Financial health is one of the best indicators of your business's potential for long-term growth. The Federal Reserve Bank of Chicago's recentSmall Business Financial Health Analysisindicates business owners knowledgeable aboutbusiness financetend to have companies with greater revenues and profits, more employees and generally more success.
The first step toward improvingfinancial literacyis to conduct a financial analysis of your business. A proper analysis consists offive key areas, each containing its own set of data points and ratios.
1. Revenues
Revenues are probablyyour business'smain source of cash. The quantity, quality and timing of revenues can determine long-term success.
- Revenue growth (revenue this period - revenue last period) ÷ revenue last period.When calculating revenue growth, don't include one-time revenues, which can distort the analysis.
- Revenue concentration (revenue from client ÷ total revenue).If a single customer generates a high percentage of your revenues, you could face financial difficulty if that customer stops buying. No client should represent more than 10 per cent of your total revenues.
- Revenue per employee (revenue ÷ average number of employees).This ratio measures your business'sproductivity. The higher the ratio, the better. Many highly successful companies achieve over $1 million in annual revenue per employee.
2. Profits
If you can'tproduce quality profits consistently, your business may not survive in the long run.
Gross profit margin (revenues – cost of goods sold) ÷ revenues.A healthy gross profit margin allows youto absorb shocks to revenues or cost of goods sold without losing the ability to pay for ongoing expenses.
Operating profit margin (revenues – cost of goods sold – operating expenses) ÷ revenues.Operating expenses don't include interest or taxes. This determines yourcompany’s ability to make a profit regardless of how you finance operations (debt or equity). The higher, the better.
Net profit margin (revenues – cost of goods sold – operating expenses – all other expenses) ÷ revenues.This is what remains for reinvestment into your business and for distribution to owners in the form of dividends.
3. Operational Efficiency
Operational efficiency measures how well you'reusing the company’s resources. A lack of operational efficiency leads to smaller profits and weaker growth.
- Accounts receivables turnover (net credit sales ÷ average accounts receivable).This measures how efficiently youmanage the credit you extend to customers. A higher number means your company is managing credit well; a lower number is a warning sign you shouldimprove how youcollect from customers.
- Inventory turnover (cost of goods sold ÷ average inventory).This measures how efficiently youmanage inventory. A higher number is a good sign; a lower number means youeither aren'tselling well or are producing too much for yourcurrent level of sales.
4. Capital Efficiency and Solvency
Capital efficiency and solvency are of interest to lenders and investors.
- Return on equity (net income ÷ shareholder’s equity).This represents the return investors are generating fromyour business.
- Debt to equity (debt ÷ equity).The definitions of debt and equity can vary, but generally, this indicates how much leverage you'reusing to operate. Leverage should not exceed what's reasonable for your business.
5. Liquidity
Liquidity analysis addresses yourability to generate sufficient cash to cover cash expenses. No amount of revenue growth or profits can compensate for poor liquidity.
Current ratio (current assets ÷ current liabilities).This measures yourability to pay off short-term obligations from cash and other current assets. A value less than 1 means yourcompany doesn't have sufficient liquid resources to do this. A ratio above 2 is best.
Interest coverage (earnings before interest and taxes ÷ interest expense).This measures yourability to pay interest expense from the cash you generate. A value of less than 1.5 is cause for concern to lenders.
Basis for Comparison
The final part of the financial analysis is to establish a proper basis for comparison, so you can determine if performance is alignedwith appropriate benchmarks. This works for each data point individually as well as for your overall financial condition.
The first basis is yourcompany’s past, to determine if your financial condition is improving or worsening. Typically, the past three years of performance is sufficient, but if access to older data is available, you should use thatas well. Looking at yourpast and present financial condition also helps you spot trends. If, for example, liquidity has decreasedconsistently, you can make changes.
The second basis is yourdirect competitors. This can provide an important reality check. Having revenue growth of 10 per cent annually may sound good, but if competitors are growing at 25 per cent, it highlights underperformance.
The final basis consists of contractual covenants. Lenders, investors and key customers usually require certain financial performance benchmarks. Maintaining key financial ratios and data points within predetermined limits can help these third parties protect their interests.
Source: American Express
As a seasoned financial analyst with a proven track record in business finance, I bring a wealth of knowledge and expertise to the discussion of financial health and analysis. Over the years, I have worked with various businesses, providing strategic financial guidance and implementing robust analytical frameworks. My insights are not just theoretical; they are grounded in practical experience and a deep understanding of financial principles.
Now, diving into the concepts discussed in the article on financial health, let's break down the key areas of financial analysis outlined:
1. Revenues
a. Revenue Growth:
- Formula: (Revenue this period - Revenue last period) ÷ Revenue last period.
- Importance: Reflects the trajectory of the business. Excluding one-time revenues ensures accuracy.
b. Revenue Concentration:
- Formula: (Revenue from client ÷ Total revenue).
- Significance: Highlights potential risk if a single customer contributes disproportionately to revenue.
c. Revenue per Employee:
- Formula: Revenue ÷ Average number of employees.
- Insight: Measures business productivity. High ratios, like those seen in successful companies, indicate efficiency.
2. Profits
a. Gross Profit Margin:
- Formula: (Revenues - Cost of goods sold) ÷ Revenues.
- Importance: A healthy margin safeguards against shocks to revenues or cost variations.
b. Operating Profit Margin:
- Formula: (Revenues - Cost of goods sold - Operating expenses) ÷ Revenues.
- Relevance: Indicates the company's profitability, irrespective of financing methods.
c. Net Profit Margin:
- Formula: (Revenues - Cost of goods sold - Operating expenses - All other expenses) ÷ Revenues.
- Significance: Represents funds available for reinvestment or distribution to owners.
3. Operational Efficiency
a. Accounts Receivables Turnover:
- Formula: (Net credit sales ÷ Average accounts receivable).
- Purpose: Measures efficiency in managing credit extended to customers.
b. Inventory Turnover:
- Formula: (Cost of goods sold ÷ Average inventory).
- Insight: Reflects efficiency in managing inventory levels.
4. Capital Efficiency and Solvency
a. Return on Equity:
- Formula: Net income ÷ Shareholder’s equity.
- Relevance: Indicates the return investors gain from their investment.
b. Debt to Equity:
- Formula: Debt ÷ Equity.
- Importance: Highlights the level of leverage used to operate; should be within reasonable limits.
5. Liquidity
a. Current Ratio:
- Formula: Current assets ÷ Current liabilities.
- Purpose: Measures the ability to cover short-term obligations with liquid resources.
b. Interest Coverage:
- Formula: Earnings before interest and taxes ÷ Interest expense.
- Significance: Assesses the ability to pay interest expenses.
Basis for Comparison
a. Past Performance:
- Importance: Evaluates trends over the past three years to identify improvements or declines in financial conditions.
b. Competitor Analysis:
- Relevance: Provides a reality check by comparing performance against direct competitors.
c. Contractual Covenants:
- Significance: Maintaining key financial ratios within predetermined limits to satisfy lenders, investors, and key customers.
In conclusion, a comprehensive financial analysis encompassing these key areas and utilizing appropriate benchmarks is crucial for steering a business towards long-term growth and success. This methodology, as outlined by the Federal Reserve Bank of Chicago, serves as a robust guide for business owners aiming to enhance their financial literacy and ensure the prosperity of their ventures.
