The purpose of all financial analysis is to determine the financial effects on a business based on current, past and possible future managerial business decisions. Since all aspects of a business are interrelated, it is imperative that accurate measurements be taken of its financial operations to determine future courses of actions in order to make the best possible financial decisions. The most important point is that every business must determine their own needs and obtain the best possible financial information so that their operations may be analyzed to whatever degree deemed appropriate.

Financial Analysis

An income statement presents your actual business revenues and expenses. The difference between these is your company's net profit (or loss) over a specified period of time. An income statement is sometimes referred to as a profit and loss statement.

A balance sheet provides a snapshot record, at a specific point in time, of everything your business owns (its assets) and all it owes (its liabilities) and the owner's equity. Assets include cash, inventory, accounts receivable and fixed assets such as property, equipment and vehicles. Liabilities include accounts payable, mortgages, leases, loans, and taxes owed. On the balance sheet total assets equal the total liabilities plus the owner's equity.

A projected (pro forma) balance sheet is a prediction of your business' net worth at a specific time in the future. Potential lenders or investors will want to see a projected balance sheet covering one to three years into the future.

Financial Ratios

Essentially, financial ratios are compiled by taking numbers from a business's financial statements and converting them into meaningful relationships and indicators of the financial performance of the business. These ratios are expressed as either as a times multiple (x) or a percentage (%). Calculating financial ratios covering the current and past fiscal years or periods of a business and then comparing them against each other or comparable industry averages for the same time period will provide an insight into the business's financial condition and operational performance. Generally, financial ratios are categorized into five sections: liquidity, debt, profitability, cash flow and market measurability.

Financial ratios do have limitations in their application and are not meant to be used as definitive answers as to the understanding of the financial operations of the business. They are simply used to provide additional evidence in the determination of the results of financial decisions that have or are being made. Financial ratios also become more appropriate when calculated and tracked over time to ascertain trends in the business.

There are a number of business ratios which potential lenders and investors will use in order to assess the relative health of your business. Ratio analysis is a useful management tool because it helps identify positive and negative trends in your business performance.

Comparing current assets to current liabilities is an indicator of your business' ability to pay its bills. For example, a ratio of 2:1 means that you have twice as many current assets, as you do current liabilities.

Formula:

This ratio is the same as the current ratio without including inventory. Some inventory is not easy to sell, so this ratio is seen as the better measure of relative "liquidity".

Formula:

This ratio compares what the business owes (debt) to what it owns (equity), giving a picture of what proportion of the business's financial commitments are covered by the owners' investment. A ratio below 2:1 is desirable.

Formula:

Net profits are compared to investment (equity) and the results is show as a percentage (e.g. 7% ROI). Return on investment is considered one of the best criteria for determining a busienss' profitability.

Formula:

While not a true ratio, working capital represents assets available to protect the ability of the business to repay short-term obligations. This number alone, however, is not useful without knowing how the working capital is being utilized. The other ratios, above, provide this analysis.

Formula: Current assets - Current liabilities = $?

Source: Financial Planning for Small Business, Alberta Economic Development, 1996

Examples of the calculation of these ratios together with their meanings can be found in most accounting text books in any library or by requesting this information from the accounting firm that handles the financial affairs of the business. Various computer software packages are available that will calculate financial ratios and provide written analysis given that the appropriate financial information is provided from the financial statements of the business.

However, a word of caution, an individual ratio calculation should be tempered by taking into account other ratio analyses which results in a more effective evaluation of the financial operations of the business. Similarity, using industry averages as a comparative tool can also lead to inappropriate assumptions, as these industry averages may be based in dissimilar accounting policies and practices. Therefore, it is imperative that calculation of these industry averages be fully understood before using them as a comparative tool.

Industry averages of various types businesses can be obtained for a fee from organizations such as: Statistics Canada, Dun & Bradstreet Canada, RMA Annual Statement Studies, Standard and Poor's Corporation, etc.

The most frequently consulted Canadian averages include:

• Small Business Profiles (Statistics Canada) The Small business profiles present selected revenue, expense, profit and balance sheet items as well as financial ratios and employment data on small business in Canada.
• Financial Performance Indicators (Statistics Canada) Information on the financial performance and balance sheets of Canadian businesses. These indicators are developed using the income tax returns of about 1 million corporations, along with data from Statistics Canada's quarterly and annual programs of financial statistics for enterprises.