When you are presented with your financial statements at the end of a period, do you ever wonder how to interpret what they say about your company? The statements may be required by a third party, but how can you, as a business owner, also benefit from looking at your financials and translating that data into valuable feedback? How do you know where to focus your efforts to present your company in the best possible manner? Here are some basic tips to understand the story your numbers are telling.
The basic balance sheet formula is Assets = Liabilities + Equity. If your company owes more than it owns, the equity balance will be negative. This
can happen when a company has had more years of losses than it had years with income, or when profit distributions have been paid out in excess of the income generated by the company.
To determine how leveraged your company is, divide your total liabilities by your total equity for your debt to equity ratio. This will highlight how reliant the company is on outside funding in order to keep the business going. The higher the ratio, the more likely it is that the company may have difficulty paying down its debt. This could signify that the company is not managing its resources well. Generally, if you owe money, you will want the assets that were obtained with that debt to be able to generate future cash flows, such as buying equipment with a loan to increase output and related revenues.
The current ratio gives you an indication of the company’s solvency. To calculate it, divide your current assets by your current liabilities. Is the result greater than one? If so, it’s a sign that you’ll be able to pay what you need to with what you already have. If the number is below one, how will you make up the difference? Will ongoing operations be sufficient to cover obligations as they are paid, or will the company need to borrow to supplement the deficit?
Turnover ratios give an indication of how efficiently the company is operating. Insight into how quickly certain assets are being converted into cash is valuable because it will unveil which areas need immediate attention. It is fine for your accounts receivable balance to be high if you had a banner sales month. But if those receivables
are stale or haven’t been collected on time, they ultimately decline in worth and could result in needing to record additional write offs.
Similarly, divide your annual cost of goods by your average inventory balance to find out how many times you’ve turned over that inventory during the year. If you have inventory that hasn’t moved in a while, your turnover is likely low and you may want to consider discounting some obsolete inventory to generate funds to purchase new
items that are in high demand.
Profitability is another vital factor, and while consistency is important, an off year may not be a red flag if it is reasonably explained. Gross margins should reveal what percentage of the sale price you are retaining after all of the direct costs associated with that sale have been deducted. Margin percentages vary widely across industries, so ask your accountant what range may be appropriate for the type and size of your company.
It’s important as a business owner to look at the data on a regular basis as the year progresses. This will help you understand what is causing any fluctuations or unfavorable variances in a timely manner, rather than being surprised months later when compiling year-end information after the fact.
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