The Credit Process: A Guide
For Small Business Owners
... Continued From Previous Page
A Profit and Loss Statement
Shows the profit or loss for the year. The profit and loss statement, also called the income statement, takes the sales for the business, subtracts the costs of goods sold, then subtracts other expenses.
A Statement of Cash Flows
Presents the sources of cash in your business—from net income, new capital, or loan proceeds—versus the expenditures, or uses of the cash, over a specified period of time. An example of the cash flow statement for F.E.D. Foods Company is shown below.
It's at this stage that you will appreciate having an effective accounting system. Without this system, you won't know if you are profitable or not, let alone if you are liquid enough (simply put, have enough cash on hand) to pay for the next order of merchandise. A good system also will help you track your company's growth and anticipate future cash needs.
Ratio Analysis
Another tool the lender will use is financial ratio analysis. Ratios permit review of a company's current financial performance versus that of previous years. In the same way that a medical checkup tests one's heart, lungs, and changeable factors such as body weight, an analysis of a company's financial performance considers the status, changes, and relationships of critical components of a company's health.
The lender also may use financial ratio analysis to consider how a company is doing when compared to another company. A limitation of such comparative analysis is that different industries are driven by different factors. As a result, the financial ratios of a manufacturer and retailer can be quite different even though both companies may be similarly successful.
Lenders are trained to appreciate both the benefits and limitations of ratio analysis and to consider financial results in the context of the company's "peer group" of similar companies within its industry. To find out what the benchmarks are for your type of business, you may refer to guides published by Robert Morris Associates and others.
The following section presents some widely used ratios from four financial ratio categories: profitability, liquidity, leverage, and turnover. The section also provides examples of the ratios calculated for the sample company, F.E.D. Foods Company. Your lender's analysis also may include ratios specific to your particular industry.
Profitability
Profit is the compensation an entrepreneur receives for the assumption of risk in a business venture. The profitable business must cover its overhead expenses and generate profits for its owner out of its "after-product-costs" cash.
Gross Profit Margin
One commonly used measure of profitability is gross profit, which is your sales minus your product costs. In ratio form, it is called the gross profit margin.
Operating Profit Margin
Another measure of your profitability is the operating profit margin. This is the core cash flow source that is expected to grow year to year as your business grows, and it excludes interest expense, taxes, and "extraordinary items" such as the sale of property or other assets.
Higher profitability from one year to the next is generally considered a good sign for a company.
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