Businesses are required to file federal tax returns on an annual basis. The information contained in these tax returns can be used to determine the business’s financial strengths and weaknesses. Lenders often perform a detailed analysis of a business’s tax returns to assess the risk associated with lending. Analysis involves examining the tax return and calculating financial ratios from tax return numbers. Comparisons are often made to other businesses in the same industry to ascertain the business’s performance according to industry benchmarks.
Create Microsoft Excel spreadsheets using the information contained on the business’s tax return. One spreadsheet should include the details of all components of income and expenses and another should include the details of all assets, liabilities and owner’s equity. After creating the column for the dollar value of the business tax return, calculate the common size income statement and balance sheet in the following column of the spreadsheet. Common size income statements represent all income and expense items as a percent of total revenue. Common size balance sheets represent all assets, liabilities and owner’s equity as a percent of total assets.
Create a spreadsheet for at least the past three years for both the income statement and balance sheet. Ideally, common size income statements and balance sheets should be created for a five-year period. A five-year period allows the individual analyzing the financial data to determine if unusual results are anomalies that need to be investigated further.
Examine the common size income statement and balance sheet. Compare the common size statements to industry statistics. Industry statistics can be found in The Risk Management Association's "Annual Statement Studies" or industry publications.
Calculate liquidity ratios. Liquidity ratios signify how easily the business can turn assets into cash. The current ratio is determined by dividing total assets by total liabilities and indicates if the business has sufficient assets to cover its current debt payments. A current ratio of less than 1:1 is a red flag that the business may not be able to meet current debt payments easily.
Calculate the business’s working capital by subtracting current liabilities from current assets. Working capital is a measure of cash flow. Lenders often require a minimum level of working capital.
Calculate the business’s debt to net worth ratio by dividing total liabilities by total net worth. This ratio indicates the business’s level of reliance on funds from lenders as opposed to funds from investors. A greater debt to net worth ratio may preclude a business from obtaining a loan.
Calculate profitability ratios such as gross profit margin and net profit margin. Gross profit margin is determined by dividing gross profit by net sales. Gross profit is calculated by subtracting cost of goods sold from net sales. Net profit margin is determined by dividing net profit by net sales. Profitability ratios should be compared to that other companies in the same industry to provide an indication of performance.
Calculate management ratios such as accounts receivable turnover and return on investment. Accounts receivable turnover is calculated in two steps. First, divide the net credit sales during the year by 365 to arrive at daily credit sales. Second, divide accounts receivable by daily credit sales. Accounts receivable turnover indicates how well the company collects money from sales made on credit. Return on investment is determined by dividing net profit before tax by net worth. The return on investment indicates whether or not the investors made a wise choice in their investment. If the return on a risk-free investment is greater than the return on investment in the business, an investor may rethink his investment choice.