In looking for a financial analyst, one small business posted a listing looking for someone who could work with the finance team to create financial reports, analyze data, review costs and prepare monthly financial statements. Job duties include analyzing and interpreting financials to look at past financial performance and positively influence “future financial probabilities.”

The person would compare actual results to budgets and forecasts to determine financial performance. They would regularly review costs and perform project analysis, develop forecasting reports and create financial schedules used in monthly operational reviews and the budgeting and forecasting processes. And they would combine historical financial and operational data with other unstructured data throughout all of it.

That job description provides a great introduction to what financial analysis entails for a small business.

What Is Financial Analysis?

Like the job description suggests, financial analysis is the practice of reviewing past financial performance, comparing budgets to actual results and running financial forecasts to provide small businesses with the data they need to make informed decisions. This exercise helps a company understand where it stands financially as it plans for the short- and long-term future.

Financial Analysis Basics for Small Businesses

Ideally, small businesses should analyze their finances every week. There is a strong link between business leaders monitoring and understanding the financial health of their business and successful, growing companies. A Federal Reserve study noted 78% and 92% of companies with above-average and excellent financial health, respectively, had an annual income of at least $1 million. Forty percent of businesses with poor financial health, on the other hand, had revenue of less than $100,000.

Additionally, the study found 90% of organizations with excellent financial health always build a budget and have a separate bank account for payroll, compared to just 5% of those with poor financial health.

What Do I Need to Conduct a Financial Analysis?

To conduct a financial analysis, a business needs all its historical data. Track all revenue, payments, deposits, invoices and business expense records because you will need that information to create financial statements. The most critical financial statements include the income statement, balance sheet and cash flow statement, plus accounts receivable reports, accounts payable reports and inventory reports.

Inspect the numbers on those statements carefully to spot anything that doesn’t make sense or is anomalous compared to past weeks/months. That could signal a problem or reveal a change the business should make to save money or drive sales growth. This information will help you assess two dimensions of the financial health of the business—margins and utilization of capital—and provide the basis for many other detailed metrics.

Why Do I Need to Conduct a Financial Analysis?

The Federal Reserve study says financially healthy small businesses have four things in common: they have strong knowledge and experience with various types of credit, keep a higher level of unused credit balances, put together a budget more regularly and save cash specifically for payroll obligations.

That study showed that there is a “direct correlation between financial management and small business financial health.” Being able to understand a financial statement—and make decisions based on the numbers—can make the difference in a company being able to survive and grow. Factors and metrics to track in an analysis include profitability, cash flow cycle, working capital requirements, available liquid/near liquid assets, credit to fund operations/expansion and personal credit score.

Producing accurate financial statements to work from is the first step in sound financial analysis. Each statement provides information that can be used to analyze the business’s financial standing. Four statements every company needs are an income statement, balance sheet, cash flow statement and statement of retained earnings.

Income Statement

An income statement illustrates the net income or net loss of the business—if the expenses exceed revenue, then you’ll see a net loss and vice versa. This is measured by calculating profit margins, including the gross profit margin, operating profit margin and net profit margin. Board Evaluation, a UK-based consultancy that helps boards and directors develop best practices for governance, says that at a financially strong company, these metrics shouldn’t change much year-over-year.

To find gross profit margin, a company simply divides gross profit by sales and multiplies that number by 100.

Say the cookie bakery “Chip Off the Old Block” has a gross profit of $800 and $1,000 in revenue; the gross profit margin is 80%. That means the direct costs of producing its tasty treats are 20% of the revenue, and there’s 80% left over to cover other expenses and distribute profit to stakeholders. Higher gross profit margins are good—they indicate the company is efficiently converting its product into profits.

The second number to look at is operating profit margin, which is a good indicator of whether the company is making money from its core business and how well it’s being managed. Operating profit margin is calculated by taking earnings before interest and taxes or EBIT (gross profit – operating expenses), dividing that by revenue and multiplying that number by 100.

If Chip Off the Old Block has $500 in EBIT from $1,000 in revenue, the operating profit margin is 50%. That means 50% of the company’s revenue is available to pay non-operating costs. Increasing operating margins can indicate better management and cost controls within a company.

Finally, net profit margin is an indication of the overall success of the business. Higher net profit margin indicates that the company is efficiently converting sales into profit. Profit margin should be measured within the context of the specific industry in which the company operates.

To calculate net profit margin, divide net profit by sales and multiple the result by 100. If Chip Off the Old Block has h $400 in net profit and $1,000 in revenue, the net profit margin is 40%. That means for every $1 of revenue, the company earns 40 cents in profit.

Balance Sheet

Analyzing balance sheets can indicate how well the company is using its capital, why the company may be borrowing money and whether that borrowing is justified.

Two calculations completed by using information from the income statement and the balance sheet are return on assets percentage and working capital ratio. Return on assets is found by dividing profit after tax by total assets and multiplying that number by 100.

So, if Chip Off the Old Block earned $400 in net profit and has $10,000 in assets, that would make its return on assets 4%. For every dollar in assets, it earned four cents of profit. The company can then compare that percentage to other bakeries how efficiently it converts money invested in assets into profit.

Another important financial metric is working capital ratio and what that ratio is as a percentage of sales, for instance. The working capital ratio and working capital as a percentage of sales metrics show how well the company is using its capital and also its liquidity.

To find the working capital ratio, simply divide current assets by current liabilities. A ratio of less than one is a warning sign of cash flow issues, while a ratio of around two indicates solid short-term liquidity. If Chip Off the Old Block has $10,000 in assets and $5,000 in liabilities its working capital ratio is 2.

The business can measure how well it’s using that capital to generate sales by evaluating working capital turnover. You can calculate working capital turnover by taking net annual sales and dividing that by the average amount of working capital for the same year. A lower ratio could suggest that the business isn’t running efficiently, but there is a lot of nuance in those numbers and they must be viewed in the context of the industry.

Cash Flow Statement

To measure solvency, use the cash flow statement. Calculating operating cash flow will indicate how easily the company can cover its current liabilities. To find the operating cash flow ratio, take the total cash flow from operations on the cash flow statement and divide it by the current liabilities (accounts payable, debt, other liabilities).

If the business has $10,000 in assets but $5,000 of that is from operating cash flow, and $5,000 in liabilities, its operating cash ratio is 1. The company earns $1 for every $1 in liabilities. In general, positive cash flow is a good thing, of course. The company wants to have enough cash to cover its liabilities. But taking a deeper dive into the cash flow statement can shed light on some important nuances. Positive investing cash flow and negative operating cash flow could be a sign of problems—the company may be selling off assets in order to pay its operating expenses, which could quickly become unsustainable.

Negative cash flow isn’t always bad, either. A negative investing cash flow could mean the business is making investments in property and equipment to produce more of its products. The key is to look at all the cash coming in during the year—what is driving cash on hand, what is absorbing cash and is cash inflow bigger than cash outflow?

Calculate Sales Forecast

With accurate information from these financial statements, the company can complete one of the most important forecasts: the sales forecast. It enables the business to make connections between sales and expenses that inform how to make business decisions moving forward. You should break sales into units and price per unit to see whether price, volume or both caused a gap between expected and actual results.

In a simple sales forecast, Chip Off the Old Block multiplies how many cookies it sold by the price per cookie and looks at how that changed month over month. For instance, on Valentine’s Day, it sold three as many cookies as in January. This helps the company to plan inventory needs, staff and set prices.

Calculate Cash Disbursements

These statements can also give small businesses a good idea of how much they will need to spend and then plan accordingly. Cash disbursement is when organizations use cash or cash equivalents to pay for expenses like materials, labor, manufacturing overhead (minus depreciation because it’s not a cash flow) and other costs. Cash disbursements are recorded in the general ledger.

For small businesses, analyzing cash disbursement on a regular basis could show meaningful trends in payments to vendors and can help prevent duplicate payments or overpayments.

For instance, Chip Off the Old Block gets its flour from its vendor Sunflower. Early payment terms have enabled the company to save 5% on its monthly invoices. But in January, it didn’t make the payment early and missed out on really good payment terms for the additional flour it orders for the February Valentine’s Day rush.

Statement of Retained Earnings

The statement of retained earnings show how much of a business’s profit remains in the business and how much is distributed to stakeholders. A statement of retained earnings shows beginning retained earnings for year, net income, dividends paid to stakeholders and ending retained earnings balance.

For instance, a Chip Off the Old Block just launched this year and had no earning, so it started with a balance of $0. It made $1,000 in revenue. It paid out $250 to the owner and the owner’s grandfather who lent him the money to start the business. That means retained earnings for the year are $500.

How to Use Financial Analysis Findings

The Federal Reserve’s analysis of the financial health indicators of small businesses says leaders and investors should not put too much weight to revenue growth as an indicator of financial health. The study also showed that better financial planning and management contribute to a higher financial health score. Discipline in digging into the numbers and analyzing metrics that point to profitability, efficiency and liquidity will give small businesses the information they need to make sound business decisions.

Automating more accounting processes also gives the finance team easy access to data for financial analysis. Businesses of every size increased their accounting automation with software over the last year, with the most likely functions automated including invoicing, financial report generation, data collection and document storage and compliance.

Having accurate data to create financial reports and make sales forecasts is the foundation of strong financial analysis to help the business determine when to hire people, buy more inventory, scale back and more.