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Understanding your Financial Statements Part 8 (Final) – Limitations of Financial Statements

Understanding your Financial Statements Part 8 (Final) – Limitations of Financial Statements

This series of articles has been an introduction to how to read your financial statements and how to use the information to improve your business. Financial statements provide very valuable insights, but they are not perfect and do not tell you everything. In this final article, we look at 8 limitations of financial statements, and where to go from here to dig deeper for business improving information.

1. Information Provided

There’s an old expression used for data management systems: “rubbish in equals rubbish out”. The quality of the output we get from our financial statements, and any other performance measuring system, can only be as good as the information fed into it.

To get reliable, useful financial statements, make sure you provide complete and correctly classified information to your accountant. All business-relevant transactions, whether processed through the business bank accounts or not, should be included.

2. Financial Measures Only

You can argue that your financial statements present the end result of all business efforts. However, there is more to evaluating the health and prospects of a business than just the financial results. How satisfied are your customers? Are your staff developing their skills? How is your firm’s reputation?

To run a business, you need both financial and non-financial measures with information from the accounting and other systems.

3. Internal Information Only

Financial Statements show the business’s results, but do not consider what is going on outside of the business.

A business manager needs to also look at environmental factors when making decisions such as economic conditions, law changes and competitor’s activities.

4. Looking Backwards

Your financial statements will tell you what happened in the last financial year. This provides a great learning opportunity. Those numbers are real. However, we want to take those lessons and use them when looking forward.

To improve your financial performance, you need to use the knowledge of what your actions to date have achieved, and projections of what will change in the future. Forecasts can incorporate pending new contracts, or loss of contracts, plans for new services and other challenges that do not impact your financial statements.

5. No Intangible Assets

If a business spends money on marketing, developing skills or building its reputation, these costs are expensed. I.e., they reduce profit. However, they could be considered an investment. If these business development efforts are effective, the business will be growing intangible assets as skills and brand reputation are real assets that improve future financial results. Due to the difficulty in valuing these assets, accounting rules require that we just write the costs off.

To get a true picture of the financial position, intangible assets must also be considered.

6. Historical Cost

Generally, financial statements record everything at historical cost meaning that the value all assets in the balance sheet are based on their original cost.

A more relevant picture of the financial health includes the current worth of assets. This is especially relevant with assets like real estate and livestock where the valuation in the accounts may bear no resemblance to current values.

7. Owner’s Situation

Small business accounts include items that reflect the current owner’s individual situation. Home office costs are determined by the owner’s level of mortgage debt or rent. Interest costs are determined by the financial structure chosen by the owner. Most significantly, the accounts may not include a market cost for the owner’s time.

To get a full picture you need to separate the owner’s own situation with the actual business operations. That is why a potential purchaser of a business will adjust the existing accounts to find a profit figure that reflects the actual business operations they will be taking over.

8. Accounting Policies

Financial statements must follow rules. For small businesses, these are generally rules set by Inland Revenue and their purpose is to help determine tax payable. The rules do not always produce the most realistic measure of business performance.

For example, when you buy a fixed asset, we depreciate it (expense the cost) over the expected useful life of the asset, thus spreading its cost against the income it is used to generate. IRD provide a schedule of rates that we use for depreciating assets. If you buy some computer equipment that will last you for five years, you could realistically recognise 20% of its cost each year. However, when following IRD tax rules, we write it off at 50% per year, overstating expenditure in the first couple of years of owning it.

So where can we look for more relevant or detailed information?

Management Accounts

Financial statements are prepared primarily for external users, such as IRD and potential investors, as opposed to business owners. They still provide valuable management information but are not specifically designed to inform management decisions.

Management accounts on the other hand are prepared specifically to help a manager make good decisions and are not bound by external rules. Business operators serious about growing and developing their investment want information focused on the key results that measure their progress. Management accounts, typically prepared monthly or at regular intervals, are part of this.

Management accounts can provide the following information that is generally not disclosed in annual financial statements.

Drilled-down information – While financial statements show overall revenue and profitability, to find out exactly where the profits are being made and lost, we need to dissect it. Management accounts can usually be drilled into to split profits by appropriate segments. This could be by product or service, client, type of client or business manager. Often there will be one or more areas of your business responsible for most of your success, while other areas are actually costing you.

Seasonal Trends – Financial statements show changes happening year to year but will not reveal the ups and downs during a year. To manage work loads and cash flow fluctuations, we need to plan on a monthly basis, not just a full year. Management accounts can be prepared in any time-frame, but typically will be monthly or quarterly.

Up to date – Financial statements show you what happened in the last financial year. Management accounts can show us what happened last month, within a few days of the month finishing.

Forward looking – By combining recent actual figures with forecast figures, we can get an accurate picture of how your current year is turning out.

Non-financial measures – By combining non-financial measures with financial measures, a management reporting package can provide a wider view of the business.

Conclusion

Financial statements are a great place to start analysing your business, especially as you are already paying to have them prepared. But, you get financial statements once a year, usually a while after the year has finished, and the information they provide has some limitations.

If you are serious about developing a successful business, you need regular, relevant information on which to base informed business decisions. This includes financial and non-financial measures, internal and external information, backward and forward focused.

Understanding your Financial Statements Part 7 – Comparing your Results

Understanding your Financial Statements Part 7 – Comparing your Results

So far in these articles you have looked at how to read your financial statements and how to calculate meaningful measures to gauge your profitability, cash flow management and financial structure. But the numbers on their own do not mean much until you compare them to something.

You can make meaningful comparisons to:

  1. Your past figures – are you getting better or worse?
  2. Other businesses – how do you compare to other similar businesses?
  3. Your targets – are you on track to meet your goals or not?

Comparing to your past results

If you have been in business for more than a year, your financial statements will contain two columns: the most recent year’s figures and the previous year’s. You could also find earlier years by digging out your older financial statements.

Comparing to prior years shows your trends – where you are making progress and where there maybe danger signs. A worsening result in one area could spell problems down the track.

For example, if your revenue is growing, you would expect your debtors to grow too as you are sending out more invoices. But, if your debtors are growing at a faster rate than your revenue, you may be heading for a cash flow crisis. As discussed in part 5 of this series, growth absorbs cash and so cash flow needs to be managed carefully.

Comparing to other businesses

If your business has revenue of $400K and a profit of $40K, you have a 10% profit margin. How do you know if that is that good or bad? By comparing it to other similar businesses.

Comparing a solo consultant’s $40K profit with a 20-staff firm’s profit is of little help. However, comparing the 10% profit margin is relevant. The advantage of ratios is they are relative measures, and help you make meaningful comparisons with any sized business.

A high profit margins relative to other businesses may mean you have a competitive advantage. Maybe you could take advantage of that with aggressive pricing knowing that the average firm won’t be able to compete. A low relative profit margin indicates you need to examine your pricing, efficiency and costs.

Where do you find figures for other businesses? Your industry’s professional body will probably carry out surveys and have figures available. Waikato University’s Institute for Business Research carries out an annual business benchmarking survey covering all sorts of industries. IRD also track benchmark figures and have published them for some industries.

Comparing to your budgets or targets

Business budgeting involves choosing goals and setting financial targets that will get you to those goals. This process highlights whether your ideas are feasible or whether you need to tweak your plan. It also gives you a marker to measure your progress against, highlighting when you go off course and need to act.

Without any budget, or target, figures, it can be hard to know why things are turning out the way they are. Looking at the variances between your actual results and your target results may reveal where the problem is that you need to fix.

Maybe you are flat out with work but still struggling to pay your bills. Where do you look?

First, is your revenue meeting your budget? If not, you could look at your pricing, how efficiently you are getting the work done, whether particular clients are draining your resources, etc.

If revenue is on target, how is your cash flow management? Is your Working Capital Ratio worse than in your budget? If so, that will explain the cash flow struggles. Maybe you have too many jobs in progress and not getting them billed.

If your cash flow measures are OK are your costs blowing our compared to budget? You may need to focus on controlling costs.

Focusing on the right measures

These articles have covered various measures and there are many others you could use. In reality, you can only keep a close eye on a few. The key is choosing the measures which have the biggest impact for your business.

Let’s say you are very efficient with profit margins among the best in the industry. You probably won’t make great improvements to your bottom line by trying to squeeze another 1 or 2 percent out of your margins. But focusing on growth, while maintaining your margins, will bring big profit increases.

To grow your business, a good “lead” indicator might be the number of sales presentations you make. The “lag” indicator might be revenue growth. Comparing actual revenue against forecast revenue will show you whether your efforts are working.

In a small, one-owner business, you may focus on only one measure on a daily basis, with occasional checks of other parts of the business.

The information in your financial statements is not perfect. In the next and final article in this series, we look at the limitations of your financial statements.

Understanding your Financial Statements Part 6 – Business Finance

Understanding your Financial Statements Part 6 – Business Finance

In this article, we step back and look at your business as an investment.

Being a business owner goes beyond being self-employed – i.e. being your own boss – to having an asset that you can grow into a valuable investment. You are investing, by injecting money and/or your personal effort, or “sweat equity”, into your business. To grow your investment, you have to think like an investor, and not just a business manager.

One of the fundamental principles of investment is risk versus reward. A safe investment such as a bank deposit will generate lower rewards, such as a modest interest rate. Riskier investments, such as a share or property fund, demand higher returns on average, but less certainty as returns will fluctuate and sometimes go backwards.

If investing in a fund of publicly listed companies is risky, it is nothing compared to investing in a single small business. For this reason, small business investors such as angel investors and venture capitalists look for returns as high as 40 to 50%. A large portion of small businesses fail, taking your whole investment with them. On the positive side, you are in control of your business, so its success or failure is largely up to you.

How much is your business worth?

When you invest in businesses, whether it is a few shares in a multi-national company or 100% of your own consulting firm, you are buying an entitlement to the business’s future earnings and capital gains. Therefore, a business’s fundamental value is based on its profits. The value increases as profits increase.

In investment jargon, a share’s value can be quantified by a price-to-earnings multiplier. I.e., the value of the business is a multiple of its earnings, or profit. Shares in an established public company may sell for say 8 to 20 times its current profit, depending on expectations for earnings growth etc. An established small business may sell for a price multiple of 2 – 4, reflecting the much higher risk of smaller enterprises.

Let’s assume a business is worth 4 times its current profit. If the profit is $125K, it will be valued at $500K. Looking at it another way, the owner has a $500K investment making a 25% return (125K / 500K x 100). 25% is the return on the owner’s investment, or their equity in the business. Let’s call this Return on Equity (ROE). To increase the return, and therefore the investment value, the business must increase profit.

Three steps to generating a Return on Equity (ROE)

We can view the overall business process as three steps:

1. The business raises funds to finance business assets
2. The assets are used to generate sales
3. Sales are turned into profit

Return on equity is a function of these three steps. Let’s look at each.

1. Raising funds to invest in assets

As discussed in part 3 of this series, assets are items of value owned by the business that will bring future economic gains. This includes tangible (physical) assets such as business equipment and cash, and intangible assets such as knowledge, systems and clients. A business uses assets to generate sales and these assets are funded by long-term finance.

On a balance sheet, assets = liabilities + equity. I.e., the value of total assets on one side of the balance sheet is funded by an equal amount of equity and liabilities (debt) on the other side of the balance sheet.

Equity is the owners’ investment while debt is money lent from outside parties. The mix of debt versus equity affects the ROE. While small businesses are sometimes 100% equity financed, having some debt can increase returns but will also increase risk. The ratio of debt to total finance is called the debt ratio.

Returning to our example, we have a $500,000 business investment making a $125,000 profit. If it is entirely funded by equity, the owner is making a 25% ROE (125K / 500K x 100).

Let’s see what happens to the owner’s return if the business is financed with 50% debt and 50% equity – a debt ratio of 50%. To do this it raises a $250K loan at 10% interest. The owner now has $250K equity invested.

The annual interest charge on the loan is $25K ($250K x 10%). The interest is an expense to the company, reducing the profit to $100K ($125K – $25K).

The owner now has a return of $100K from their $250K investment, a 40% ROE, up from 25% with an all equity investment.

While the business is generating a return on its assets (25% in this case) greater than the cost of its debt (10%), debt finance will increase the return on the equity. However, debt increases risk because if the return on assets decreases to below the cost of the debt, the return on equity will decrease and, with too much debt, could go into a loss.

2. Turning assets into sales

The second factor in determining ROE is how efficiently the business generates sales from its assets. The greater the sales relative to total assets, the higher the return.

A measure for this is asset turnover: annual sales / total assets. This calculates the number of times per year the assets are “turned over” by sales. If our $500K business has an asset turnover of 2, it will have sales of $1,000,000 (500K x 2).

To improve the return on investment, we can either increase sales without a proportional increase in assets, or decrease assets (i.e. a lower amount invested) without a proportional decrease in sales.

3. Turning sales into profit

The final step in generating ROE is turning sales into profit. The business needs sales to make money but only the profit is available to the owner.

Our measure of the business’s efficiency in doing this is profit margin. Profit margin is profit as a percentage of sales. Continuing our example, the $125K profit with sales of $1M gives a profit margin of 12.5%: (125,000 / 1,000,000 x 100).

Increasing the profit margin will increase the return on investment.

Example

The table below shows our example business.

We have:

A debt ratio of 0% (i.e., no debt)
Asset turnover of 2
Profit margin of 12.5%

The next table shows the starting point in column 1, and the effect of increasing each of the three variables by 10% in columns 2 – 4.

Column 5 shows the overall result of a 10% increase in all three variables, being an increase in ROE from 25% to 32.5%.

The 32.5% return on equity in column 5 assumes the total asset value, or value of the whole business, is still $500K. However, we have now increased our business earnings and therefore the business value will increase.

Returning to our business valuation, if we assume that we can still demand a profit multiplier of 4, our equity investment is now worth 4 times the profit, or $585,000 ($146,250 x 4). As our equity investment was $450K (with 10% debt finance), this is an increase in the value of our investment of $135K, or a 30% increase.

Summary

Business ownership entitles you to a share of the business’s earnings. Therefore, the value of your investment is determined by the business’s profits. Profit, in turn, are a function of three factors:

1. The value of assets in the business. This can be increased, relative to your equity investment, by adding in debt finance. We monitor the extent to which debt is employed using the debt ratio.
2. The value of sales generated by the assets. We measure this using asset turnover.
3. The profit relative to sales. We measure this using profit margin.
Investing in a small business involves significant risk but provides potential rewards way above most other investment options.

These articles have examined how to measure your business’s financial health using the information in your financial statements. It is one thing to do the calculations, but how do you know if your results are good or if you need to improve them? In the next article, we will look at how to put your results in perspective.

Understanding your Financial Statements Part 5 – Cash Flow

Understanding your Financial Statements Part 5 – Cash Flow

Your business needs profits to grow and to provide a return on your investment. But profits cannot be used until they become cash. When businesses fail, they are often profitable but still run out of cash, unable to pay their bills. Cash flow management is as important as profitability.

Balance sheet recap

The third article in this series discussed reading a balance sheet. In summary, the balance sheet contains three types of values:

Assets: Assets are items of value owned by the business, such as equipment and money in the bank. Assets will bring future financial benefits to the business.

Liabilities: Liabilities are items owed by the business, such as amounts owed to suppliers (creditors) and bank loans. Liabilities will cause future financial outflows from the business.

Equity: Equity is the surplus of assets over liabilities and represents the net worth of the business to the owner(s).
We can break both assets and liabilities into current and non-current, with current being due within one year and non-current being due after a year. E.g., if you have a bank loan with a five-year term, the portion payable within the next year will be included in your balance sheet under current liabilities while the remainder, due during years 2 – 5, will be shown separately under non-current liabilities.

To manage our short-term cash flow, we focus on the current items. We want to know whether our current assets will cover our current liabilities. I.e., will we collect enough cash to pay our bills. This part of our balance sheet (current assets and liabilities) is known as our working capital.

A balance sheet normally lists current assets from most current down to least current. I.e., cash and money in the bank will be at the top, as they are immediately available. Debtors (money owed by clients) may be next, as they should be collected in cash within the next few weeks. Work in Progress (WIP) may be next, as it is work yet to be completed before it can be billed and eventually paid for.

Likewise, current liabilities due sooner will be listed above current liabilities due later.

Measuring your cash flow

We will look at two ways to measure your business’s short-term financial health, or its ability to pay its bills as they become due: the working capital ratio and the cash conversion cycle.

1. Working Capital Ratio

Working capital ratio = current assets / current liabilities
The working capital ratio measures the ratio of current assets to current liabilities. I.e., the amount of current assets to come in for each dollar of current liabilities to go out. The higher the result, the better able the business is to pay its bills.

E.g., if your balance sheet shows total current assets of $30,000 and total current liabilities of $20,0000, you have a current ratio of 1.5 (30,000 / 20,000).

Whether 1.5 is good or not depends on the nature of your business. A consultant whose clients (or patients) have a consultation then pay before they leave, will not need as high a current ratio as a consultant who invoices their clients for payment on the 20th of the following month. The cash consultant knows they will collect money from cash sales over the following days and weeks in addition to the current assets in the balance sheet.

A variation of the working capital ratio is the quick ratio. The quick ratio excludes Work in Progress leaving just the most liquid, or readily convertible to cash, current assets. The quick ratio may be a better test of ability to pay bills if WIP will likely take some time to be completed.

Quick ratio = (current assets – WIP) / current liabilities

2. Cash Conversion Cycle (CCC)

CCC = WIP days + debtor days – creditor days
A second way to analyse your business’s cash flow, is by calculating the number of days it takes to generate cash. The cash conversion cycle (CCC) is slightly harder to calculate than the current or quick ratios, but may better explain the business’s ability to generate cash. Each of the three variables in the CCC equation above (WIP days, debtor days and creditor days) require separate calculations.

WIP days = WIP / direct costs x 365
WIP days measures how many days, on average, it takes for the business to complete work and get it invoiced, turning WIP in debtors. The fewer days, the more efficiently the business processes jobs once they have been started.

To calculate WIP days, take WIP from the balance sheet and divide it by the total expenses per the Profit and Loss. Multiply by 365 to convert it to the number of days.

Debtor days = debtors / fees (or sales) x 365
Debtor days measures how many days it takes to collect debtors. A low number of days indicates you have efficient trading terms and credit control. To calculate, use debtors from the balance sheet and fees from the profit and loss.

Creditor days = creditors / expenses x 365
Creditor days measure how long it takes you to pay your creditors. As you keep your money until you pay your creditors, a higher creditor days figure improves cash flow. It is generally considered good practice to delay paying creditors as long as you can without damaging your relations with your suppliers. Prompt payment discounts must also be weighed up.

To calculate, take creditors from the balance sheet and expenses from the profit and loss.

The following example shows a firm taking 25 days to complete jobs, 30 days to collect its debtors and 20 days to pay its bills. Its Cash Conversion Cycle is 35 days:

Cash flow for growing businesses

A business absorbs cash when it grows. Increased spending on staff, contractors and other expenses precede increased billing and cash collection. The longer the cash conversion cycle, the more money will be absorbed to grow the business.

When we hear that a failed business “grew too fast”, it really means they didn’t have the funding to grow that fast. Good cash management, reducing the CCC days, limits the amount of growth cash required. However, there will usually still be shortfall which will have to be financed.

In the next article, we will look at long-term financing and how to ensure that a business has the resources to grow without running out of cash.

Understanding your Financial Statements Part 4 – Profits

Understanding your Financial Statements Part 4 – Profits

In the previous two articles, we looked at the Profit and Loss Statement (P&L) and the Balance Sheet and how to read them. In this article, we will recap the P&L then dig deeper to analyse profitability, so you can make informed decisions to improve your business’s bottom line.

Profit is like oxygen for your business. You may have objectives beyond making money, but without money, you won’t achieve much. As well as providing you with a living, profit provides options. Profits are required to fund business growth and development including expanding into new service offerings or target markets. Without profit, or an endless supply of funds from elsewhere, your business will not survive for long.

Profit and loss recap

Revenue – expenses = profit

As per the second article, the P&L calculates profit. It takes total revenue and deducts business expenses to calculate the remaining profit. I.e., how much money your business has made for you, the owner. Here is a simple example:

We have subcategorised profit as gross profit and net profit.

Gross profit is profit after deducting direct expenses such as subcontractors used on chargeable jobs. Direct expenses are directly incurred to produce revenue and therefore increase or decrease as revenue increases or decreases. These are sometimes known as variable expenses as they vary with revenue.

Net profit is profit after deducting all other expenses from gross profit. The other expenses are indirect, as they are incurred to run the business but not directly to produce revenue. As they do not tend to vary as revenue changes, at least within a certain range of revenue, they are often assumed to be fixed expenses.

Gross margin

Gross margin = (Gross profit / revenue x 100)%.

Gross margin is gross profit as a percentage of revenue. It measures how efficiently you are generating revenue. A gross margin of 60% means that you are spending 40% of the revenue to generate it, leaving 60% to contribute towards indirect expenses and net profit.

Net margin

Net margin = (net profit / revenue x 100)%.

Net margin is net profit as a percentage of revenue. It measures how efficiently you are turning revenue into bottom line profit. A net margin of 30% means it is costing you 70% of your revenue to produce it and run your business.

Now let’s look at how to increase our profits.

Cost volume profit (CVP) analysis

Cost volume profit (CVP) analysis is a powerful tool for evaluating profit and how changes to the revenue, gross margin or net margin affect your bottom line.

Our “Me and Co Consultants” P&L above shows the following:

Revenue = $200,000

Gross margin = 60% (120,000 / 200,000 x 100)%

Net margin = 30% (60,000 / 200,000 x 100)%

Let’s now see how a change in any one of these three variables will affect the net profit, i.e. the bottom line figure that the owners are making from their business.

Revenue

Presuming all else remains the same, an extra dollar of revenue will produce an extra 60 cents of gross profit, as the gross margin is 60%. It will also contribute an extra 60 cents to net profit, as fixed expenses do not change. All the additional gross profit is added to the bottom line.

Here is an adjusted P&L assuming Me and Co has increased revenue by 10%, from $200,000 to $220,000.

 

Net profit has increased by $12,000, a 20% increase (60,000 + 20% = $72,000). So, a 10% increase in revenue has created a 20% increase in net profit. While gross margin has remained the same, net margin has increased due to the indirect expenses being fixed.

Gross margin

Let’s see what happens when we increase gross margins without increasing revenue.

The following P&L assumes Me and Co has increased gross margin from 60% to 70%, with revenue remaining at $200,000.

As the gross margin has increased by 10%, an extra 10%, or $20,000, of the revenue is captured as gross profit. This also translates to an extra $20,000 of net profit.

Net margin

Net margin is a result of gross margin and indirect expenses. To improve net margins without changing gross profit above, we need to reduce indirect expenses.

Continuing with our Me and Co Consulting example, let’s see what happens to the original P&L if we decrease our indirect expenses by 10%, leaving everything else unchanged.

A 10% reduction in indirect expenses from $60,000 to $54,000 has increased net profit by $6,000 or 10%.

Indirect expenses can be broken into discretionary and nondiscretionary.

We can control discretionary costs. An example is professional development costs. We can decide as we go whether spending $275 for a seminar will increase our ability to do our job and thus indirectly increase our long-term revenue generating ability.

Nondiscretionary costs are set in place and cannot be easily changed. If we sign a six-year office lease, we can’t choose month to month whether it is worth paying or not.

We make long-term decisions regarding our indirect expenses that will affect our profit. Healthy net margins require indirect spending to be efficient, paying for things that are necessary and helpful to facilitating our business efforts. But on a month to month basis, we should generally focus on revenue and direct expenses.

Improving profit

To summarise our examples above:

Improving indirect expenses can help but unless there is gross wastage, ongoing efforts should generally be focused on revenue and direct costs, i.e., gross profit.

When we look at gross profit, we often focus too much on revenue, thinking we just need more business. Sometimes, attention on gross margins can bring greater rewards without increasing our workload.

Our example looked at a consulting business starting with reasonably high gross margins. Other businesses, especially product businesses, would have lower gross margins. The lower the starting gross margins of the business, the more sensitive the net profit is to changes in the margin. So, where there is potential to increase gross margins, this can be the most effective place to start looking.

If your gross margins are already high, you can focus on increasing revenue knowing that any increase will add substantially to the bottom line.

Next article

While profits fuel our business, profitable businesses still fail if they run out of cash. The next article looks at managing our cash flow.

Understanding your Financial Statements Part 3 – Balance Sheet

Understanding your Financial Statements Part 3 – Balance Sheet

While the profit and loss statement tells you your business’s financial performance over a period, the balance sheet tells you your business’s financial position at one point in time. Your balance sheet tells you what your business:

  • Owns (its assets)
  • Owes to third parties (its liabilities)
  • Owes to its owners (its owners’ equity)

The Balance Sheet in summary is:

Assets = Liabilities + Equity

The balance sheet summarises your business’s worth in financial terms. Let’s look at the above three terms in more detail.

Assets

Assets are items of value that your business owes. Assets will bring economic benefits to your business in future. A business bank account with $1,000 in it, is a $1,000 asset. Business equipment, financial investments and intellectual property are all assets.

Assets can be tangible or intangible. Tangible assets are physical such as office equipment while intangible assets are not physical such as the rights to use a tradename or a client database.

A firm may work hard and spend money building a brand that is valuable to the firm. The brand is an asset because it will attract clients and generate revenue. However, it is often hard to objectively value the brand, or goodwill, so it will usually not appear in the balance sheet.

If a brand, or other intangible asset had been purchased, then there is an objective value that will be brought into the balance sheet. This could happen if a firm buys another established firm and pays for the goodwill of the purchased firm. The portion of the purchase price allocated to the goodwill has been valued by the buyer and seller during negotiations.

Liabilities

Liabilities are amounts owed by the business to outside parties. Liabilities are obligations for future economic outflows. They include loans from banks or other financiers, bills owed to the firm’s suppliers, and overdrawn bank accounts.

Equity

Equity, or owners’ equity, is the net worth of the business to the owners. If the business were to sell all its assets for their values on the balance sheet, and pay off all its liabilities at the values on the balance sheet, the remaining money is the owners’ equity.

To look at it another way, a business needs assets to operate. Most businesses require at least some equipment and money to pay ongoing bills. These assets must be paid for and they can only be funded from two sources: liabilities from outsiders or equity from owners. The more the assets of the business increase, and the less liabilities the business has, the higher the owner’s equity, or net worth of the business.

Equity can take different forms. A company’s share capital is money paid by owners to the company to purchase their shares in the business. Share capital will generally remain the same unless the company issues more shares or buys some its own shares back.

When a business makes a profit, and retains the profit within the business, it is added to owners’ equity as “retained profits”. When part of those retained profits are paid out to owners, owner’s equity is reduced.

Date of Balance Sheet

As mentioned, a balance sheet shows the financial position of your business at a specified point in time. A business can prepare a balance sheet at any time, but would typically produce one for management purposes at a month end, or quarter end. Annual financial statements, as discussed in these articles, will include a balance sheet dated the last day of the financial year, typically 31 March.

What to look for in your Balance Sheet

Within the assets, liabilities and equity amounts, a balance sheet may contain a complicated list of numbers and sub-classifications. To find answers and meaning, we will focus on two aspects of the balance sheet:

The overall financial position, being the level of equity both as an absolute value and relative to total assets, and
short term (or current) financial position being the business’s ability to meet its short-term financial commitments.
Both assets and liabilities can be classified as current or non-current, and most balance sheets will separate individual asset and liability amounts into these categories.

Current assets and liabilities

Current generally means within one year.

A current asset will be expected to be utilised within the following year, such as money in the bank which is immediately available, or amounts owed by clients (debtors) which are usually due within a few weeks.

A current liability is due to be paid within the following year. A bank overdraft, amounts owed to suppliers such as subcontractors or a phone bill are current liabilities.

Working capital is a term often used for your short term financial position. When we say we require some funding for working capital, we mean we need funds to pay for day-to-day operations, as opposed to funding long-term assets such as machinery or equipment.

Working capital = current assets – current liabilities

As a measure, working capital is the excess of current assets over current liabilities. If your balance sheet shows current assets of $30,000 and current liabilities of $10,000, you have working capital of $20,000. This means, you should realise the $30,000 of current assets during the following 12 months, be able to pay the $10,000 of current liabilities, and have an excess of $20,000.

If current liabilities exceed current assets you have a shortfall in your ability to fund your operations and will need to find short-term funding. Funding can be generated internally with profits or introduced from external sources – either debt or equity.

Total assets and liabilities

Non-current assets bring benefits over more than one year. Examples are motor vehicles, long-term investments and goodwill.

Non-current liabilities are liabilities that will be settled more than a year from now. A bank loan may be payable over the next five years. This will be split in the balance sheet with the portion due within the following 12 months under current liabilities, and the remaining amount, to be paid during years 2 – 5, under non-current liabilities.

Total assets and liabilities, including current and non-current, measure the overall financial health of your business as at the balance sheet date. The amount of equity the business has is a measure of the long-term financial position. More equity, both as an absolute number and relative to total assets, indicate a secure position with sufficient assets to service liabilities.

Liabilities (or debt) are not necessarily bad. Businesses borrow funds from outsiders believing they can use the funds to generate a return greater than the cost of the funds. If a business takes out a bank loan with 10% interest, and uses the funds to increase profits by 20% of the funds, the business will grow.

The key to long-term financial health is to get the balance right. A business needs to finance its assets and, as above, this finance can come from equity or liabilities (or debt). Raising debt provides some advantages over raising equity, as we will see in later articles, but the more debt we have the more risk we take on. Debt entails a legal obligation to pay interest and repay principal per the agreement terms. Investors of equity share in the risk of the business and only receive a return if the business makes profits and other gains.

So, debt can increase business value and is usually required for growth, but too much debt will put the business at risk of not being able to service it.

Summary

Your balance sheet shows your financial health at a point in time. We will focus on the short-term (current) health and the long-term (non-current) health of the business.

A fundamental purpose of business is making money. In the next article, we return to the Profit and Loss Statement and see how to analyse your business’s profitability.

Understanding your Financial Statements Part 2 – Profit & Loss Statement

Understanding your Financial Statements Part 2 – Profit & Loss Statement

Your Profit and Loss Statement (P&L) tells you how your business performed over a certain period. It tells you how much:

  • revenue you generated
  • expense you incurred to generate that revenue
  • profit remained for the business owner(s)

The Profit and Loss Statement in summary is:

Revenue – Expenses = Profit

Revenue is money made by your business. Your business will primarily make revenue from selling products or services and this will generally be shown as “sales” on your P&L, or “fees” in the case of a professional services business. Other revenue may come from interest or dividends on funds invested or gains on sales of business assets etc.

Expenses are financial outflows from your business, incurred to generate revenue or to run the business. Expenses may be:

  • direct expenses, directly incurred to generate revenue, such as the cost of buying products for resale, or
  • indirect expenses, incurred to manage your business, such as office rent, administration staff salaries and telecommunications.

Profit is the amount left over for the business owner. Profit can also be broken down into various types of profit. The most common classifications are:

gross profit, the profit after deducting direct costs from sales, and
net profit, the final profit after deducting all expenses.

Period covered by your P&L

A profit and loss statement shows the financial performance of your business over a specified period. Businesses typically prepare a P&L as part of their management accounts for a month, quarter or year-to-date. These articles are discussing financial statements which usually cover a financial year.

What to look for in your P&L

A P&L typically consists of a whole list of numbers and, without any direction as to what to focus on, can become confusing. To get valuable information on your business performance, you need to focus. Here we will discuss three numbers and how to find meaning with them:

  • Sales
  • Gross Profit
  • Net Profit

1. Sales

Sales (or fees) is the amount of revenue generated from core business activities. If you are a business coach with 20 clients, each paying you $250 per month, your sales should be $60,000 per year (20 clients x $250 x 12 months = $60,000).

For any number in your financial statements to be meaningful, it must be compared to something. $60,000 may provide a very healthy income for a semi-retired business coach, but would likely be a disaster for a full-time two-person partnership. Whether your sales figure is good or not depends on the needs of your business.

2. Gross Profit

Sales – direct costs = gross profit

Gross profit is only relevant if you have expenses that are directly incurred to generate sales.

Examples for a product business are the cost of goods for resale. For a furniture shop to sell a chair, it must purchase the chair. Each sale requires a purchase so cost of sales increase or decrease as sales increase or decrease.

Gross profit is relevant for a service business if it directly incurs costs, such as direct labour, to provide services. If you use a subcontractor to deliver a service to your client, paying them for each service delivered, their cost is directly incurred in providing services and will increase or decrease with sales.

If making an extra sale does not increase your costs at all, then you have no direct costs and don’t need to worry about gross profit. An example might be a business selling electronic products from its own website where an extra sale incurs no sales costs or production costs.

3. Net Profit

Total revenue – total expenses = net profit

This is where the expression “the bottom line” comes from. Ultimately, net profit, which is the number on the bottom line on the P&L, is the business owner’s return on their investment.

Although net profit is the most important figure, focusing on sales and gross profit can have a greater impact on improving results, as discussed in a later article.

These three measures, sales, gross profit and net profit, take into account all the activity in the P&L. Gross profit incorporates sales and direct costs while net profit incorporates all other revenue and expenses. When these measures are not what they should be, we can then drill down into the individual expense items to determine where improvements can be made.

In the next article, we look at the other primary financial statement: the balance sheet.

Ratios – Making Sense of your Numbers

Ratios Making Sense of your Numbers

How to Make Sense of Your Financial Statements

Often when I show a client a financial report, they respond with a blank stare. When I point out a figure in the report, such as their net profit, they may ask something like: “is that good?”.

They are appropriate responses because numbers can seem meaningless on their own. Only when they are put into some context do they become useful, which is where ratios come in.

Is that a good profit?

A ratio compares the relationship between more than one number, giving them context. For example, the net profit margin is the percentage of your revenue (or sales) left after deducting all your business expenses. It is important because it shows how efficiently you turn your revenue into profit.

If your financial statements show a net profit of $80,000 and revenue of $400,000, your net profit margin is 20% (80,000 / 400,000 x 100%).

To put it another way, your net profit is your revenue multiplied by your net profit margin. The higher the margin the more of your revenue you keep:

Net Profit = Revenue x Net Profit Margin

($400,000 x 20% = $80,000).

Using ratios, we now have a measure that we can put into context.

Meaning comes from comparing

If your revenue had been $500K instead of $400K, but your net profit margin only 15% instead of 20%, you would have only made a profit of $75K ($500,000 x 15% = $75,000). So, focusing on growing fees without maintaining margin is no use. You can be working a lot harder for less money.

Industry comparisons

So, is our 20% net profit margin good? The best indicator is a comparison to other businesses in the same or a similar industry. If we are an independent consultant, comparing our $80,000 net profit with a top four consulting firm would be meaningless – and depressing – but comparing our net profit margin is useful.

Taking our 20% net profit margin, if others in our industry are achieving 13%, we are very efficient. Maybe we have lower overheads, or we are focused on high margin services while they cover a wider range.

Benchmarking figures are available from various sources for different industries and can be sliced and diced into regions, business sizes etc to get meaningful comparisons.

Internal comparisons

By comparing our ratio with previous years, we can see if we are getting better or worse.

By comparing our ratio with our budget, or target figures, we can see if we are heading towards our goals and budgets or not.

Good decisions are based on good management information and our ratios will reveal where we can concentrate our efforts to achieve the most dramatic impacts on our results.

Let’s look at another couple of examples.

Paying the bills

It is one thing to make a profit, but it’s no use until we collect it. Profitable, growing businesses still collapse when they can’t collect it quickly enough to pay their bills.

The current ratio is a measure of our ability to pay our bills. It compares our current assets (money we will collect in cash in the short-term) with our current liabilities (money we will have to pay out in the short-term).

Our current assets include money in the bank and debtors. Current liabilities include creditors, upcoming tax payments and other short-term financial obligations. The current ratio shows us how much we have in current assets to cover our current liabilities. I.e., how much money we have coming in to pay our bills.

Current Ratio = Current Assets / Current Liabilities

If our financial statements show current assets of $45,000 and current liabilities of $45,000, we have a current ratio of 1. Whether this is good or not depends on the industry we are in.

A supermarket can survive on a low current ratio as they have a plentiful supply of cash sales coming in each day. A consultant may need a much higher ratio. It takes time to deliver services, get them invoiced, then collect the money. While some businesses may be comfortable they can pay their bills with a current ratio under 1, a consultant may need a ratio over 2.

Getting new clients

Ratios can be used to measure all parts of our business, not just our financial results. To grow our client base, we need to convince people who are interested in our services to become clients. The rate of turning these leads into clients is our conversion rate.

Conversion Rate = No. of Sales / No. of Leads x 100%.

If ten people enquire about our services, and two of them become clients, we have a 20% conversion rate (2 / 10 x 100%).

If we are generating plenty of enquiries but few new clients, improving our conversion rate will have a big impact on our results. We may need to work on our sales pitch.

If our conversion rate is high, concentrating on generating more leads will bring us many more clients. We may need to increase our marketing efforts.

Using ratios effectively

The first step to improving business performance is getting meaningful information that shows us where our business is at now. Armed with this information, we can understand what needs to change for the biggest impact on our results.

There are unlimited potential measures but the fewer we focus on the more energy we can put into changing them. A good business dashboard may contain four different measures covering four different parts of the business.

As management accountants, we help you take your business beyond guesswork and focus your efforts where they will get the greatest return.

Contact us with your business questions.