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:
- Your past figures – are you getting better or worse?
- Other businesses – how do you compare to other similar businesses?
- 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.