The financial health of a small business is one of the best indicators of its potential for long-term growth and success. The Federal Reserve Bank of Chicago recently published the results of its Small Business Financial Health Analysis. The results show that business owners who are knowledgeable about business finance tend to have companies with greater revenues and profits, more employees and generally have more success.
The first step towards improving small business financial literacy is to conduct a financial analysis of your own business. A proper analysis is organized into five key areas with each area containing its own set of data points and ratios.
Analyze revenues
Revenues are the main source of cash for established businesses. The quantity, quality and timing of the revenues determine long-term success.
- Revenue growth (revenue this period – revenue last period) ÷ revenue last period – When calculating revenue growth do not include one-time revenues which can distort the purpose of the analysis.
- Revenue concentration (revenue from client ÷total revenue) – If a high percentage of revenues come from a single customer the company could face serious financial difficulty if that customer stops buying. No client should represent more than 10 percent of your total revenues.
- Revenue per employee (Revenues ÷average number of employees) – This ratio measures the productivity of a business. The higher the ratio the better. Many highly successful companies achieve over $1 million in annual revenue per employee.
Analyze Profits
Profits are why businesses exist. A company that cannot produce quality profits consistently will sooner or later be out of business.
- Gross profit margin (revenues – cost of goods sold) ÷ revenues – A healthy gross profit margin allows a company to absorb shocks to its 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 do not include interest or taxes. This determines a company’s ability to make a profit regardless of how it finances its 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 the business and for distribution to owners in the form of dividends.
Analyze operational efficiency
Operational efficiency measures how well managers are using a 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 a company manages the credit it extends to customers. A higher number means that the company is managing credit well; a lower number is a warning sign that it needs to improve how it collects from its customers
- Inventory turnover (cost of goods sold ÷ average inventory) – this measures how efficiently a company manages inventory. A higher number is a good sign; a lower number means the company either isn’t selling well or its producing too much for its current level of sales.
Analyze capital efficiency and solvency
Capital efficiency and solvency are of interest to lenders and investors.
- Return on equity (Net income ÷ shareholder’s equity) – represents the return that investors are generating by investing in your business.
- Debt to equity (debt ÷equity) the definitions of debt and equity can vary here but generally this indicates how much leverage the company is using to operate. It’s important to ensure that leverage does not exceed what is reasonable for your business.
Analyze liquidity
Liquidity analysis addresses a company’s ability to generate sufficient cash to cover its cash expenses. No amount of revenue growth or profits can compensate for poor liquidity.
- Current ratio (current assets ÷ current liabilities) – This measures a company’s ability to pay off its short-term obligations from its cash and other current assets. A value less than one means that the company does not have sufficient liquid resources to do this. A ratio above 2 is best.
- Interest coverage (earnings before interest and taxes ÷ interest expense) – This measures a company’s ability to pay its interest expense from the cash it generates. A value less than 1.5 is a cause for concern to lenders.
Basis for comparison
The final and most important part of the financial analysis is to establish a proper basis for comparison. This way a company can determine if its performance is in line with appropriate benchmarks. This works for each data point individually as well as the overall financial condition of the company.
The first basis is the company’s past. The goal is to determine if the financial condition is improving or worsening. Typically the past three years of performance is sufficient, but if access to older data is available then it should be used as well. Looking at the company’s past and present financial condition also provides an opportunity to spot trends. If over the past several years, for example, liquidity has gone down consistently then the owners have to make some changes to reverse the trend.
The second basis is the company’s direct competitors. Financial conditions vary greatly between industries and scale. A $50 billion revenue pharmaceutical company isn’t a good basis for comparison for a $5 million revenue used tire exporter. This basis is important because it provides a reality check for business owners. Having revenue growth of 10 percent annually may be a welcome change for the business when compared to its past performance, but if competitors are growing at 25 percent then it highlights underperformance.
The final basis for comparison consists of any contractual covenants. Lenders, investors and key customers usually require certain financial performance benchmarks as part of their contracts. This is to ensure that the company doesn’t take decisions that could adversely affect them. A lender doesn’t want a borrower to take on too much debt; an investor wants the company to grow; a key customer doesn’t want their vendor to stop delivering on time. The discipline of maintaining key financial ratios and data points within predetermined limits helps these third parties protect their interests.
