While the business landscape has always been unforgiving when it comes to financial decision-making, it is doubly the case now due to the heavy clouds of a recession that constantly threaten to rain down and drown out any business that makes even the slightest mistake in their financial management.
Because of the impending doom that may come knocking at any business’ doorstep if they make one wrong move, it is now more than ever integral for entrepreneurs to invest in the business’ accounting function. The only way to mitigate the chances of the current immensely volatile economy closing the doors of any business is to invest in sophisticated financial management strategies. These strategies involve cash flow management, budgeting and planning, forecasting, and the like.
Looking at the numbers presented by the United States Small Business Association, businesses that spend time weekly understanding financial statements and reports have a 95% chance of succeeding, compared to those who do not engage in the practice.
But before any of these strategies can be developed, the first matter of business is to evaluate and analyze the business’ financial statements.
In this blog post, we will explore the importance of financial statement analysis in making informed financial decisions. We will start by explaining what financial statements are and how they provide valuable information about a company’s finances. The four basic financial statements – the balance sheet, income statement, and cash flow statement – will be briefly discussed, highlighting their key components and what they reveal about a company’s financial position, revenues, expenses, and cash flow.
Table of Contents
What Are Financial Statements?
Financial statements can be called the DNA of the business’ finances. Everything about the business’ finances over a specific period of time, from the business’ regularly maintained books of accounts to its tax filings can be found on the business’ financial statements.
Financial statements are immensely useful documents, as they provide succinct and informative details regarding the business’ financial health and performance. This information can then be leveraged in a variety of ways through financial statement analysis.
There are four basic types of financial statements, three of which we will cover briefly before moving on to the subject at hand. For anyone seeking an in-depth explanation of financial statements, EA publication titled “The Guide to The Four Basic Financial Statements” is a concise and informative breakdown of the four basic financial statements.
The Four Basic Financial Statements
1. The Balance Sheet
The balance sheet contains information on the business’ assets, liabilities, and shareholders’ equity. Assets are any material or conceptual properties in the business’ possession that have value, including cash. Liabilities are the debts the business owes, whether they be rent, wages, or loans. The shareholder’s equity is essentially the amount that would be left if the business paid off its liabilities and spent all its assets. This is divided among the shareholders.
2. The Income Statement
The Income statement in a nutshell contains data regarding the business’ generated revenue and incurred expenses over a certain time period. Essentially, the income statement is a snapshot of all the data regarding the business’ finances over the regular course of operations at a certain point in time.
3. Cash Flow Statement
The cash flow statement records the flow of cash through the business. It shows where money entered the business, how it changed hands through the business’ functions, and where it ultimately ended up. The cash flow statement’s primary purpose is to illustrate changes in the business’ cash flow over time, which can help identify cash flow management concerns that need to be dealt with to keep the business’ cash flow positive.
Leveraging Financial Statement Analysis for Decision-Making
Horizontal Analysis
As defined by the Corporate Finance Institute, “Horizontal analysis is an approach used to analyze financial statements by comparing specific financial information for a certain accounting period with information from other periods.”
Horizontal financial statement analysis is basically a historical comparison of the business’ current financial health and performance with its past records. When it comes to understanding financial statements and reports, horizontal analysis is one of the best ways to wring out useful data for decision-making.
To understand this in technical terms, let’s say you are comparing the ratio of the business’ revenue over the course of three years. Assume that the revenue for years 1, 2, and 3 is $10, $20, and $8 respectively. horizontal analysis selects one time period’s financial statement as a “base”, in this case, let’s take the first year’s revenue as the base.
Now, the revenue of the other years is interpreted as percentages of the base. So, this would mean that the ratio of years 1, 2, and 3 would be 100%, 200%, and 80%. Here, we can see that the business doubled its revenue in year 2, but the trend drastically shifted downwards in year 3.
In this way, by comparing the business’ present financial reports with its past, you can clearly see how the business’ growth is coming along. If the business performs better one year and worse the next, then you can look at your operations records and figure out what activities lead to what outcome, and focus on the lucrative ones while discontinuing the useless ones.
Horizontal analysis can also be helpful in understanding financial statements and reports of the business’ competitors. The analysis need not be with the business’ present and past financial statements, but rather can also be used to compare your business’ progress and performance with others in the market.
Vertical Analysis
Datarails defines vertical analysis as a way of understanding financial statements and reports by presenting each line on the financial statement as a percentage of another item on the financial sheet.
Technically speaking, it means selecting a “base” as a fixed point of reference from the financial sheet’s items itself and then representing other items as ratios of the base. While in historical analysis the comparison would be between financial statements of different time periods.
For example, there is a manufacturing company that conducts a vertical analysis of its balance sheet to assess its debt-to-equity ratio. They find that the ratio has been increasing over the years, indicating higher financial leverage. This prompts the company to prioritize debt reduction efforts and seek equity financing to achieve a healthier capital structure.
It allows for easy comparison of different components and identifies areas that require attention. For example, comparing the cost of goods sold as a percentage of revenue can reveal changes in the company’s production efficiency.
Ratio Analysis
There are also a number of financial ratios, i.e., simple math formulae that have been developed to help easily convert the raw financial data in the financial statements into useful information. Ratio Analysis, the name for this process, is one of the simplest yet most effective practices when it comes to understanding financial statements and reports.
There are numerous financial ratios present, each with its own unique and important purpose. To keep things short, we won’t be delving into all the financial ratios out there. Click here to learn more about financial ratios, as well as find out which seven financial ratios we think are the most important for business.
Ratio analysis is tremendously useful in gleaning deeper insights into the business’ operations, and identifying and flagging potential problems or opportunities. It also helps in budgeting and planning for future endeavors.
Cash Flow Analysis
Cash flow management is vital for businesses, and therefore, analysis of the cash flow statement is very high on the list when it comes to understanding financial statements and reports.
To paraphrase Netsuite’s explanation of cash flow analysis, it is the process of correlating line items in the three different cash flow types, i.e., cash flow from operating activities, cash flow from investing activities and cash flow from financing activities.
This helps businesses see where the money came in from, how it flowed through the business, and where it was spent. This is very useful in evaluating financial health, as a business must always have a positive cash flow. Especially in these economically uncertain times, market volatility and other external factors can cause the business’ cash flow to quickly drop into the negative and fall out of control. Cash flow management during a recession is immensely important, click here for a crash course on the matter.
Making Informed Decisions
Investment Decisions
When looking at potential investment opportunities, such as in future projects for the business or any growth-related endeavors, having an understanding of financial statements and reports is key to making an informed decision.
By having an accountant provide you with a detailed analysis of your financial statements, you can see how well your business is doing, and how much money you have to invest. This helps in budgeting and planning out future investments, and assures that your investments aren’t going to set your business back.
Business Relationship Decisions
On the opposite end of the spectrum, by understanding the financial statements and reports of any business you choose to partner with for any project or venture, or simply act as a supplier for, you can better set the terms and conditions of the relationship. And vice-versa, they will be doing the same. Financial statement analysis is an incredible tool for sizing up other businesses before you commit to any business relations.
Operational Decisions
Management can make effective use of financial statement analysis when it comes to improving and optimizing business operations. Businesses can be defined as a collection of processes all working towards generating a profit, and the efficiency and potency of those processes can be judged based on the results they bring in the financial statements.
For example, you can introduce a change to a business process, for example in the sales department, and see how it fares. By comparing the business’ sales numbers in the financial statements before and after the change, you can clearly spot how much of an impact that change had. And so on and so forth through trial and error, management can make informed decisions on what areas they need to focus on when it comes to processes and where their attention is not as needed. They can also make informed decisions in matters of implementing cost reduction and budgeting and planning.
Risk Management
Your financial statements also act as indicators of potential risk. For example, by performing a horizontal analysis, you may find that your business’ revenue is trending downwards and will lead to negative cash flow if you don’t do something about it. Similarly, perhaps your debts have accrued too high, and it’s negatively affecting your day-to-day operations. Whatever the problem may be, it will be identifiable if you try understanding financial statements and reports rather than being reactive and dealing with risks when they become reality.
Conclusion
Hopefully, this article proved to be an insightful and enjoyable read for our audience. With the looming recession staring down the business landscape, it is absolutely critical that entrepreneurs use this short article as a foundation and research deeper into the matter of financial statement analysis, and hiring an accountant to help.
Even small businesses —as tight as their budgets may be— must by any means necessary get a hold of an accountant. Whether it be through in-house hiring, or by leveraging outsourced accounting services, the point is to secure a finance professional and get your act together before things fall out of control.