Column: Financially Analyzing Your Company

      Your company’s financial statements are a reflection of the organization’s management ability, its financial strategies (or lack thereof) and its successes as well as its failures.

      There are many potential users of these financial statements including management, investors/owners, banks, government and vendors, among others, all who look to gain insights into your firm and its financial performance. But what are they looking for and why? This article will discuss how to financially analyze your company.

      There are three primary reports that are included in a set of financial statements – Balance Sheet, Income Statement, and Statement of Cash Flows (there are others but these are the primary ones).

      A Balance Sheet is a snapshot in time of the assets of the company, the ownership equity it has accumulated, as well as the liabilities it has incurred but not yet paid.

      The Income Statement discloses the financial performance on your contracts as well as the overall financial performance of the Company.

      Finally, the Statement of Cash Flows discloses how much cash was generated or used by operations of the Company, the investments it has made, as well as financing arrangements it has entered into. Taken together, these three statements provide the reader the ability to assess the financial performance of an entity.

      There are two primary approaches to analyzing financial statements. One is a trending analysis, comparing one period to another or many others (monthly, quarterly, annually). The other is a ratio analysis, using ratios to analyze a firm’s performance against itself, against other companies and against industry standards.

      Some of the more common means utilized to analyze financial performance are:

1. Liquidity Analysis – Working Capital: Liquidity refers to how easily assets can be converted into cash. Working capital measures the ability of a company to pay its bills when they become due. It is calculated by subtracting current liabilities from current assets. It discloses how much liquidity would remain if all current liabilities (liabilities coming due within one year) were to be paid off. The larger this dollar amount is, the better the liquidity of the company.

2. Liquidity Analysis – Current Ratio: The Current Ratio is computed by dividing current assets by current liabilities. It discloses how many dollars of current assets are available to pay off one dollar of liabilities. The lower this ratio, the higher the likelihood that the organization will need to obtain outside financing or equity to fund its operations.

3. Number of Days Revenue in Billed Accounts Receivable: This is a measure that estimates how quickly the company is collecting its receivables. While the government has greatly improved its processing of contractor invoices, the longer the contractor takes to get its invoices out the door after month-end, the higher the result will be. Contractors should aim to keep this figure in the 30–45 days range. If the contractor is running above those times, steps should be taken to understand why and take corrective action.

4. Liquidity Analysis – Unbilled Accounts Receivable: Unbilled accounts receivable represents work that has been performed by the contractor (and thus costs have been incurred) but for some reason, the company has not invoiced at this time. The larger the dollar amount a company has tied up in unbilled accounts receivable, the poorer its cash flows will be. Common categories of unbilled receivables include:

• Billing lags
• Fixed price milestone contracts
• Indirect rate differential on cost plus contracts
• Contracts awaiting funding, modification, or options to be exercised.

5. Gross Margin and Operating Profitability: Gross margin is the difference between the revenue/billings and the direct costs of your contracts.

      This amount, when expressed as a percentage of revenue, should remain fairly consistent over time. Wide fluctuations in this ratio generally indicate something is not going according to plan in terms of contract performance.

      The operating profits of a Company, when expressed as a percentage of revenue, should closely track the profit percentages you are bidding on your contracts. Large variations can indicate that either the company is not properly bidding its contracts or it is over/under spending in its indirect costs.

6. Cash Flows from Operations

      The Statement of Cash Flows breaks down the cash flows of the company into the categories of operations, investing, and financing. The dollar amount of cash flows from operations indicates how much the contracts of the company are generating in excess cash flows (if positive) or is being used (if negative). Ideally, this amount should be positive, however, there are instances when it is expected to be negative including during large growth periods for the company. A negative cash flow from operations means that the Company will likely have to borrow funds to pay for ongoing operations.

Conclusion

      The financial statements of a Company tell everyone a story. Knowing how to analyze the numbers to gain an understanding of its financial story is a skill that every business owner should have.

Michael Smigocki, CPA, ABV is the Senior Managing Director of Federal Strategies Group, LLC. He provides government contract and management consulting, M&A advisory, litigation support and expert testimony to the government contracting industry. He can be reached via email at MikeS@FedStrat.com.

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Column: Financially Analyzing Your Company

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