Purpose of Financial Analysis

Individual investors or firms that are interested in investing in small businesses use financial analysis techniques in evaluating target companies' financial information. By examining past and current financial statements -- balance sheets, income statements and cash flow statements -- potential investors can form opinions about investment value and expectations of future performance. Financial analysis can also assist small-business owners as they weigh the effect of certain decisions, such as borrowing, on their own companies.

Financial Statements

If a firm is interested in investing in a small business, its financial analysts will likely examine the company's past and current financial statements. The objective would be to discover possible weaknesses and any problem areas that should be discussed with company owners. The analysts would look for unusual movements in items from year to year and for patterns in revenue and profits. Steady growth is normally positive, and severe ups and downs might be a sign of discord. Cash flow statements should indicate how the business normally obtains and uses cash. The management team of a small business might conduct a similar analysis as a part of an annual review of the business. The company's financial adviser or accountant might participate in such reviews.

Ratio Analysis

Ratio analysis compares values within the company from year to year and against other companies and the industry. Liquidity ratios such as the current ratio (current assets divided by current liabilities) show the company's ability to pay its short-term obligations on time. The debt ratio (total assets divided by total liabilities) shows how much of the company's assets are provided by debt. A lower percentage shows a lower dependence on debt. The higher the percentage, the more risk the company has taken on. Business owners and small-business management teams might use ratio analysis in their regular planning, to measure their companies against others in their industry. If ratio analysis shows that a company has a great deal more debt than other businesses in its industry, the owner might be prompted to pay off or reduce some loans.

Future Performance

Financial analysis can assist small businesses in their planning. Evaluation of a company's balance sheet, income statement and cash flow statement -- interpreting trends and identifying strengths and weaknesses -- might yield enough information to enable management to make projections of revenues and profits for three to five years. With knowledge of trends in the general economy and in the company's industry, they can form a reasonable estimate of how well the company might fare in the coming years. Such analyses can be helpful to businesses that need to plan equipment purchases and other initiatives.

Benefits

By employing expert financial analysis on an ongoing basis, firms are able to make investment decisions or recommendations based on sound reasoning. Companies might employ their own financial analysts who would keep watch over the company's strengths and weaknesses and advise upper management accordingly. Alternatively, some companies might decide to engage the services of financial consultants who could conduct periodic financial analyses.