Financial statement analysis and managerial perspective of performance
The financial statement is considered to be an essential set of business document from an accounting perspective that provides a comprehensive view of the corporation’s financial health at some particular point, providing relevant insights into operations, cash flow management, business performance, and profitability that helps business owners to make logical decisions based on the information presented to them.
There are three essential statements within a set of financial statements: balance sheet, income statement, and cash flow statement. Let’s understand what information these statements contain and how by performing financial statement analysis can help you in the successful run of the business.
The balance sheet contains three essential account balances that include assets, liability, and equity.
Assets are valuable items the business owns; these items are expected to generate cash flow for your business in the future. For instance, if you have some machinery used in the production, it’s an asset because it provides some economic value to your business.
There is one technique you can use to assess if an item in the balance sheet is an asset or no; the technique is to ask yourself, “Will you receive some economic value/cash if you sell this item of the business.” If your answer is yes, it’s an asset.
The volume of the assets is considered an essential factor in determining the size of the business. If the worth of the assets owned by the business is higher, it’s considered to be a stable business, and investors will feel ease to lend money. Even, some financial institutions only enter in dealt with the business if they own certain specific worth.
It’s important to note that asset account can be compared with the previous periods to get an idea of any changes. So, if there is some unusual change in the account balance, it needs to be investigated. For instance, if there is some significant decrease in your assets, you need to check if someone is stealing or there are some weak controls on the assets.
Liability is the money that a business owes to outside parties. In other words, the business has to pay someone to settle the liability. Usually, more liability in the balance sheet is not considered a good sign for the business’s financial health because it indicates the business may be facing some financial problems.
So, as a business owner, you need to keep an eye on the liability balance. The volume of liability can be tracked by comparing it with the previous periods. Again, if there is some massive increase in the liability, it needs to be monitored.
If there is significant increase in the liability, you need to investigate if increased liability is genuine. It’s because there is a risk that there may be some ghost suppliers or fake bills being recorded and paid from your business.
Equity/net assets are attributable to the business owners. It’s important to note that all of the assets in your balance sheet are owned, but some outsiders do have some financial stake in the form of liability. So, we need to deduct total liability from the business’s total assets; this calculation leads to the equity or real worth of the owner.
Further, it’s important to note that if your business assets are higher than a liability, equity will be positive. On the other hand, if liability is higher, equity will be negative. So, if your equity is negative, there is a need to analyze if you have taken excess cash out of business in the form of dividends or your business has been in consecutive losses. Whatever the reason is, your banks and lenders may not like negative equity and grant a loan. However, you may negotiate with the lenders and offer a personal guarantee or agree to provide collateral for some of your personal assets.
An income statement is an essential business statement that helps business owners assess the business’s current performance. By looking at the income statement, it can be assessed if the business has added value or incurred the loss in the specific period under consideration.
If there is a positive figure at the end of the income statement, that’s the profit, and your revenue is more than expenses. On the other hand, if there is a negative figure at the end of the income statement, that’s the loss, and your expenses are more than revenue in that particular period.
There are two main components of the income statement that include revenue and expenses. So, if you are concerned about increasing profit, there are two options. One is to increase the revenue, and another option is to control expenses. Let’s understand each of these and how you can measure and track these figures.
There are three main components of the sales/revenue that include gross revenue, sales return, and the discounts allowed. Sales return and sales discount are deducted from the gross sales and always need to be compared with other figures. For instance, sales return, and sales discounts are compared with the gross sales.
Further, it’s quite logical to compare the sales/revenue of the current period with the last periods to assess if there has been growth or no. In addition to this, the business’s revenue can also be compared with other businesses to locate its own size and market share.
Another income statement component is an expense that needs to be controlled and minimized to boost profitability. Further, the good thing is that income statement contains line by line listing for all types of expenses including admin expense, marketing expenses, and finance expenses.
The admin expenses need to be analyzed from period to period, but it’s equally important to compare with the revenue. If expenses have increased with an increase in the revenue, that’s fine but only in the case when your business has a greater portion of the variable cost.
Marketing expenses need to be compared with the revenue of the current year. This helps to assess the effectiveness of the marketing function. Further, marketing expenses can also be compared with the previous years, and as a general rule increase in sales should be in line with the increase in the marketing expenses.
However, it’s important to note that there is a strong need to assess the extent of the marketing expenses. For instance, if the business has a limited production capacity, making excess expenses on business promotions seems to be a waste of money. So, we recommend preparing an adequate budget for the marketing expenses that should be in line with the forecasted capacity of the business to produce the goods/perform services.
Further, finance expenses contain the cost of the interest that has been paid/payable on the loans obtained by the business. If there is higher leverage, the finance cost will be higher and vice versa.
Cash flow statement
Sometimes businesses report higher profit figures but struggle to meet basic operating expenses. For instance, some businesses have been observed to have strong profitability, yet they don’t have the cash to pay for the wages and salaries.
In a situation like this cash flow statement can be an excellent tool to track and manage the cash. It helps to understand if the cash is stuck in the receivables or the business management has taken some decision that led to cash flow problems. Let’s understand the three main activities of the cash flow statement and how these need to be managed.
These activities are related to the normal operations of the business. Different operating expenses like depreciation, impairment, and changes in the balances of the payables and receivables are considered. Analysis of the operating activities helps to understand if cash collection and other business operating functions are performing effectively or there is some need to improve their performance.
These activities help to analyze cash movement under investments. This section will help to assess if you are investing enough funds or no. Further, there can be an investment in a different class of the assets like physical assets, securities, and debt instruments, etc.
Financing activities contain the movement of the funds that how you raise the finance and pay off the liability etc. Further, activities like the sale and issue of the stock, payment for the dividend, and movement of the loans are presented under these activities.
However, it’s important to note that a sole financial statement does not add more value in analysis than applying a certain metric like ratio calculations.
Ratios help to locate the financial performance of the business by developing some grounds for comparison. For instance, net profit margin helps assess how much net profit the business compared to the revenue.
The well-known ratios include profitability, liquidity, solvency, efficiency, coverage, and market ratios. Let’s discuss the main types of ratios.
These ratios help to assess if your business is enhancing profitability, maintaining profitability, or declining. However, you need to compare ratios calculated for the current period with the previous periods. Further, these ratios can also be compared with the competitors to assess if there need to improve operations.
The main types of profitability ratios include gross profit margin, net profit margin, return of capital employed-ROCE, return of assets-ROA, etc.
It’s important to note that you may need to obtain figures from both income statement and balance sheet for calculating some of the ratios, for instance, ROCE and ROA, etc.
Specific interpretation for profitability ratios
Gross profit margin is calculated by comparing gross profit with sales. It helps to understand if the core activities of the business incur a cost. For instance, if the gross profit ratio is higher, it means the cost of sales is lower, and higher profit can be expected from a business if other expenses are controlled.
Similarly, the net profit margin is calculated by comparing net profit with sales. It gives an idea if the business has performed efficiently and managed expenses in an effective manner. For instance, if the net profit margin is higher, the business has efficiently controlled all direct and indirect costs and vice versa.
Further, return on capital employed-ROCE compares profit before interest and tax with the equity invested in the business. It helps to understand if the business is making the right use of the equity and earning a return. For instance, if ROCE is higher, the business has made effective use of the invested equity and vice versa
These ratios help to understand if you have sufficient liquid resources to pay off the liabilities that fall due in the near time. Well-known liquidity ratios include the current ratio and quick ratio that compare current assets with the current liability.
The current ratio is calculated by comparing current assets with the current liability. If the calculated answer is more than one, it means the proportion of the assets is higher than a current liability, and the business is considered to be stable as they are considered to have enough liquid resources to meet obligations falling due in one year.
On the other hand, if the current ratio is less than one, it means the company does not have enough liquid resources to pay the liabilities falling due in one year.
Solvency ratios help to measure the ability of the business to meet the long-term debt. These ratios are focused on the business’s capital structure and help assess if there is more proportion of the debt or equity. If there is more debt, lenders perceive the business is risky and may charge a higher cost of finance.
Although financial statements and ratios provide a comprehensive understanding of the business on which small businesses depend, there is a need to understand detailed managerial accounts that help to analyze activities deeply and help decide adequacy of the specific account balances.
Debt to equity is one of the essential solvency ratios and is calculated by comparing the total liabilities of the business with the total equity. If the answer of the calculation is higher, it means the business is financed with more debt there is higher leverage in the business. So, the business is considered to be risky from an investor’s point of view.
Similarly, the interest cover ratio is calculated by comparing Earnings before interest and tax with the interest expense. It helps to understand if operations of the business were efficient to cover the cost of interest. If there is higher interest cover, it’s better for the company as the proportion of profitability is higher than the cost of interest.
Although financial statements and ratios provide a comprehensive understanding of the business on which small businesses depend, there is a need to understand detailed managerial accounts that help to analyze activities deeply and help decide the adequacy of the specific account balances.
How do managerial accounts help in decision-making?
- Management accounts provide details about elements of the cost. For instance, some costs may be variable, and some costs may be fixed in nature. So, the business owner can assess the adequacy of the cost and which types of the costs can be more easily controlled.
- A detailed listing of the revenue and expenses in management accounts make it easy to compare actual figures with the budgeted figures. Hence, the difference/variance between them can be monitored and corrective action taken if needed.
- Detailed cash flow analysis is a part of the management accounts. Hence, in-depth analysis can be performed that helps to track the movement of the cash and to take decision for subsequent improvement.
- These accounts can be helpful in planning, forecasting, decision making, performance tracking, and improving functional aspects of the business. So, there is a strong need to consider usage of management accounts rather placing a complete reliance on the financial statements and analysis for cash flow movement.