Analyzing your financial statements

Now that you have prepared your financial statements, it's time to analyze them. I will mix some "stolen" tools financial analysts use to analyze companies with some tools I "invented" to analyze your personal finances.

Margins
Operating margin = operating income / revenue. The higher the operating margin, the better. This is a useful measure while you are still working to towards achieving financial independence. The margin represents the percentage of your revenue that you have left over after all operating expenses (i.e. living expenses), money that you can save and invest. Negative operating margins are very bad, it means you're heading towards bankruptcy. Operating margins less than 10% are a little low, above 10% are average, above 20% are good. Anything above 30% are very good - if you save and invest over 50%, like John, Trent's friend, you are doing extremely well.

Net margin = net income / revenue. High net margin represents good financial performance. However, this ratio can be skewed by extraordinary income and expenses.

Both operating margin and net margin are useless if you are already retired - if your revenue is zero and a margin cannot be calculated.

Returns
Return on invested assets = non-operating income / (non-current assets minus home and business equities). The higher the return on invested assets, the better, because you are earning more money on less investment.

Growth rate
Revenue growth rate = (revenue this year - revenue last year) / revenue last year. Check if your revenue is growing as fast or faster than inflation. If not, your revenue is declining in terms of purchasing power.

Operating income growth rate = (operating income this year - operating income last year) / operating income last year. If your revenue growth is negative in terms of purchasing power, you may still be able to increase your operating income by controlling your operating expenses. Operating income growth rate should at least equal, if not exceed, your revenue growth. If it does not, you are probably increasing your operating expenses faster than your revenue - time to cut costs!

Net income growth rate = (net income this year - net income last year) / net income last year. As you increase your savings and investments, your non-operating income should increase. Over time, your net income growth rate should exceed both your revenue growth and operating income growth.

Financial strength
Current ratio = current asset / current liabilities. The current ratio shows whether you have current assets to cover current liabilities in times of need. This measure is probably not as useful for an individual as it is for a company - individuals should focus more on adequate cover over operating expenses.

Current asset adequacy = current asset / operating expenses. This shows how many years of operating expenses you can cover with your current assets. Generally, you should keep this value around 0.5, which means your current assets can pay for 0.5 year, or 6 months, of operating expenses.

Interest coverage = operating income (add back interest expense) / interest expenses. This shows how many times your operating income will cover your interest expenses. If the coverage is high, that means you can afford to lose a little revenue or have a little increase with operating expenses without having trouble paying your interests.

Total liabilities to equity = total liabilities / equity. This ratio shows you how much liabilities do you have over your equity. As you pay off your debts, this ratio should fall. If this ratio is increasing, you are probably digging deeper into debt (but may also be because of your spending your assets or your assets losing value).

Notes to interpreting your financial statements
As with financial analysis of companies, your should interpret the financial statements and analysis (ratios, growth, etc.) in relation to prior years and your peers. Comparing your performance this year against previous years should be relatively easy, so long as you have been keeping records of your financial statements and analyses. It might be more difficult to compare your financial position against your peers comprehensively, but you could probably find statistics on gross income and net worth levels of your peers (sometimes published in the surveys on newspapers and magaizines).

When you are analyzing your financial statements, please bear in mind the many factors not reflected in your statements that may affect your interpretation, including:

• Your age.
• Your life plans and goals (such as whether you are getting married, planning to have 1 or 5 babies, traveling to "exotic" countries every year, etc.).
• The number of years to your planned retirement.
• Your income (revenue) and job/business stability.

Now that you know how to prepare your financial statements and analyze them, go try it for yourself! See how you are doing and keep these records. I hope your financial position will get better and better every year, and your financial statements will testify to that.

Related posts:

• Keep track of your financial progress.
• Preparing your financial statements.
• How are you performing financially?
  
• The principles of wealth accumulation.

References:

• The Simple Dollar - Sunday Conversation #1.

P.S. This post was featured in Money Hacks Carnival #10 -- Your Money, Your Life at Money Hacks.