The financial health of your business is one of the best indicators of its potential for long-term growth. The first step towards gauging the financial health of your business is to conduct a financial analysis. A proper analysis consists of five key areas, each containing its own set of data points and calculations, which are outlined below.
1. Revenues
Revenues are probably your business's main source of cash, and the quantity, quality and timing of revenues can determine long-term success. There are three key areas to focus on in order to build an accurate picture.
Revenue growth
(revenue this period - revenue last period) ÷ revenue last period
When calculating revenue growth, don't include one-time revenues, which can distort the analysis.
Revenue concentration
(revenue from client ÷ total revenue)
If a single customer generates a high percentage of your revenues, you could face financial difficulty if that customer stops buying. No client should represent more than 10% of your total revenues.
Revenue per employee
(revenue ÷ average number of employees)
This ratio measures your business's productivity. The higher the ratio, the better. Many of the most successful businesses in the world achieve over £1 million in annual revenue per employee [1].
2. Profits
If you can't produce quality profits consistently, your business may not survive in the long run. There are three key measures of profit.
Gross profit margin
(revenues – cost of goods sold) ÷ revenues
A healthy gross profit margin allows you to absorb shocks to revenues or cost of goods sold without losing the ability to pay for ongoing expenses.
Operating profit margin
(revenues – cost of goods sold – operating expenses) ÷ revenues
Operating expenses don't include interest or taxes. This determines your company’s ability to make a profit regardless of how you finance operations (debt or equity). The higher, the better.
Net profit margin
(revenues – cost of goods sold – operating expenses – all other expenses) ÷ revenues
This is what remains for reinvestment into your business and for distribution to owners in the form of dividends.
Learn how to achieve efficient and sustained business growth with our guide to profit maximisation.
3. Operational Efficiency
Operational efficiency measures how well you're using the company’s resources. A lack of operational efficiency leads to smaller profits and weaker growth. The two key ways to gauge operational efficiency are to analyse both accounts receivable turnover and inventory turnover.
Accounts receivables turnover
(net credit sales ÷ average accounts receivable)
This measures how efficiently you manage the credit you extend to customers. A higher number means your company is managing credit well; a lower number is a warning sign you should improve how you collect from customers.
Inventory turnover
(cost of goods sold ÷ average inventory)
This measures how efficiently you manage inventory. A higher number is a good sign; a lower number means either you're not selling well, or you're producing too much for your current level of sales.
Cash flow management is essential for businesses to operate efficiently. Get started with our cash flow guide.
4. Capital Efficiency and Solvency
Capital efficiency and solvency are important measures as they are of interest to potential lenders and investors. These measures are defined in two ways.
Return on equity
(net income ÷ shareholder’s equity)
This represents the return investors are generating from your business.
Debt to equity
(debt ÷ equity)
The definitions of debt and equity can vary, but generally this calculation indicates how much leverage you're using to operate. Leverage should not exceed what's reasonable for your business.
5. Liquidity
Liquidity analysis, which addresses your ability to generate sufficient cash to cover cash expenses, is done by looking at your assets, liabilities, gross earnings and interest expenses. It's a vital measure as no amount of revenue growth or profits can compensate for poor liquidity.
Current ratio
(current assets ÷ current liabilities)
This measures your ability to pay off short-term obligations from cash and other existing assets. A value less than 1 means your company doesn't have sufficient liquid resources to do this. A ratio above 2 is ideal.
Interest coverage
(earnings before interest and taxes ÷ interest expense)
This measures your ability to pay interest expense from the cash you generate. A value less than 1.5 is cause for concern to lenders.
An American Express® Business Gold Card might come in handy when it comes to managing your liquidity: it gives you up to 54 days to clear the Card balance, so you can keep your money in the account for longer and get more flexibility in your cash flow.¹
Basis for Comparison
The final part of a robust financial analysis is to establish a proper basis for comparison, so you can determine if performance is aligned with appropriate benchmarks. This works for each data point individually, as well as for your overall financial condition.
The first basis is your company’s past, to determine if your financial condition is improving or worsening. Typically, the past three years of performance is sufficient, but if access to older data is available, you should use that as well. Looking at your past and present financial condition also helps you spot trends. If, for example, liquidity has decreased consistently, you can make changes.
The second basis is your direct competitors. This can provide an important reality check. Having revenue growth of 10% annually may sound good, but if competitors are growing at 25%, it highlights underperformance.
The final basis consists of contractual covenants. Lenders, investors and key customers usually require certain financial performance benchmarks. Maintaining key financial ratios and data points within predetermined limits can help these third parties protect their interests.
- The maximum payment period on purchases is 54 calendar days and is obtained only if you spend on the first day of the new statement period and repay the balance in full on the due date. If you'd prefer a Card with no annual fee, rewards or other features, an alternative option is available – the Business Basic Card.
Sources
[1] SmallBusinessPrices.co.uk, Top 30 Companies In The World By Revenue Per Employee
