By Michael Jjingo
Analyzing a business’s financial statements for decision-making purposes especially borrowing decisions is very pertinent. This exercise helps a company understand where it stands financially as it plans for the short- and long-term future.
The business should compare actual results to budgets and forecasts to determine financial performance.
There is a strong link between business owners monitoring and understanding the financial health of their business and impactful success.
To conduct a financial analysis, the most critical financial statements include the income statement, balance sheet, statement of retained earnings and cash flow statements, plus accounts receivable reports, accounts payable reports and inventory reports.
Noteworthy, better to inspect the numbers on those statements carefully to spot anything that doesn’t make sense or is anomalous.
An income statement illustrates the net income or net loss of the business; if the expenses exceed revenue, then you’ll see a net loss and vice versa.
This is measured by calculating profit margins, including the gross profit margin, operating profit margin and net profit margin. To find gross profit margin, a company simply divides gross profit by sales and multiplies that number by 100.
Higher gross profit margins are good for they indicate the company is efficiently converting its product into profits.
In addition, the profit margin, which is a good indicator of whether the company is making money from its core business and how well it’s being managed is checked.
Operating profit margin is calculated by taking earnings before interest and taxes or EBIT (gross profit – operating expenses), dividing that by revenue and multiplying that number by 100.
Higher net profit margin indicates that the company is efficiently converting sales into profit.
Analyzing balance sheets and income statement can indicate how well the company is using its capital, why the company may be borrowing money, how indebted (gearing) and whether that borrowing is justified.
Then, the return on assets percentage and working capital ratio can be derived. Return on assets is found by dividing profit after tax by total assets and multiplying that number by 100.
The company can then compare that percentage to other similar businesses on how efficiently they convert money invested in assets into profit.
Similarly, the working capital ratio and working capital as a percentage of sales shows how well the company is using its capital and its liquidity. We divide current assets by current liabilities.
A ratio of less than one is a warning sign of cash flow issues, while a ratio of around two indicates solid short-term liquidity.
The business can measure how well it’s using that capital to generate sales by evaluating working capital turnover. We calculate working capital turnover by taking net annual sales and dividing that by the average amount of working capital for the same year.
A lower ratio could suggest that the business isn’t running efficiently, but there is a lot of nuance and they must be viewed in the context of the industry.
To test solvency, the business uses the cash flow statement. Calculating operating cash flow will indicate how easily the company can cover its current liabilities.
To find the operating cash flow ratio, take the total cash flow from operations on the cash flow statement and divide it by the current liabilities.
If the business has Shs 10m in assets, Shs 5m of that is from operating cash flow, and Shs 5m in liabilities, its operating cash ratio is 1. The business earns Shs 1 for every Shs 1 in liabilities.
In general, positive cash flow is a good thing, but Positive investing cash flow and negative operating cash flow could be a sign of problems. The company may be selling off assets to pay its operating expenses, which could quickly become unsustainable.
Negative cashflow isn’t always bad, either. Negative investing cash flow could mean the business is making investments in property and equipment to produce more of its products.
The key is to look at all the cash coming in during the year; what is driving cash at hand, what is absorbing cash and is cash inflow bigger than cash outflow?
The statement of retained earnings shows how much of a business’s profit remains in the business and how much is distributed to stakeholders.
A statement of retained earnings shows beginning retained earnings for year, net income, dividends paid to stakeholders and retained earnings balances.
In a nutshell, being able to analyze financial statements and make decisions based on numbers can make a difference in any business, and nuances to survival and growth.
Metrics to track in analysis include profitability, cash flow cycle, working capital requirements, available liquid/near liquid assets (liquidity), credit to fund operations (gearing), solvency, and many other ratios.
The writer is the General Manager Commercial Banking at Centenary Bank