Hornung & Associates, LLC

Retirement Financial Planning & Financial Analysis Software
__________________________

___________________________________________

"Identify your Company’s Strengths and Weaknesses"^©

By Michael F. Hornung

Discover what your financial statements are screaming to you that you cannot hear. It is very difficult to assess the financial well being of your company by merely looking at the dollar values reported on your financial statements. Volatile economic conditions as well as internal factors make it imperative that today’s business owners have an in-depth understanding of their company’s financial position and performance. Financial analysis is a major tool available to business owners that will allow them to acquire that knowledge.

Financial analysis is the process of identifying and evaluating critical relationships within your company’s financial and operational information. The object is to examine your company and see what it is trying to tell you. There are two primary methods used to uncover the intimate secrets of your company. They are percentage analysis and ratio analysis.

Percentage analysis is the process of evaluating line items as a percentage of a specific account or a total. Each set has a slightly different objective. A ‘percent of total’ tries to provide a picture relative to overall performance. An example would be Gross Profit as a percent of Total Sales. A ‘percent of an account’ allows for a closer view of the elements and their relationships. It is used for improving short-term management and is a little more meaningful in the day-to-day operations. Examples are Rent as a percent of Total Administrative Expenses or Cash as a percent of Current Assets. Compare your percentages to industry standards to see how your performance stacks up against your competitors and the industry as a whole. Compare your financial position and performance to last year and to budget if you have them. Have your accountant identify discrepancies and provide an explanation as part of his or her monthly reporting process.

The second method of analysis is ratio analysis. It examines the relationship between two or more items contained in your financial and operational information. There are four primary categories of ratios: liquidity, profitability, efficiency and operational performance.

Liquidity or solvency ratios determine your company’s ability to meet its current and long term financial obligations with its assets. Banks, financial institutions and suppliers utilize them to measure the risk involved in lending you money and your ability to pay your current obligations. Some examples are ‘Current Ratio’, ‘Quick Ratio’ and ‘Debt Ratio’.

Profitability ratios measure the profit earned by your company relative to its sales and capital investment. Examples are ‘Return on Sales’, ‘Return on Assets’ and ‘Return on Net Worth’. Investors and business owners use these to determine management’s overall operating efficiency and the level of return on their capital investment.

Efficiency or productivity ratios measure how effective management utilizes its assets in the process of generating sales. They relate the amount of assets needed to the sales generated. Examples of efficiency ratios are ‘Total Assets to Sales’, ‘Current Assets Turnover Rate’, and ‘Inventory to Sales’.

Operational ratios examine the efficiency of different operational functions within your company. They focus on four areas: inventory, accounts receivable, accounts payable and your overall operational effectiveness.

Inventory ratios measure the efficiency of your firm’s materials management. Carrying too much inventory or too little can have a negative effect on your company’s performance. Accounts receivable ratios help you monitor your credit policies and collection performance. Too much or too little receivables can be unhealthy. Accounts Payable ratios are used as a means of checking the terms offered to you by your suppliers and your payment practices. Many companies do not realize that both paying early or late will hurt their financial appearance.

You want to compare these operational ratios to industry standards. You can find out the amount of inventory, receivables and payables you should have by making these comparisons. You can determine other key factors such as the time it takes you to convert inventory to cash and how long you will need to finance your inventory.

You can evaluate your overall effectiveness by looking at your breakeven point. Your breakeven point determines the level of sales at which your gross profit will cover your total fixed cost. You can change the breakeven formula slightly so it will calculate the sales volume required to achieve a specified profit objective. Armed with this information you can determine if you have the operational capacity to achieve the required level of sales. You can also determine if your current market will support this change in sales volume.

Once you have completed your percentage and ratio calculations, use management-by-exception to improve your overall performance and financial position. Watch for undesirable trends and/or variances. Examine the validity and reasonableness of the numbers and their significance for further refinement or study. Explain any exceptions or variances in writing when applying to a financial institution.

A good financial analysis will help you identify your strengths and weaknesses and allow you to make more informed management decisions. You will be able to improve your financial image thereby enhancing your chances when applying for a bank loan or financing. You will be able to identify and correct performance problems before they have a major impact on your business.

Select those percentages and ratios that are most effective for your company. You can be overwhelmed with too many measurements, especially if they are not helpful to you. You can get an idea of what percentages and ratios are used by your industry by checking with your trade association or by looking at industry standards published for your business. Many published industry standards are available at the public library. The "Annual Statement Studies" published by the Risk Management Association; and "Industry Norms and Key Business Ratios" by Dun & Bradstreet are the two most widely used standards. Banks and financial institutions rely heavily on financial analysis when evaluating a company applying for a loan. Ninety-eight percent (98%) of all banks will use one or both of the standards mentioned above in their analysis. Find out what your bank and financial institution use to determine your company's credit worthiness. The difference can be whether you get the loan and what interest you will pay?

Number crunching does not have to be complex or time consuming. The power of the personal computer coupled with the sophistication of today’s spreadsheet software (E.g. MS Excel) allow today’s business owner to generate a complete analysis for even the smallest company with very little difficulty. Software packages are available at a reasonable price for those business owners that do not have the time or staff to develop their own analysis.

Nothing generates a more complete financial picture of a business and how it is performing then a good financial model. It gives business owners and managers incredible information and control over every aspect of their business.

    (Top of Page)

Send e- mail to   comments@hornungllc.com   with questions or comments about this web site.
Copyright © 2000 - 2008 Hornung & Associates, LLC