Things Financial Analysis Can Tell You

In Financial Statements are More than Results I touched briefly on financial analysis, but here I will go into some more detail. The real value of financial statements and other financial information is in the analysis. Allow me to elaborate.

A Simple Example

In math we might see the simple algebraic equation Y = 2X where Y is defined as the dependent variable and X is the independent variable. That is, Y’s value depends on the value of X.

Financial analysis is much like this in that we are looking at what independent variables drive certain numbers. Again, referring back to Cash Management -It’s Not About the Cash Account I pointed out that things such as inventory levels, accounts receivable balances, and others were the real drivers of the cash balance. Below are a few key things you can learn from financial analysis.

Accounts Receivable

By analyzing accounts receivable you can see what customers are presenting the biggest drag on cash flow. In 80/20 Rule for Receivables Management the idea of sorting past due receivable by amount can narrow down the customers you need to address. Maybe you have 100 customers and an average of 45 days receivables outstanding. This analysis may show you that 20 of those 100 customers represent 80% of the amount over 45 days.

Inventory

A similar thing can be done with inventory. Calculate the average turnover of inventory and each individual item. Then you may decide that you are only interested initially in looking at items that represent over a certain dollar amount. The items that equal or exceed that amount can then be sorted by the average days to turnover. That way you will see which slow moving items represent a significant financial impact. Then you can determine is there is a valid reason for this, whether you need to have a special sale to reduce the levels, or even if you need to simply sell them for salvage value because they have very little chance of being sold.

Liquidity

I will touch on this some more in a future blog, but for now just know that it pays to calculate the current ratio (current assets divided by current liabilities) and the quick ratio (quick assets like cash, marketable securities and receivables divided by the current liabilities) to asses whether you will be able to meet current obligations as they come due. This gives you an opportunity to make changes to maintain your liquidity.

Comparisons

It is very common for businesses to examine current results as they compare to prior periods. This is important because it helps identify trends and potential problem areas. A simple example for a distributor might be warehouse costs. If they are trending upward at a rate that increases in sales cannot justify, it may be time to take a look at just why they are increasing faster than anticipated. I recall a time when a company had become unprofitable and I used financial analysis to identify that the culprit was excessive growth in production employees. Addressing this returned the company to profitability again in short order.

Likewise, it is normal to examine actual results in relation to budgeted and forecasted results. You may find that things were omitted when budgeting and the actual results are actually acceptable. Then again, you may discover that certain areas are spending in excess of what is justifiable and take corrective action.

Comparative analysis is not restricted to the income statement. You can do the same thing with the balance sheet and identify negative trends to address before they become a significant problem. Examples would be declining cash balances, increasing accounts receivable and/or inventory, and increases in short and long-term debt that cannot be justified by actual operations.

If you don’t know where to start or just want to improve you financial analysis, AimCFO is ready to help.

If you want to know more, contact AimCFO – Contact

As always, your comments are welcomed.

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