Learning Accounting and Bookkeeping Basics

Financial Analysis - The Accountant's Tool

Financial Analysis is just playing with numbers. In the hands of an expert and a motivated management, however, it can make the difference between the success and failure of a business.

The key to success in financial analysis is to first assess the interest and needs of management by talking to them. Some owners and managers are looking simply to maintain current operations until retirement. Others hope to one day be the largest business in their industry. The more they are interested in growth, the more analysis they will want.

Determine their interest by asking management the questions below. By understanding the answers to these questions, you will be able to determine the type of analysis, they would like.

• What do they want from their business?
• What services are they hoping you'll provide?
• What type of information do they expect to receive?
• Are they interested in ideas that will improve profitability?
• Do they want to be warned of troublesome trends?
• What financial comparisons, if any, would they like?
• Are there industries, or other companies, what they wish to benchmark with?
• Are they planning on budgeting/forecasting?

There are two types of analysis that you may choose to use in a business: Horizontal and Vertical. The most common, and simplest, being Horizontal Analysis.

Horizontal Analysis

This method of analysis is simply comparing the same item in a company's financial statements from two or more comparable periods, and then calculating the difference. For instance, you may choose to compare the current month with the previous month, or with the same month last year. Another common horizontal comparison is to compare this year's year-to-date versus the same period last year.

For example, let's imagine that your business had $531,275 in sales in the current year and $552,715 in sales the previous year. The reduction in sales would be $21,440. That was easy. Now, management would want to know "WHY". That's the analysis and that's our job.

Once you understand the reason for the change in sales, you'll want to tackle Cost of Sales - then Expenses. Sometimes an increase or decrease in one account will explain the same or opposite impact in another account. For instance, an increase in Advertising Expense may be the reason for a complimentary increase in Sales (at least that's management's hope).

Even understanding the change in Balance Sheet Accounts can be valuable to the owner. For instance, what's happening to Inventory, or to Accounts Receivable? An increase in either of these two accounts can have the same impact to the Cash Account as the purchase of a piece of equipment, and may result in a cash-poor company.

Vertical Analysis

This type of analysis illustrates the relationship of certain components compared to the whole, or the financial stability of a company. There are several different types of ratios or indexes that may help us determine where the company currently stands in relationship to where it wants to go.

The most common form of Vertical Analysis is using percentages to show one account's relationship to another. For instance, often times we will include a column on the Income Statement showing each Cost and Expense, and the resulting Gross Profit and Net Income as a percentage of total Revenue. From this analysis we can determine how many pennies of each revenue dollar actually results in profit. This way we can compare one company's results with those of another, even though the size of the companies may vary significantly. If our company is profiting 10 cents for every sales dollar, and another company is getting only 4 cents it may indicate we're being more efficient.

On the Balance Sheet we might show each account balance as a percentage of Total Assets. This has lesser value, but occasionally shows trends that may or may not be enlightening.

There are a host of other analyses that companies use in determining their financial position and effectiveness. Here's just a list of a few of the more common ones and their formulas:

The resulting numbers and ratios are useless unless you have something to compare them to. One effective use of these calculations is to compare them horizontally to identify improvements or failures in the company's system. For instance, a declining trend in Inventory Turnover could indicate that the company is purchasing too much inventory for the current level of sales.

An additional source of information would be to compare one company's results with those from another company or industry average. Comparing them to another company may be difficult since most companies hold their financial data close to vest. On the other hand, libraries have reference books called 'financial abstracts' which contain industry specific financial data that is easy to compare to.

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