Your accountant will scold you for not keeping a balance sheet or income statement. Yes, maintaining accurate reports is important for any business. But what do you do with your financial documents once they’re in your hands? Analysing your financial data is just as important as collecting it.
You should run a business financial health check periodically. An annual report is prudent for the success of your business, but you may run a check more often if you are growing quickly.
Not sure where to begin? Let’s talk about the steps to taking your financial reporting and turning it into meaningful insights about the direction of your business.
Steps to determine your business’s financial health
A financial health check helps you determine if your business is meeting its financial performance expectations. Fair warning: To do the job thoroughly, you need to analyse multiple documents and compare many financial ratios. In other words, you can’t simply look at your bank statement to determine if you’re doing well.
To run a complete financial health check for a business, you should look at your balance sheet and income statement, analyse your current cash flow, and look at common financial ratios related to your debt and equity.
Analyse your balance sheet
A balance sheet is an important bookkeeping document. This report reveals the financial liquidity of your business at any given moment in time (how quickly could you pay off your current debts?). It also reveals the state of your working capital, or whether or not you have the cash to complete day-to-day operations.
Your business’s balance sheet lists assets on one side and debts and stakeholder equity on the other side. In short: Assets = Liabilities + Equity. The two sides of a balance sheet should even out. If you are doing well, your assets will be in the positive and continue to grow over time.
A balance sheet with errors, or a series of balance sheets that trend toward more liabilities than assets, may be red flags about your financial health.
Analyse your income statement
An income statement is a bit more specific than your balance sheet. It narrows its focus to your earnings and expenditures during a certain period of time, often a financial quarter.
This report reveals whether you have experienced profit or loss during the time period covered in the document. In fact, the report is often called a profit and loss statement. Your gross profit is determined by taking your revenue and subtracting the cost of goods sold.
If your income statements have an upward trend, you are likely in good shape. However, an income statement may also reveal that your expenses continue to outpace your revenue — not a good sign.
Analyse your cash flow statement
A cash flow statement measures the money or money equivalents that are coming in and out of your business. It doesn’t look at revenue like your income statement does, but rather answers the question: Where is our money going?
You can use a cash flow statement to identify seasonal trends. For instance, you may notice that costs are higher during certain periods of time. The sale of your goods and services may also wax and wane over the course of a year. Comparing cash flow statements can help you identify when to buy materials and when to market certain products.
There are several main components that should go into your cash flow analysis:
- Opening balance. How much cash and cash equivalent do you have on hand at the start of the analysed period?
- Cash incoming. How much money came in from sales, grants, tax rebates, and other sources? You should calculate your total cash incoming.
- Cash outgoing. What did you spend on purchases, rents, marketing, payroll, and other expenditures? Calculate your total outgoing cash.
- Closing balance. When you subtract the total cash outgoing from cash incoming, are you left with a positive or negative number?
Look at financial ratios
There are several key ratios often used during a business financial health check.
- Profit Margins: Your business has a gross profit margin and a net profit margin. Your gross profit margin measures your profits per sale before expenses. Your net profit margin reveals that percentage of each sale that counts as profit after expenses.
- Coverage Ratio: Broadly, a coverage ratio measures whether your business can pay its debts. But coverage ratios are often broken down into more specific expenses. For instance, the earned interest ratio tells you whether you can make interest payments. The formula is: earnings before income and taxes/interest expenses. You should aim for an interest coverage ratio of at least 2:1.
- Current Ratio: This figure tells you whether you can pay your debts that are due in the short term. Divide your total current liabilities by your total current liabilities. A healthy ratio is at least 2:1.
- Debt-to-equity ratio: Your debt-to-equity measures how many of your assets are being funded by liabilities, or borrowed money. The lower the percentage, the better.
- Return on equity (ROE): This formula measures how efficient you are at generating profits. ROE is determined by dividing net income by average shareholders’ equity.
- Return on assets (ROA): Similarly, ROA determines how well you use assets to create income. Net income is divided by total assets.
Need help determining your business’s financial help?
As a burgeoning business, running your own financial health check can lead to honest mistakes. And, well, even an established organisation can use a lot of help. As income streams evolve and the expenses of your business change, it can be hard to make heads or tails of whether you’re on the right track.
A trained professional can do everything from keep your payroll to offering CFO-level insights into your financial habits. An outsourced bookkeeper can keep your accounting expenses low while offering meaningful analysis and keep your documents in order. Sign up for Visory’s free financial health check to see if your business is headed in the right direction.