Effective financial management is essential to managing a successful small business or non-profit. To ensure this, you need to review and analyze the financial statements and financial ratios of your organization on a consistent basis. This review and analysis is critical for a thorough understanding of your financial statements, identifying trends over time, and measuring the overall financial status of your business. Learning about each of these pieces will help you to better understand the importance of this process.
An organization’s financial statements are the formal records of the financial activities and position of the business, communicating overall details of the financial performance to any end-users. There are three main financial statements that should be prepared and reviewed on a regular basis: Income Statement (financial performance), Balance Sheet (financial health), and Statement of Cash Flows (cash management). Each of these statements is inter-dependent on the other, and the full financial statement package provides the complete picture of the business.
Reviewing the Income Statement will help you to see trends in revenue and profitability. It also will aid in making decisions on which revenue streams to invest in or abandon, potential cost cutting measures, and optimizing debt within the organization. During this review, you should ensure positive gross profit, operating income, and net income. Also, keep in mind that business profits typically grow as the top-line revenue grows, as margins earned on sales tend to flatten or diminish as time goes on. Red flags to be aware of when reviewing the Income Statement are negatives at any line-item, declining sales or profitability, and expenses as a percentage of sales increasing.
Positive signs to note while reviewing the Balance Sheet include strong current asset values and positive retained earnings. Comparing to prior periods will help to determine your company’s ability to collect and pay debts over time. Some warning signs to be aware of during this review are mountains of debt (both short-term and long-term), little to no cash, and excessive growth of assets with no comparable sales growth noted. Also, negative retained earnings can indicate your business is not performing well, and you need to implement some remedial measures immediately to help with sales growth or cost containment.
The Statement of Cash Flows should show net cash provided by operating activities as a positive, as this indicates the current operations of the business are infusing cash into the organization to help with future growth initiatives. The investing and financing sections of this statement should remain consistent period-over-period, and should be in-line with current performance and future expectations. Reviewing this statement helps you with evaluating inventory policies and purchase strategies, accounts receivable collections and terms with customers, as well accounts payable timing.
Utilizing pieces of information from the financial statements, financial ratios are an essential quantitative analysis tool that act as key performance indicators identifying positive and negative trends. Watching these ratios and trends allows you to make and implement ongoing financial strategies, and if necessary, change course on short-term plans to better the business. Ratio analysis also allows for the comparison of your company’s financial state to other businesses within your industry. Several ratios exist that fall into one of the following five categories: liquidity, working capital, asset usage, efficiency, and profitability. Finding the right mix of available ratios for your organization is key, and your internal accounting function or external accounting consultants can help create the optimal dashboard for you.
A thorough review and understanding of your financials and what they mean for your organization is absolutely essential for a productive business. Adding this review to your typical monthly or quarterly processes is imperative for continued business success.