Financial Statement Analysis For Small Businesses

1 Copyright 2004 Florida Small Business Development Center Network Florida SBDC Network grants permission for use and modification of this manual to the Virginia SBDC July 16, 2008. 1 Financial Statement Analysis For Small Businesses A Resource Guide Provided By Virginia Small Business Development Center Network (Revised for the VSBDC by Henry Reeves 3/22/2011) Copyright 2004 Florida Small Business Development Center Network Florida SBDC Network grants permission for use and modification of this manual to the Virginia SBDC July 16, 2008. 2 Contents Topic Page Introduction 3 Importance of Financial Statements 4 Collecting and Managing Data 5 The Income Statement 7 The Balance Sheet 9 Reconciliation of Equity or Statement of Changes in Stockholder Equity 12 Statement of Cash Flows 12 Notes to Financial Statements 13 Financial Ratios Explanation 13 Key Terms and Concepts 20 Financial Statements as a Management Tool 24 Three Case Studies 32 Figure 1: Summary Table of Financial Ratios 36 Figure 2: K-L Fashions, Inc.

2 Financial Statements 38 Figure 3: Breakeven Analysis 46 Figure 4. - Sample Cash Flow Statement (without numbers): 47 Conclusion 48 Sources of Financial Analysis Information 49 Copyright 2004 Florida Small Business Development Center Network Florida SBDC Network grants permission for use and modification of this manual to the Virginia SBDC July 16, 2008. 3 Introduction Financial statements provide Small business owners with the basic tools for determining how well their operations perform at all times. Many entrepreneurs do not realize that Financial statements have a value that goes beyond their use as supporting documents to loan applications and tax returns. These statements are concise reports designed to summarize Financial activities for specific periods. Owners and managers can use Financial Statement Analysis to evaluate the past and current Financial condition of their business, diagnose any existing Financial problems, and forecast future trends in the firm s Financial position .

3 Evaluation pinpoints, in Financial terms, where the firm has been and where it is today. Diagnosis determines the causes of the Financial problems that Statement Analysis uncovers and suggests solutions for them. Forecasts are valuable in Statement Analysis for two reasons: You can prepare forecasts that assume that the basic Financial facts about a company will remain the same for a specified period in the future. These forecasts will illustrate where you're likely to stand if the status quo is maintained. Or, you can gain insights into the impact of certain business decisions by calculating the answers to what if questions. When you test the consequences of changes you re contemplating, or that may occur because of changing market conditions or customer tastes, for example, you achieve a greater understanding about the Financial interrelationships at work in a business. The two key reports for all sizes and categories of business are the Balance Sheet and the Income Statement .

4 The Balance Sheet is an itemized Statement that lists the total assets and the total liabilities of a business, and gives its net worth on a certain date (such as the end of a month, quarter, or year). The Income Statement records revenue versus expenses for a given period of time. Regular preparation and Analysis of Financial Statement information helps business managers and owners detect the problems that experts continue to see as the chief causes of Small business failure -- such as high, operating expenses, sluggish sales, poor cash management, excessive fixed assets, and inventory mismanagement. By comparing statements from different periods, you can more easily spot trends and make necessary management decisions and budget revisions before Small problems become large ones. This Resource Guide is intended to provide you with a basic understanding of the components and purposes of Financial statements. The Balance Sheet and Income Statement formats are designed as general models and are not complete for every business operation.

5 Computation of income for Financial accounting purposes is done according to the rules of Generally Accepted Accounting Principles (known as GAAP). Be aware that income and losses computed using GAAP rules will not necessarily be the same as those calculated to comply with the Internal Revenue Code. Copyright 2004 Florida Small Business Development Center Network Florida SBDC Network grants permission for use and modification of this manual to the Virginia SBDC July 16, 2008. 4 In addition to this Resource Guide, business owners and managers should take advantage of the other free or low cost sources of marketing information. Free business counseling services provided by Certified Business Analysts and many low-cost seminars and workshops are offered by the Virginia Small Business Development Centers throughout the state. For the location of the Small Business Development Center nearest to you call visit Universities, community colleges, and public libraries have other books and publications on this topic.

6 A tremendous amount of information is available on the Internet, using a search tool such as Google. Importance of Financial Statements Many business experts and accountants recommend that you prepare Financial statements monthly; quarterly at a minimum. Some companies prepare them at least once a week, sometimes daily, to stay abreast of results. The more frequently a company prepares their Financial statements, the sooner timely decisions can be made. There are four types of Financial statements; compiled, reviewed, audited, and unaudited: A compiled Statement contains Financial data from a company reported in a Financial Statement format by a certified public accountant (CPA); it does not include any Analysis of the Statement . The reviewed Statement includes an Analysis of the Statement by a CPA in which unusual items or trends in the Financial Statement are explained. An audited Statement (also prepared by a CPA) contains any Analysis which includes confirmation with outside parties, physical inspection and observation, and transactions traced to supporting documents.

7 An audited Statement offers the highest level of accuracy. An unaudited Statement applies to a Financial Statement prepared by the company which has not been compiled, reviewed, or audited by a outside Small business owners must be aware that they may be required to submit Financial statements in nine circumstances: 1. Virtually all suppliers of capital, such as banks, finance companies, and venture capitalists, require these reports with each loan request, regardless of previous successful loan history. Banks may need CPA compiled or reviewed statements and, in some cases, audited statements. They may not accept company or individually prepared Financial statements, unless they are backed by personal or corporate income. Typically, as a condition of granting a loan, a creditor may request periodic Financial statements in order to monitor the success of the business and spot any possible repayment problems. 2. Information from Financial statements is necessary to prepare federal and state income tax returns.

8 Statements themselves need not be filed. Copyright 2004 Florida Small Business Development Center Network Florida SBDC Network grants permission for use and modification of this manual to the Virginia SBDC July 16, 2008. 5 3. Prospective buyers of a business will ask to inspect Financial statements and the Financial /operational trends they reveal before they will negotiate a sale price and commit to the purchase. 4. In the event that claims for losses are submitted to insurance companies, accounting records (particularly the Balance Sheet) are necessary to substantiate the original value of fixed assets. 5. If business disputes develop, Financial statements may be valuable to prove the nature and extent of any loss. Should litigation occur, lack of such statements may hamper preparation of the case. 6. Whenever an audit is required--for example by owners or creditors--four statements must be prepared: a Balance Sheet (or Statement of Financial position ), Reconcilement of Equity (or Statement of Stockholder s Equity for corporations), Income Statement (or Statement of Earnings), and Statement of Cash Flows.

9 7. A number of states require corporations to furnish shareholders with annual statements. Certain corporations, whose stock is closely held, that is, owned by a Small number of shareholders, are exempt. 8. In instances where the sale of stock or other securities must be approved by a state corporation or securities agency, the agency usually requires Financial statements. 9. The Securities and Exchange Commission (SEC) requires most publicly held corporations (such as those whose stock is traded on public exchanges) to file annual and interim quarterly Financial reports.. Collecting and Managing Data The language and principles of modern accounting have evolved from the centuries-old need for accurate record keeping. Today, the Financial Accounting Standards Board (FASB), the SEC, and the American Institute of Certified Public Accountants (AICPA) continue to refine and revise concepts and practices. Regardless of how complex a Financial Statement may seem, it is based on logic and practicality.

10 Collecting information for Financial statements begins with the daily arithmetic of business and follows a continuing process called the audit trail. First, figures from original documents such as invoices are journalized, or recorded, daily in the book of original entry, which is called the journal. Today, these journals are maintained in electronic format. Items that are not normally recorded in the daily operations, such as those for depreciation and amortization, are called end-of-the-period adjustments and are calculated and journalized periodically. All of these detailed transactions are then posted to the general ledger. Amounts are balanced (credits must equal debits) and then used to prepare Financial statements. Copyright 2004 Florida Small Business Development Center Network Florida SBDC Network grants permission for use and modification of this manual to the Virginia SBDC July 16, 2008. 6 In most computerized accounting systems the balancing is maintained in real-time, behind the scenes, allowing Financial statements to be prepared at any time.