Financial Analysis

Leverage

Leverage refers to the proportion of a company's capital that has been contributed by investors as compared to creditors. In other words, leverage is the extent to which a company has depended upon borrowing to finance its operations A company that has a high proportion of debt in relation to its equity would be considered highly leveraged. Leverage is an important aspect of financial analysis because it is reviewed closely by both bankers and investors. A high leverage ratio may increase a company's exposure to risk and business downturns, but along with this higher risk also comes the potential for higher returns.

Profitability

Profitability refers to management's performance in using the resources of a business. Many measures of profitability involve calculating the financial return that the company earns on the money that has been invested. Most entrepreneurs decide to start their own businesses in order to earn a better return on their money than would be available through a bank or other low-risk investments. If profitability measures demonstrate that this is not occurring—particularly once a small business has moved beyond the start-up phase—then the entrepreneur should consider selling the business and reinvesting his or her money elsewhere. However, it is important to note that many factors can influence profitability measures, including changes in price, volume, or expenses, as well the purchase of assets or the borrowing of money.

PERFORMING ANALYSES WITH FINANCIAL RATIOS

Measuring the liquidity, leverage, and profitability of a company is not a matter of how many dollars the company has in the form of assets, liabilities, and equity. The key is the proportions in which such items occur in relation to one another. A company is analyzed by looking at ratios rather than just dollar amounts. Financial ratios are determined by dividing one number by another, and are usually expressed as a percentage. They enable business owners to examine the relationships between seemingly unrelated items and thus gain useful information for decision-making. Financial ratios are simple to calculate, easy to use, and provide a wealth of information that cannot be gotten anywhere else. Ratios are tools that aid judgment and cannot take the place of experience. They do not replace good management, but they can make a good manager better.

Virtually any financial statistics can be compared using a ratio. Small business owners and managers only need to be concerned with a small set of ratios in order to identify where improvements are needed. Determining which ratios to compute depends on the type of business, the age of the business, the point in the business cycle, and any specific information sought. For example, if a small business depends on a large number of fixed assets, ratios that measure how efficiently these assets are being used may be the most significant.

There are a few general ratios that can be very useful in an overall financial analysis. To assess a company's liquidity, analysts recommend using the current, quick, and liquidity ratios. The current ratio can be defined as Current Assets/Current Liabilities. It measures the ability of an entity to pay its near-term obligations. Though the ideal current ratio depends to some extent on the type of business, a general rule of thumb is that it should be at least 2:1. A lower current ratio means that the company may not be able to pay its bills on time, while a higher ratio means that the company has money in cash or safe investments that could be put to better use in the business.

The quick ratio, also known as the "acid test," can be defined as Quick Assets (cash, marketable securities, and receivables) / Current Liabilities. This ratio provides a stricter definition of the company's ability to make payments on current obligations. Ideally, this ratio should be 1:1. If it is higher, the company may keep too much cash on hand or have a poor collection program for accounts receivable. If it is lower, it may indicate that the company relies too heavily on inventory to meet its obligations. The liquidity ratio, also known as the cash ratio, can be defined as Cash/Current Liabilities. This measure eliminates all current assets except cash from the calculation of liquidity.

To measure a company's leverage, the debt/equity ratio is the appropriate tool. Defined as Debt / Owners' Equity, this ratio indicates the relative mix of the company's investor-supplied capital. A company is generally considered safer if it has a low debt to equity ratio—that is, a higher proportion of owner-supplied capital—though a very low ratio can indicate excessive caution. In general, debt should be between 50 and 80 percent of equity.

Finally, to measure a company's level of profitability, analysts recommend using the return on equity (ROE) ratio, which can be defined as Net Income/Owners' Equity. This ratio indicates how well the company is utilizing its equity investment. ROE is considered to be one of the best indicators of profitability. It is also a good figure to compare against competitors or an industry average. Experts suggest that companies usually need at least 10-14 percent ROE in order to fund future growth. If this ratio is too low, it can indicate poor management performance or a highly conservative business approach. On the other hand, a high ROE can mean that management is doing a good job, or that the firm is undercapitalized.

In conclusion, financial analysis can be an important tool for small business owners and managers to measure their progress toward reaching company goals, as well as toward competing with larger companies within an industry. When performed regularly over time, financial analysis can also help small businesses recognize and adapt to trends affecting their operations. It is also important for small business owners to understand and use financial analysis because it provides one of the main measures of a company's success from the perspective of bankers, investors, and outside analysts.

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