To keep your business healthy and vigorous, you as an entrepreneur need to develop some sense of control over your financials. One effective form of control you can exercise is to analyze the financial information generated by your accounting system. Indeed, the data in your financial statements can regularly provide you with valuable signals and insights about where your business is heading.
For example, a strong signal that your company is headed for trouble is a successive decline in profit margins, which would most likely be due to uncontrolled expenses or a rising inventory and accounts receivable. You should watch out because a fall in profits can seriously affect your productivity and even threaten the survival of your business.
Precisely how do you analyze financial information?
Ratio analysis. A common way to analyze a financial statement is by computing ratios. When you do a ratio analysis, you try to extract a meaningful relationship between any two numbers in a financial statement. This helps you identify potential problem areas and opportunities within the company.
You need not let the details of your financial statement overwhelm you, and you need not take so many ratios either. In practice, you can adequately see your financial position by taking just three sets of ratios: the liquidity ratios, the leverage ratios, and the profitability ratios.
Liquidity ratios. The ability of your business to pay its short-term suppliers can be measured by the current ratio. The current ratio, which belongs to a bigger class of liquidity ratios, is the result when you divide current assets by current liabilities. Current assets are those assets that your business expects to convert into cash within the year, such as cash, accounts receivable, and inventory. Current liabilities, on the other hand, are those financial obligations that you expect to pay within the year, such as accounts payable and accruals.