The Importance of Financial Analysis for Business Success

When I think about a business's success, financial analysis immediately comes to mind.  How are business owners reviewing their financials?  Are they using an accounting system or relying on Excel worksheets? 

​It's crucial for small business owners to understand the significance of performing financial analysis.  To grasp the monthly activities of their business, owners should be familiar with the following aspects of financial statement analysis:

Key Elements of Financial Statement Analysis

1. Trends. Identify trends by creating trend lines for key items in the financial statements over multiple periods.  This helps in assessing the company's performance.  Common trend lines include revenues, gross margin, net profits, cash, accounts receivable, and debt.
2. Proportion analysis. Utilize various ratios to understand the relationship between different accounts in the financial statements.  For instance, the quick ratio estimates a company's ability to pay its immediate liabilities, while the debt-to-equity ratio indicates if the company has taken on too much debt.  These analyses often compare revenues and expenses on the income statement with assets, liabilities, and equity on the balance sheet.

The Power of Financial Statement Analysis

Financial statement analysis is an exceptionally powerful tool for various users, each with different objectives in understanding the financial circumstances of a business.

Users of Financial Statement Analysis

• Creditors. Lenders are interested in a company's ability to repay debt, focusing on cash flow measures.
• Investors. Both current and prospective investors examine financial statements to assess a company's ability to issue dividends, generate cash flow, or maintain growth.
• Management. The company controller conducts ongoing analysis of financial results, particularly in relation to operational metrics not visible to outsiders (e.g., cost per delivery, cost per distribution channel, profit by product).
• Regulatory Authorities. For publicly held companies, financial statements are reviewed by the Securities and Exchange Commission (SEC) to ensure compliance with accounting standards and SEC rules.

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​For many small business owners, extending credit to customers seems like a no-brainer since it can be a great way to attract customers and build profitable long-term relationships with them.
 
Credit is convenient and will probably win customers, but sales revenue will be delayed for either the discount period or the credit period, or perhaps longer if the customer is late in making the payment.
 
Business owners and those responsible for the day to day task should understand that the analysis of receivables method is based on the assumption that the longer an account receivable is outstanding, the less likely that it will be collected.  Accounts receivable constitute the primary source of incoming cash flow for most businesses, so you should analyze these invoices in aggregate to ascertain the health of the underlying cash flows.

The analysis of receivable method is applies as follows:
Step 1:  The due date of each account receivable is determined
Step 2:  The number of days each account is past due is determined.  This is the number of days between the due date of the account and the date of the analysis.
Step 3:  Each account is placed in an aged class according to its days past due which is typically aged as follows:

• Not past due
• 1-30 days past due
• 31-60 days past due
• 61-90 days past due
• 91-180 days past due

Step 4:  The totals for each aged class are determined.
Step 5:  The total for each aged class is multiplied by an estimated percentage of uncollectible accounts for that class
Step 6:  The estimated total of uncollectible accounts is determined as the sum of the uncollectible accounts for each ages class.

The preceding steps include summarizing an aging schedule and this overall process is called aging the receivables.  An example of a business’s aging report is provided below.  

​A detailed process such as accounts receivable should be an extensive documented process for any business.  This process will ensure cash flow is managed appropriately by those responsible.  Fontenot & Associates Solutions LLC can support with the development and analytical process of the monthly accounts receivable, we are just a click away.