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?
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