Part 7 of our blog article series: "Strategies for business success"
While many small business owners prefer brainstorming new ideas to reviewing financial statements, achieving a solid grasp on financial analysis can be remarkably empowering.
Taking the time to regularly review financial reports can help you assess and improve current performance, avoid risk and make realistic plans for future growth.
Protect the financial health of your business by learning your way around these important financial reports:
1. The cash flow statement
The cash flow statement is arguably the most important report for small businesses. A business needs cash flow to pay its debts and finance obligations, make cash distributions to owners, and to supplement other sources of capital to grow the business.
It is worth highlighting that the actual cash flow of a business can be different to its profit shown in the profit and loss statement, due to asset sales or purchases, finance drawn down or repaid, and other capital revenue or expenses. The profit and loss statement can also include non-cash items such as depreciation and livestock adjustments.
Understanding and regularly reviewing your cash flow statement can help you avoid a cash shortfall by revealing precisely where you cash has been spent, and if you're at risk of running out of it!
Monthly examination of your cash flow statement can help you predict and forestall a "cash crunch" by tracking:
The in and out flow of money for operational activities; investments (such as the purchase of office equipment or the sale of portfolio holdings); and financing (such as loan repayments)
Whether your net operating cash flow is less than your profits after tax (which means you are spending more than you earn)
Trends that show cash running low in some months and high in others, allowing you to take steps to build a reserve and ensure continuous "cash on hand" in future
Using a cash flow forecast, based on expected cash coming in and cash expenditure going out, will allow you to predict when additional finance is required, or when additional funds are available. It is a useful monitoring tool and will highlight when your business is not going according to plan so that early remedial action can be taken.
2. The statement of profit and loss
Your profit and loss statement (also known as an income statement) summarises the revenue, cost of sales and expenses your business has incurred over a specific period of time.
Unlike the cash flow statement, the profit and loss statement does not report the cash inflows of sales and cash outflows of expenses. Therefore the bottom line of the profit and loss statement is not a cash flow number.
In order to give you an accurate overview of your financial performance, the profit and loss statement typically breaks down into four sections:
Your revenue (known as the "top line")
The cost of the goods or services you sell (known as cost of goods sold)
The total costs of doing business, such as operating expenses, administration expenses, and expenses associated with taxes and interest
Your net income (the often quoted "bottom line"), which is what remains when the costs of doing business are subtracted from your top line revenue
The profit and loss statement can be used to calculate a number of important key metrics. Two of the more important ones are gross profit margin and net profit margin.
The gross profit margin shows how efficiently you are managing your resources and where optimisation is needed so you can work towards a healthier bottom line. The equation looks like this:
Once you know your gross profit you can divide it by your total revenue to calculate your gross profit margin.
The net profit margin calculation goes a step further by determining how much revenue remains after subtracting all expenses, including COGS. Net profit reveals your precise profit per dollar of sales after deducting operating expenses, interest paid on debt, etc. In order to keep in touch with your financial status, it's wise to calculate net profit every month. Be aware that if you are reviewing your profit and loss statements throughout the year, the net profit margin will generally be before any income taxes on profit have been calculated.
3. The statement of changes in equity
The changes (or movements) in equity statement shows the change in your business's net worth over the financial year, and identifies the factors that resulted in the change in equity, such as:
- dividend payments - dividends paid must be deducted from the shareholder equity as they represent distribution of wealth to shareholders
- share capital - the value of further share capital issued or redeemed
- reserves - gains and losses arising from the sale or revaluation of assets or investments
- non-taxable herd adjustment - relates to movements in livestock values of qualifying livestock which are revalued each year based on Inland Revenue determinations
4. The balance sheet
The fourth invaluable financial report for small businesses is the balance sheet. The balance sheet summarises what your business owns (assets), what you owe (liabilities) and the current value of your business to investors (owners' equity).
The balance sheet shows the relationship of the business assets on the one side, to its liabilities and equity on the other side. You have probably heard at some time the traditional accounting equation: "Assets equal Liabilities plus Owners Equity".
You might also have heard the term solvency, which relates directly to the balance sheet of a business. Solvency is the ability of a business to cover its liabilities with the assets it owns.
Your assets may include cash in the bank, short-term investments, accounts receivable, inventory, equipment and property.
Your liabilities may include a bank line of credit, accounts payable, wages payable, rent, tax, and utilities.
A business can build up a good sales volume and have a good net profit margin, but if the business can't pay its bills on time, opportunities for growth could be lost and, at worst, the business could fail.
There are two key ratios that measure solvency:
The current ratio is the total current assets divided by the total current liabilities. The current assets include cash, accounts receivable, inventory, and prepaid expenses.
In order to be solvent and cover liabilities, a general rule is that a business should have a current ratio of 2 to 1, meaning that it has twice as many current assets as current liabilities, however in saying that it does depend on the type of industry your business operates in.
The quick ratio uses only cash and accounts receivable, as these assets are the only ones that can be used to pay off debts quickly. The quick ratio is a 1 to 1 ratio, meaning cash and accounts receivable must equal the amount of debt. This is a more difficult ratio to achieve.
These ratios are just as important to lenders as they are to business owners. Banks will look closely at these ratios to determine if the business has sufficient assets to service the additional debt.
Together with the cash flow, profit and loss and changes in equity statements, the balance sheet provides crucial insight into your company's operations and overall performance.
If you still feel unsure, who better than your accountant to help walk you through each report? Clarify any concerns and ask all your questions when you meet with them to review and finalise your financials, so you will feel comfortable analysing them independently. It's well worth the effort! When you understand your key financial data, you pave the way to smarter decision-making and more sustainable growth for your business.
As always, we are only a phone call or e-mail away if you wish to discuss your financial reports with us in greater detail.
Keep on eye on our blog this month as we present a series of articles on
strategies for business success
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