Financial health is one of the best indicators of your business’s potential for long-term growth. The first step toward improving financial literacy is to conduct a financial analysis of your business. A proper analysis consists of five key areas, each containing its own set of data points and ratios.
Revenues are probably your business’s main 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 percent of your total revenues.
- Revenue per employee (revenue ÷ average number of employees). This ratio measures your business’s productivity. The higher the ratio, the better. Many highly successful companies achieve over £1 million in annual revenue per employee.
If you can’t produce 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 you to 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 your company’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’re using 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 you manage the credit you extend to customers. A higher number means your company is managing credit well; a lower number is a warning sign you should improve how you collect from customers.
- Inventory turnover (cost of goods sold ÷ average inventory). This measures how efficiently you manage inventory. A higher number is a good sign; a lower number means you either aren’t selling well or are producing too much for your current 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 from your business.
- Debt to equity (debt ÷ equity). The definitions of debt and equity can vary, but generally this indicates how much leverage you’re using to operate. Leverage should not exceed what’s reasonable for your business.
Liquidity analysis addresses your ability 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 your ability to pay off short-term obligations from cash and other current assets. A value less than 1 means your company 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 your ability to pay interest expense from the cash you generate. A value 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 aligned with appropriate benchmarks. This works for each data point individually as well as for your overall financial condition.
The first basis is your company’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 that as well. Looking at your past and present financial condition also helps you spot trends. If, for example, liquidity has decreased consistently, you can make changes.