For business owners lacking finance experience, analyzing financial data to make smart decisions can seem intimidating initially. Learning key metrics provides invaluable insights to steer the company toward success. However, grasping some fundamental concepts and terminology will make financial data far less overwhelming.
With a structured approach and the right tools, even beginners can learn to derive meaning from financial statements. This guide covers the basics of how to analyze the financial health and performance of your business.
Understand the Core Financial Statements
Three essential reports provide the raw data needed for financial analysis; the income statement, balance sheet, and cash flow statement. As a business owner, you should be fluent in what each conveys.
This summarizes all revenues earned and expenses incurred over a set time period, typically monthly, quarterly, or annually. Subtracting expenses from revenues gives you net income or net loss for that period. Tracking income statements shows whether profits are rising or falling over time.
Like a financial snapshot, the balance sheet lists all company assets and liabilities at a given moment. Assets are resources owned, like cash, inventory, and property. Liabilities include debt obligations like loans and accounts payable. The difference between assets and liabilities gives you equity, reflecting total company value.
Cash Flow Statement
While income statements show profitability, cash flow statements depict the actual inflows and outflows of cash. This helps determine liquidity, the ability to cover current debts and expenses. Analyzing past cash flow patterns allows better cash flow forecasting.
Calculate Key Financial Ratios
While the core statements provide raw data, financial ratios make interpreting that data easier. Key ratios help assess company performance and identify strengths, weaknesses, and trends. Useful ratios for beginners include:
- Gross Margin – Gross profit divided by total revenue. This reveals profitability of sales before operating costs.
- Operating Margin – Operating income divided by total revenue. Represents profitability after operating expenses are deducted.
- Return on Assets – Net income divided by average total assets. Signals how efficiently assets produce profits.
- Return on Equity – Net income divided by average shareholders’ equity. Shows effectiveness of increasing shareholder value.
- Current Ratio – Current assets divided by current liabilities. Tests short-term liquidity to cover immediate debts.
- Debt-to-Equity – Total liabilities divided by shareholders’ equity. Assesses financial leverage and long-term solvency.
Compare Results to Industry Averages
Context is key for interpreting financial ratios. Compare your company’s ratios over time to identify positive or negative trends. Also compare your ratios to average industry benchmarks to see where your company excels or lags behind competitors. Industry average financial ratios can be found in published sources like trade association data, government census records, and financial information websites.
As an example, an increasing debt-to-equity trend may indicate concern—unless the average for your industry is even higher. Seeing your current ratio consistently above the industry average paints a more positive picture of liquidity. Comparing to industry norms provides a reality check on your company’s financial standing.
Understand Common Financial Analysis Methods
While ratios are simple to calculate, more complex financial analysis is also possible. Three common methods experts use are common size analysis, trend analysis, and percent change analysis.
Common Size Analysis
This converts all figures on financial statements to percentages of a common base number rather than dollar amounts. The base number is typically total assets for balance sheets, total revenues for income statements, and total cash flow for cash flow statements. Converting statements to percentages makes it easier to compare multiple periods regardless of differing asset, revenue, or cash flow totals. Observing changes in the percentage makeup provides insights on financial structure and operations.
Reviewing financial data over consecutive periods rather than in isolation depicts trends and trajectory. Graphing results makes trends plainly visible,for example, showing steadily climbing revenue over the past year. Comparing month-to-month or quarter-to-quarter shows whether performance is improving, holding steady, or declining.
Percent Change Analysis
This directly calculates the extent of change from one period to the next. For each line item, compute the percent difference compared to the previous period. This quantifies by exactly how much each metric is rising or falling. Visualizing the percent change on a graph highlights most dramatic fluctuations at a glance.
Make Strategic Use of Financial Analysis
The purpose of regularly analyzing your company’s financial data is not just to crunch numbers. Put insights gleaned to work guiding decisions and future plans. Here are some key ways analysis can inform strategies for strengthening the business:
- Identify emerging trends and changes in financial health. Detect early warning signs like rising costs or slowing cash flow.
- Pinpoint strengths to leverage, like increasing profit margins or revenue from new products.
- Uncover issues requiring intervention, such as accounts receivable backlogs indicating collections problems.
- Assess where costs are misaligned with revenues so expenses can be adjusted.
- Support initiatives to boost efficiency and returns on investments.
- Forecast future capital requirements based on expected growth and expenses.
- Evaluate potential risks and benefits of major business decisions like expansion or taking on debt.
- Set realistic operational benchmarks and financial goals.
Regular financial analysis transforms data into actionable knowledge for steering your company successfully.
Leveraging Financial Data Analysis Tools and Services
While basic analysis can be done manually in spreadsheets, leveraging the right tools makes the process far more efficient. Here are some resources tailored for small business owners new to financial data crunching.
Cloud-based small business bookkeeping platforms like QuickBooks Online and Xero automatically generate core financial statements and key ratios. Built-in custom reporting and visualization features let you easily view trends and drill into details. Setting up automated reporting saves time and ensures analysis gets done consistently.
Add-on tools integrate directly with bookkeeping software to provide expanded analytics and insights. For example, Fathom pulls data from QuickBooks Online to provide ratio analysis, revenue metrics, and income statement projections. Using add-ons avoids toggling between different applications.
For those comfortable working in Excel or Google Sheets, templates allow calculating ratios and visualizing financial data. Spreadsheets also allow great flexibility in customizing calculations and reports. However, they require manual data entry which can be time-consuming and prone to human error.
Financial Data Analysis Services
Turning analysis over to financial professionals or services like an experienced accounting company relieves business owners from tackling it solo. Experienced analysts provide an objective outside perspective and can spot obscure issues. They also stay on top of best practices in analysis methods and tools. The cost of outsourcing must be weighed, but gains in insights and time savings often justify the fees.
Where to Focus Your Analysis Efforts
As a beginner, delving into every possible financial metric can quickly become overwhelming. Start by focusing analysis on these fundamentals:
Sales Volume and Growth
Top-line sales activity establishes the revenue engine. Tracking sales volume, new customer counts, average order value, and growth rates over time shows demand trends. Breaking sales down by product lines, sales channels, territories, and customer segments focuses marketing.
Gross, operating, and net profit margins indicate profit levels at different stages. Compare margins over time and to industry benchmarks. Analyze operating expenses categorized by department, function, or business process to identify cost drivers.
The current ratio assessed along with cash flow patterns depict day-to-day cash positions to meet obligations. Forecasting cash flow needs during slower periods allows adjusting credit lines or taking other steps to shore up liquidity ahead of time.
Return on assets gauges how well assets generate profits. Improving inventory turns, days sales outstanding, accounts receivable turnover all tie to stronger asset efficiency. Identifying underperforming assets indicates areas for corrective action.
Review total debt balances along with metrics like debt-to-equity ratios. Also analyze upfront costs, interest rates, terms and monthly payments on any new loans considered. Avoid excessive debt that puts long-term viability at risk.
Learning to stay on top of these core aspects of financial health helps fledgling businesses gain stability and put all resources to optimal use.
Final Tips for Getting Started
Learning the ropes of financial data analysis takes some dedication upfront. But sticking with it brings long-lasting benefits. Here are some final tips for getting started:
- Commit to regular monthly reviews even during busy periods. Set calendar reminders to block time.
- Take an online course or read educational books to boost financial acumen.
- Start simple. Add more advanced metrics over time as knowledge progresses.
- Ask your accountant or financial advisor questions to clarify anything confusing.
- Use visualization tools like charts and graphs to quickly spot data trends.
- Be patient; financial mastery requires persistence through a learning curve.
- Let analysis guide actions toward reaching financial goals.
Don’t let financial data overwhelm, get excited about the insights waiting to be uncovered. Consistent analysis unlocks understanding that powers strategic decisions and fuels growth. Even financial novices can chart a course to stability one metric at a time.