examination. Their are two basic financial statements: the balance sheet and the income statement. The balance sheet shows what the firm owns and how these assets were purchased - whether through loans or owner investment. The income statement shows how much money the firm made over a period of time. These two statements, along with a few financial ratios will allow you to understand many hidden aspects to your business. Financial ratios fall into three categories:

1. Profitability

2. Short term solvency

3. Long term solvency

Profitability ratios are designed to assist in the evaluation of management performance. For example, a gross profit ratio might show you that for every dollar of sales that you generate, you'll make 35 cents at the gross profit level. A return on equity ratio would could show you that for every dollar you've invested in the business, you'll generate a return of 22 cents. A sales to assets ratio could tell you that for every dollar in assets in your business, you've generated $2.60 in sales. These ratios help show how efficiently your operation is being managed.

Short term solvency ratios substantiate if the business has enough cash resources to enable it to pay its bills and stay in business. Liquidity means survival, and insufficient liquidity means bankruptcy to a business. For example, your current ratio might indicate that you have $1.50 in current assets to pay every dollar in current liabilities. Your accounts receivable turnover ratio might indicate that on average you collect your accounts receivable 9 times a year or every 40 days. Your inventory turnover ratio might confirm that on average, you turn your entire inventory 6 times per year or every 60 days. These ratios help a manager realize how fast they can safely expand or grow a business.

Long term solvency ratios show a firm's ability to service debt. For example, your debt to equity ratio might indicate that for every dollar the owner put into the business, they owe creditors $2.75. This shows the degree of protection provided by the owners toward the creditors. A firm with a low ratio usually has greater flexibility to borrow in the future, because they have little debt. A highly leveraged firm has a more limited debt capacity, because they have substantial debt already. Additionally, these ratios show how vulnerable your company is to a business downturn and if you can safely borrow more money.

To be meaningful, financial ratios need to be measured in relation to a standard or appropriate yardstick. The simplest yardstick is to compare the current ratios of a firm against previous periods. This will help the owner see trends and patterns. Another way ratios can be meaningful is when one firm is compared with others in the same industry, or against composite ratios for the entire industry as a whole. Industry ratios for small businesses are often available from firms specializing in financial statistics such as RMA or FRA.

Comparing yourself to others in your industry helps you make better decisions, and affirms that you're actively managing your business. Just like in human health, it's important to check the financial "health" of your business frequently. If you need free, confidential help reading your financial statements, please give your local BizCenter a call.

Marty Schulz is a business counselor for the Albany BizCenter. The center exists to help local business owners achieve greater success.