If you've heard me talk about reporting, you know the Balance Sheet and Income Statement (Profit & Loss Statement) are not my favorite reports. While they are the most popular, I don't think they are the most effective when it comes to managing your wealth and tax strategy.
As a result, I've had many people share the following challenge with me:
The only reporting I currently have in place is my Balance Sheet and Income Statement that I get from my accounting software (or bookkeeper or accountant). If these reports are not the best for giving me information to manage my wealth and tax strategy, what can I do?
The very first thing to do is to make a plan right now to get proper reporting in place. There is no substitute for proper reporting. Meet with your wealth strategist to get this done.
In the meantime, there is a way to extract better information from your Balance Sheet and Income Statement in order to leverage the reporting you currently have.
While your Balance Sheet and Income Statement on their own don't provide the most helpful information to manage your wealth or business, there is a way to use the information to make it more helpful.
I'm talking about ratio analysis.
The information in your Balance Sheet and Income Statement can be used to calculate financial ratios. Financial ratios are the most well-known and widely used of financial analysis tools. You can use ratios to measure the performance of your business (or investing) against other companies, industry standards, or other benchmarks of performance. Financial ratios provide you with information about the riskiness and solvency of your business (or investing) and how it compares to other businesses (investments) in the market.
Commonly Used Ratios
Below are a few examples of commonly used ratios. Remember, all the information needed to complete these ratios is in your Balance Sheet and Income Statement.
You'll notice that I don't provide the specific formulas for the ratios here. That's because some of these are specific to each industry and need to be adjusted accordingly. The specific formulas can be found in books or websites dedicated to ratio analysis. If you'd like help customizing your ratio analysis to your specific industry and goals, please contact my office at cs@ProVisionWealth.com or 866.467.5809.
Ratios to Measure Liquidity
Liquidity indicates the ability of your business to meet its current obligations when they come due. It tells the story of whether your business has any assets in excess of those required for its operating needs.
Liquidity is critical to the success of your business because sufficient liquidity allows your business to meet its current obligations, gives your business the flexibility to grow and provides your business the ability to sustain operating losses.
Ratios to assess and manage liquidity include:
– Current Ratio
– Quick (Acid Test) Ratio
Ratios to Measure Leverage
Leverage is the use of resources to a fixed cost.
For example, financial leverage is the use of borrowed capital in the expectation of being able to use those funds to produce a return greater than the interest cost. In other words, if your business gets a loan with an interest rate of 8%, then financial leverage is achieved if your business can turn a profit on that money that is greater than 8%.
Ratios used to analyze leverage income include:
– Total Debt to Total Assets
– Debt to Equity
– Equity to Total Assets
Leveraging Ratio Analysis
To truly leverage ratio analysis, you want to look at what the trends of the ratios tell you.
For example, let's say your business has a current ratio of 1.0. A ratio of 1.0 indicates your business can meet its current obligations.
On the surface, this may seem like good news. However, if your current ratio last month was 1.8, then your current ratio of 1.0 indicates that the liquidity in your business is decreasing and you need to take action now.
It is the ratio trend analysis that helps you make proactive decisions in your wealth and tax strategy.