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Your financial statements allow you to properly assess your company’s situation. They serve as a valuable decision-making tool for leaders.
SME owners and managers who wish to ensure their business’s profitability and better plan its development should be aware of its financial health.
The following information can help you to better understand and analyze your company’s financial performance.
Financial statements, a tool for growth and longevity
Financial statements essentially reflect your organization’s performance. Therefore, these assessment tools are central to tracking your company’s financial performance over a specific period (annually, quarterly or monthly). Company leaders with an in-depth knowledge of their financial statements can make better-informed decisions that allow their business to stay the course or improve.
The two primary elements of financial statements are the:
- Balance sheet;
- Statement of earnings.
The balance sheet
The balance sheet is a snapshot of your organization at a specific time. It’s determined using this accounting equation:
Assets = Liabilities + Equity
Assets, which reflect all the assets of a business, include, in particular, cash and investments, capital assets, accounts receivable and inventory. Intangible assets such as patents are also included.
Liabilities, which reflect all the debts of a business, may include accounts payable, bank debt and other payables.
Equity includes your company’s share capital and retained earnings.
In a nutshell, your balance sheet allows you to determine, among other things, whether your business has enough assets to cover its liabilities.
The statement of earnings
Your statement of earnings is another essential tool that allows business owners to determine their company’s profitability. The statement of earnings is determined using this equation:
Revenues – Expenses = Net income (or loss)
A statement of earnings can be used to assess your company’s revenues and expenses at certain periods (the end of the fiscal year, for example) or your monthly, quarterly or weekly results.
It can also be used as a comparison tool. You can compare results with the previous fiscal year or the corresponding period (month, quarter or week) of the previous year. A business leader who is concerned about losses of $200,000 recorded in March 2024 can compare the losses to the March 2023 results and determine whether the situation has improved or not.
Your statement of earnings allows you to set a budget for your company, make financial forecasts and carry out strategic planning.
What are the most important financial ratios?
A month-end close is a vital step in a company’s accounting and financial management process. This exercise is shorter and simpler than it seems. It paints an accurate portrait of your organization’s financial situation at the end of each month. SME leaders who dedicate an hour or two every month to the process can compile and analyze data that reflects their business’s financial health.
This month-end exercise makes it easier to analyze certain financial ratios that are key to assessing your company’s performance. It allows you to compare the performance of a particular period to previous periods and your financial forecasts at the beginning of the year.
You can also compare your ratios to those of other SMEs in the same industry.
1 – Start out by reviewing your statement of earnings
First of all, you should look over your statement of earnings and, based on your knowledge of your organization, ensure that the revenues and expenses are recorded for the correct time of the year.
For example, if your maintenance and repairs account expense is higher than expected, you can request the account details and determine whether an expense was incorrectly charged or you missed certain expenses.
2 – Then calculate your financial ratios
The purpose of calculating these ratios is to effectively evaluate your performance and financial situation.
Here are a few of the main ratios that you can monitor.
Profitability ratios
These performance ratios allow you to pinpoint your company’s gross and net margins. A gross margin is calculated as follows:
Gross profit/Revenues
This indicator allows you to determine the difference between direct production costs and the selling price. It also allows you to calculate the profitability of a product or service.
Your net margin is calculated as follows:
Net profit/Revenues
It measures a company’s overall profitability and provides an overview of how costs are controlled compared to similar competitors.
Liquidity ratio
A liquidity ratio allows a company to measure its ability to settle its liabilities and current assets. It’s determined using this equation:
Liquidity ratio = Current assets/Current liabilities
Therefore, in order for a company to pay its invoices, its liquidity ratio should be greater than 1. Otherwise, it would struggle to meet its financial obligations. For example, an organization with current assets of $125,000 and current liabilities of $90,000 would have a liquidity ratio of 1.39. It would have $1.39 to pay off each dollar of debt.
Payroll to Revenue Ratio
This ratio allows you to measure the total salaries versus revenues within a month. Where the percentage is low and your sales exceed the salaries you pay, your profit is higher.
Given the current labour shortage, monitoring total payroll is a very important consideration. It allows you to detect any inefficiencies.
Let’s bear in mind that a company’s financial performance is defined by several parameters. Before you can optimize your organization’s processes and make informed decisions, you must be able to paint a clear picture and regularly assess the situation. Your financial statements are the first step towards a prosperous business.