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Value of Internal Analysis Models Preparing financial statements and creating models and analysis tools are both subsets of financial reporting. Models and analysis tools are internally focused although they may be based on external needs and reporting requirements. The most critical time to establish analysis models and measurement tools is during the early stages of business. Even though a company may not be sophisticated enough to create and manage a collection of such tools, having a small number of simple measures will offer a framework/measuring stick for growth. Knowing what aspects of business work and do not work is critical. Waiting until all company resources are exhausted before realizing that an aspect of the business model did not work is detrimental to business success. Analysis models, even simple ones, will provide a way for the small and emerging business owner to gauge progress and avoid failure. Developing and Maintaining Internal Analysis Tools Generating analysis tools and metrics will enable managers/owners to gauge company progress and provide the platform for making adjustments to the overall business strategy. How will management develop effective tools that are reliable and relevant? Weak and irrelevant tools are just as ineffective as strong tools that cannot be populated with accurate data or interpreted properly. These two areas of concern will drive development of analysis tools/metrics. The small and emerging business owner must understand the areas of business that must succeed in order for the entire organization to flourish. The early stages of business development will be dependent on profitability and cash flow. Issues related to capital structure, turnover, and operating leverage may be important; however, the ability to generate revenue and free up cash will secure the foreseeable future of any organization and position it to succeed. Another factor shaping analysis tools lies in the finance function’s ability to deliver data in the appropriate form. Does it gather the necessary data? Can it gather the data in a timely manner? These matters represent an upper-tier consideration that, in the multilevel model, will affect lower-tier considerations. Pegging tools and metrics that depend on data/information that the data flow process cannot gather or process will result in weak management tools. Additionally, how will these analysis tools change as the business changes? If the organization pursues a different strategy or changes its market focus, will these analysis metrics still be relevant? For example, managing margins (sales less cost of goods sold) in a lowvolume business may be different than doing the same in a high-volume business. Although high margins may be necessary in a low-volume business, a high-volume business may be representative of a low-margin business. Both business models are valid, but the business profile must fit the circumstances. Understanding the underlying assumptions of analysis tools will also drive their development. The assumptions, dependencies, or limitations must be understood before the ratio, model, or line item is relied on to make decisions. For example, when using balance sheet accounts for performing ratio analysis, using average balances is more meaningful than using ending or beginning balances. Ensuring that the data used in the tool or model is accurate and timely is another key area of concern. A metric or ratio should not exist on its own, it should be compared to the company over time or to other companies in a similar industry. Ratios and metrics should never be taken out of context or used to rationalize a decision; rather, they should stand as part of a series of measures that augment the owner/ managers’ subjective understanding of the business. The level of sophistication of the data customers who will interpret and analyze these tools also plays a role in developing them. The capacity of management/ owners to understand these tools and translate their meaning into workable initiatives or strategies will play a role in their development. For example, financial ratios that focus on working capital components of the balance sheet will be lost on decision makers who do not understand the relationship between current assets and current liabilities. Analysis of working capital is particularly important when it comes to cash flow analysis. Because many inexperienced entrepreneurs do not understand the dynamics of certain crucial areas of the balance sheet, namely inventory and accounts receivable, developing metrics and analysis models that focus on these areas will be of little value to them. The combination of poor analysis tools and management inexperience may result in decision making that is misguided in the most critical area of the business: cash. These soft components of the finance function must be easily interpreted and clear to all data customers regarding what they imply about the business. Types of Internal Analysis Tools Analysis tools derived from company-generated financial data may come in the form of simple, line item reporting metrics or relationships between classified data elements. Examples of the former are revenue, margin, earnings before interest and taxes (EBIT), and net income. These measuring tools are straightforward and consist of certain line item accounts on financial statements. Analysis tools that represent relationships between classified data elements come in the form of balance sheet and P&L ratios. Ratios can convey very powerful information regarding a company’s well-being and performance. They also can be relatively complex to construct and decipher. Due to the limitations of certain ratios and analysis tools, the small and emerging business owner should take time to review upper-tier considerations of the multilevel approach to strategizing and determine a slate of analysis tools to use to evaluate the business. Simple financial reporting metrics are based on financial statements prepared by the company. The power in these analysis tools is their simplicity and objectivity. They are limited, however, in their reliance on the data that defines them and the methodologies used to derive the balances. Upper-tier considerations of the multilevel approach will impact the effectiveness and reliability of these analysis metrics. Understanding management’s analysis needs will help the finance strategist develop infrastructure that adequately feeds these measures. Most small and emerging businesses rely on P&L-oriented metrics to measure success. The following analysis tools provide valuable input on the performance of the company: - Revenue - Margins - EBIT - Net income - Operating expense - Total equity (positive versus negative) Financial ratios come in a myriad of forms and serve varying analysis needs. They can analyze anything from simple liquidity, to profitability, to capital structure. The small and emerging business owner will benefit best from simple ratios that focus on areas that are the most critical in the early years of the business. Using critical as the chief criteria narrows the focus down to cash/liquidity ratios and - Cash and marketable securities divided by current liabilities - Cash and marketable securities divided by sales - Cash and marketable securities divided by total assets - Cash plus marketable securities and current receivables divided by current liabilities (quick or acid test ratio) - Current assets divided by current liabilities (current ratio) - Net income divided by revenues - Net income divided by shareholder’s equity - Net income divided by total assets
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