Because of the economic woes seen during the past few years, many businesses have seen decreased profits. Some companies that were barely getting by and didn’t adjust during these tough times have gone out of business.
Remarks often heard from such businesses are “How could this happen?” and “We didn’t see it coming.”
While it’s true that few people could have predicted the overall downturn in the economy, some business owners simply did not pay attention to the general health of their company. They failed to analyze the financial information available to them, saying, “Things seem to be running just fine,” “Why bother?” or “I’m just too busy.”
A review of the statement of cash flows could have revealed that operations had been using – not providing – cash and that the company had been relying greatly on bank financing to stay afloat. An analysis of the accounts receivable may have alerted business owners and managers that a majority of their receivables were not current and collection issues might arise in the future.
Optimizing business with an internal review
Management, more than any outside user, benefits most from the use of financial statements.
Management should analyze financial information to find ways to improve profitability, identify problems, make projections, cut costs and assist in the decision-making process. Management’s review of the financial statements can also help identify and mitigate fraud or theft.
Many small businesses, due to their limited number of employees, usually do not have proper segregation of duties.
To help compensate for the lack of segregation, management should, at a minimum, perform a monthly review of financial statements, compare actual amounts to budgets and prior periods, and investigate any unexpected differences. Management should also review bank reconciliations and bank statements to see who’s getting paid and how much.
Analyzing financial information
Comparative financial statements
By analyzing financial statements for different periods side by side, a company can see how it has performed over time and identify trends in accounts.
The company should make inquiries not only on percentage and dollar changes but also on its expectations based on operations. For example, if the number of plant employees at a manufacturing company doubled from last year, all things being equal, the company should expect revenues – as well as wages, supplies and other direct expenses – to increase.
The goal of a budget is to identify specific areas for spending the revenue of the company. Budgets are good for accountability and control of spending. The company should compare budget to actual figures on a regular basis and investigate major variances.
Financial ratios are an important part of the financial statement analysis. Ratios generally hold no meaning, unless they are benchmarked against past performance or the industry. By benchmarking certain key income statement lines with industry data, an organization can see how it compares to similar companies.
Companies can use ratios when analyzing income statements to make sure the numbers appear reasonable. They can do this by looking at their driving factors and comparing them to revenue for the period. For example, for a medical practice, a direct relationship should exist between the number of patient visits or surgeries and the revenues for a given period.
There are many ratios, so a company should focus on key industry ratios and ratios important to its business – such as ratios required by loan covenants.
Considering the bottom line
Financial statements say a lot about the overall health of a business, which can affect its bottom line. Companies should consider whether they can afford not to do an internal review of their financial statements.