Every company's financial statements tell a story about the
value of the business. That's why the financial statements
are the starting point in any appraisal of a business
(commonly referred to as a business valuation).
Here is what every business owner should understand about
how their financial statements impact the value of their
business:
- Income Statement Analysis
- Balance Sheet Analysis
- Ratio Analysis
Income Statement Analysis:
Earning power is one of the most important elements of the
value of a business. The income statement develops this
story.
The income statement matches total revenues and total
expenses over a period of time, and it represents the best
measure of management's ability to utilize company
resources in the production of a profit. A review of the
company's one-year operating figures compared to previous
year's results and results of other companies over the same
periods takes on more meaning and helps evaluate the
efficiency and consistency of management's operation of the
company. These variances and trends tell a story. The story
may identify increasing, decreasing, stagnant, or erratic
behavior related to pricing, expense control, or marketing
ability to generate sufficient sales volume.
Once variances and trends are identified, the next question
is "why?" The answer to this question tells the story about
management's ability to efficiently and consistently
control operations and future earning power of the company.
This then tells the story about the company's long-range
viability.
Balance Sheet Analysis:
The balance sheet provides a financial picture of a company
at a given point in time. It represents resources in the
form of assets, liabilities, and owners' equity that the
company has available to generate sales or revenues.
Understanding each balance sheet account tells the story of
the company's financial condition and ability to generate
cash flows or sustain future business downturns.
The balance sheet has three major categories: assets,
liabilities and equity.
Assets represent the gross book value (i.e., historical
cost, not fair market value) of a business and are analyzed
in terms of quality and liquidity.
Liabilities represent claims against assets and are
evaluated in terms of the expected repayment source or
repayment requirements and their availability as sources of
financing for the company.
Equity is the difference between asset book values and
liabilities. Equity tells an important story. The more
equity, the more likely it is that the owners of the
company will work diligently to protect the equity and
repay the liabilities.
Understanding each balance sheet account provides the story
on the financial condition of the company.
Ratio Analysis:
After understanding the financial statements, the data from
the financial statements is used to calculate financial
ratios. Financial ratios are the most well-known and widely
used of financial analysis tools. Ratios are used as a
comparative tool to measure a company's performance against
other companies, industry standards, or other benchmarks of
performance. Financial ratios tell the story about the
riskiness and solvency of a company and how it compares to
other businesses in the market.
Representing the major financial analysis concepts, ratios
can be grouped into the five following areas:
- Liquidity
- Leverage
- Coverage
- Profitability
- Activity
Liquidity:
Liquidity is defined as a company's ability to meet its
current obligations when they come due. It tells the story
of whether the company has any assets in excess of those
required for its operating needs, which is a common issue
in business valuation. Liquidity is critical to the success
of the company: Sufficient liquidity 1) allows the company
to meet its current obligations; 2) gives the company the
flexibility to grow; 3) gives the company the ability to
sustain operating losses. Ratios to determine liquidity are:
- Current Ratio
- Quick (Acid Test) Ratio
Leverage:
Leverage is the use of resources to a fixed cost. Operating
leverage occurs when a company has fixed cost in its
overall cost structure. Financial leverage is the use of
borrowed capital in the expectation of being able to use
those funds to produce a return greater than the interest
cost. Typical ratios used to analyze leverage are:
- Total Debt to Total Assets
- Equity to Total Assets
- Long-Term Debt to Total Capital
- Equity to total Capital
- Fixed Assets to Equity
- Debt to Equity
Coverage:
Coverage ratios measure the extent to which certain current
payment obligations are met or exceeded by a measure of the
company's cash flow. Coverage ratios are:
- Times Interest Earned
- Coverage of Fixed Charges
- Various Cash Flow Coverages
Profitability:
Profitability is a measure of a company's success in
achieving its objectives. It tells the story of a company's
ability to grow, remain solvent, and repay debt. Ratios to
determine profitability are:
- Return on Equity
- Return on Investment
- Return on Total Assets
- Sales/Payroll Dollar
- Sales/Full-Time Equivalent Employee
Activity:
The story of how efficiently a company uses its assets can
be measured by analyzing activity ratios. Common activity
ratios are:
- Accounts Receivable Turnover
- Inventory Turnover
- Sales to Net Working Capital
- Sales to Fixed Assets and Total Assets
- Accounts Payable Turnover
The income statement, balance sheet and financial ratio
analysis tell the story about the value of a business. What
story do your financial statements tell?
----------------------------------------------------
Tom Wheelwright is not only the founder and CEO of
Provision, but he is the creative force behind Provision
Wealth Strategists. In addition to his management
responsibilities, Tom likes to coach clients on wealth,
business, and tax strategies. Along with his frequent
seminars on these strategies, Tom is an adjunct professor
in the Masters of Tax program at Arizona State University.
For more information, visit
http://www.provisionwealth.com.com .
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