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Financial analysis components for small business

Editorial Team

6 min read
Reports on laptop and tablet

Many aspects of starting a small business are hard. For many entrepreneurs, the biggest challenge lies in growing their business with steady sales. The path to improved stability, increased efficiency, and higher profits revolves around careful financial analysis of your operations.

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This analysis allows you to better understand:

  • How your small business is performing
  • What areas need improvement
  • Where the future is likely to take you

Conducting a deep financial analysis to guide your business growth requires focusing on several critical components. These elements empower you to develop a more complete picture of your small business’s financial health.

Financial analysis components at a glance

Although there are many reports you can use to gauge your business’s performance, below are three of the most important financial analysis components. Together, they provide a fairly accurate snapshot of how you’re doing. When used correctly, these specific financial analysis components can also help you better forecast where your business is heading.

1. Income statement

An income statement analysis reveals how your business has performed over a set period of time, usually three to 12 months. It’s calculated by subtracting all your business’s expenses from its earnings over that timeframe. As long as the money generated from sales outpaces the money put towards expenses, your business is profitable. In fact, income statements often go by another name – profit and loss statements (P&Ls).

2. Balance sheet

Also known as a statement of financial position, a balance sheet analysis provides a picture of:

  • What your small business owns, which includes assets such as equipment, inventory, cash, accounts receivables, investments, and even prepaid expenses
  • What your small business owes, which includes liabilities such as debt, merchant cash advances, accounts payable, interest payable, wages payable, and equity shares in the company

Most balance sheets are segmented with assets on one side and liabilities/equities on the other – with the totals from both columns (ideally) balancing to zero.

3. Cash flow statements

A cash flow statement analysis reveals how much cash your business has generated (and lost) from activities such as selling merchandise. However, it can also include money generated from other income streams – such as investor financing, bank loans, and dividends from side investments associated with your business.

The goal of a cash flow statement is to determine how solvent you are at any given moment. It can also be used to forecast your ability to meet short-term expenses or absorb sudden shocks (e.g., a global pandemic).

Small business financial analysis: some quick definitions

By looking at data from these three core components of financial statement analysis, you can derive useful insight into how your business is performing. Below are some of the most important aspects of this analysis.

1. Revenue and revenue growth

Revenue represents all incoming sales and cash. Most small business owners calculate their revenue growth using the formula below:

(current period’s revenue – previous period’s revenue) / previous period’s revenue x 100

For example, if you earned $225,000 in revenue this quarter as compared to $150,000 last quarter, then your growth rate is 50%. You canuse this calculation for your preferred time period: monthly, quarterly, bi-annually, or yearly.

Obviously, the goal is to improve revenue growth over time. However, you can earn a lot of revenue and still be in the red, which is why the next metric is often more useful.

2. Profit

Profit is the amount you are left with after subtracting all expenses. Some entrepreneurs focus on profit margin, which is calculated with the following formula:

(sale price – cost to manufacture) / sale price x 100

For example, if you sell a pair of jeans for $50, and those jeans cost $15 to manufacture, your gross profit margin would be 70%.

Net profit margin provides a more comprehensive picture of your business’s financial health since it factors in all your costs:

(revenue – all expenses) / revenue x 100

For example, if you own a lawn service and make $10,000 a month, but it costs you $3,000 to provide services (e.g., equipment costs, transportation expenses, and payroll), your monthly net profit margin would be 70%. If the result of your net profit margin is negative, you’re losing money. If it’s positive, there’s money left to pay shareholders, including yourself, or reinvest into the business.

3. Operational efficiency

This equation measures how efficiently you’re using resources to generate sales. More specifically, operational efficiency calculates how much profit you’re able to bring in based on what it costs to run your business.

It’s calculated by dividing operating expenses by revenues. Operating expenses include things such as inventory costs, marketing, payroll, insurance.

Many small business owners overlook operational efficiency – preferring to focus on marketing and advertising to increase profits. But, if you can maintain your current sales level with fewer costs, this will also help boost profits. Something as simple as switching to a more economical supplier or investing in timesaving technology can help reduce your expenses and, thus, improve operational efficiency.

4. Capital efficiency

Capital efficiency is the ratio of how much you’re spending to grow revenue and how much you’re getting in return. For instance, if you earn one dollar per every one dollar spent on growing your company, that is a 1:1 ratio.

5. Solvency & Liquidity

Solvency is a measure of financial health. It determines whether a company’s cash flow is sufficient enough to handle its long-term debt obligations. Although many entrepreneurs use loans to grow their small businesses, lenders and investors will want to know your debt-to-equity ratio to determine your ability to repay loans and generate returns. This ratio is calculated with this formula:

debt / shareholder equity

Liquidity measures how much cash you have on hand to cover short-term debts and liabilities. There are several ways to calculate this ratio, with the formula below being one of the most popular due to its simplicity:

assets / liabilities

As long as this value stays above one, you should have enough stability to continue running and growing your business.

Best practices for small business financial analysis

As a small business owner, it can be overwhelming and confusing when it comes to financial analysis.

However, regularly conducting financial analysis can help your small business run more efficiently and profitably. The more detailed this analysis becomes, the more success you’ll find in your venture. This is why it’s vitally important to:

  • Understand generally accepted accounting principles
  • Conduct small business financial analysis at regular intervals
  • Double check your calculations to verify their accuracy
  • Never hesitate to ask for help from financial experts

Last but not least, you should leverage technology to automate as much of the above as possible. With our POS solutions’ business tracking and reporting capabilities, for example, you can instantly generate detailed financial statements without having to crunch the numbers or collect receipts by hand.

To learn more about how our payment solutions can help make financial analysis easier and faster, schedule a free consultation with our merchant services team today.

This information is provided for informational purposes only and should not be construed as legal, financial, or tax advice. Readers should contact their attorneys, financial advisors, or tax professionals to obtain advice with respect to any particular matter.

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