In this series, we’ve examined basic financial statements and what each can do for you as a business owner. Read part one here.The next step is learning how to analyze the information presented in those statements and interpret the language of your financials, so you can:
- Appreciate your practice performance.
- Find ways to generate more profits.
- Look for early clues of problems and opportunities.
- Find ways to maximize your dental practice value.
Practical financial analysis helps you to achieve significant progress and accelerate your practice growth and development. It’s not enough to just look at your financial statements—you need to be able to interpret what the data is telling you. For that, you can use financial statement analysis. Examining financial statements without proactive steps to improve your practice performance is pointless. Financial statements are designed to be analyzed and acted upon.
Read part one ... Why financial statements are the key to growing your practice and your wealth
Putting information to work
Financial analysis is a process. Decades ago, that meant hours of number crunching with a calculator or spreadsheet. Today, it’s fast and easy because most of these capabilities are built into your accounting system. But knowing how to apply financial analysis principles is a learning process; it takes training to interpret the results. The good news is learning is not a very arduous process.
This is a popular definition of financial statement analysis: “Financial statement analysis is a process of analyzing a company’s financial statements for decision-making purposes.”1
It sounds simple, but as with everything else in this world, it depends. It depends on who’s doing the analyzing and for what purpose.
While internal users (practice owners and office managers) use financial analysis as a monitoring tool, helping them manage finances and apply necessary means to improve practice performance, external users utilize it to understand the practice’s overall health and evaluate the financial performance of the business. The most crucial goal of external users is to establish the actual value of the practice as a business enterprise.
Understanding the dynamic nature of financial analysis is also important. The financial statement is a record of critical financial data that reflects significant elements of business performance. However, applying financial analysis does not just reflect historical business activities; it can be used to model future business performance. As such, it is prudent to apply financial analysis to evaluate business enterprises on a basis of historical, current, and projected performance.
Finally, accounting information compiled in the financial statements provides both external and internal users “with a starting point to understand and evaluate the key drivers of a firm, its financial position, and performance.”2
Subtraction as well as addition
As stated before, financial analysis is a process. It is part science but also part art. While the science part lies in applying analytical formulas, the art part rests with using information derived from the analysis to develop a vision of the business’ future and exploration of future business opportunities. The good news is that today, mainly due to technology, there is a lot more science and less art in financial statement analysis.
Modern-day accounting software systems provide vast options for reporting and analysis of financial data, where one can almost effortlessly generate a detailed report reflecting the company’s financial condition. However, like everything else, this analytical process requires a time investment, training, or reliance on professional expertise.
Financial analysis is a complex process, and it’s easy to become overloaded with information. While analyzing financial statements, it is crucial to understand that there is a balance between too much and too little information. Part of financial business management is understanding what to pay attention to and what to ignore. Initially, though, your job is to get familiar with everything so you can tell the difference.
An objective look at your practice
The best way to objectively analyze financial statements to derive the most benefit is to remove or suppress your emotions. Simple reliance on numbers provides an objective review of your business. Being a practice owner comes with a significant emotional toll, and it’s easy to put stories to facts and soften your approach to addressing problems. Remember that financial analysis delivers valid numbers to you unbiasedly, helping you establish reliable benchmarks of your practice profitability, overall enterprise value, and creditworthiness.
This unbiased approach to financial analysis is the best way to build the value of your enterprise, since that’s how potential buyers or investors would ultimately value your practice.3
Understanding your practice’s financial health
Reviewing your practice’s overall health using financial statement analysis is an integral part of the accounting process. Additionally, you can use these analytical techniques to reflect on your business’ strengths and weaknesses and create an opportunity to develop a solid improvement plan. In brief, financial analysis is similar to your business’ financial report card.
So, once your financial statements are prepared, how do you go about analyzing them? First, let’s briefly summarize the three documents involved in financial statement analysis:
Balance sheet: A balance sheet summarizes your practice’s assets, liabilities, and equity—in other words, what you own (assets) and owe (liabilities) and your practice’s financial value (equity) as of a specific period.
Income statement: This document details your practice’s revenues and expenses, showing how much net profit your practice is generating.
Cash flow statement: This statement shows how much cash or cash equivalent has flowed in and out of the practice in a specific period.
5 methods of financial statement analysis
Financial statement analysis is not a simple one-way process. There are different ways to do this analysis, but these are the five standard methods:
1. Horizontal analysis: Horizontal analysis compares financial information over time (figure 1). This is where you relate financial statement data from various past periods (months, quarters, and years) to see how the business performs compared to previous periods. While horizontal analysis is performed by comparing financial data from the past income statement, it is advisable also to analyze positive and negative variations, such as higher or lower earnings, to understand the reasons for those fluctuations.4
