What do Accountants and Business Experts look for in Financial Statements to Grow Businesses?

Contrary to common perception among newbies at business, financial statements are not just a formality to appease the regulators and keep accountants in business. Your financial statements contain valuable information that should form the foundation of your strategic planning and ongoing management of your business. The fact that you’re required to produce one for reporting (and usually pay someone to do create one) means you may as well be milking it for every ounce of value you can extract from it. The good news is your financial statements are a powerful tool that can pay for itself multiple times over if wielded correctly.

Understanding the movement of cash within your business is a must as anyone who has faced insolvency can tell you! Cashflow is the pulse of your business, so it’s no wonder your cashflow statement serves as a medical exam of common ailments that plague SMBs.

But first things first – what is a financial statement? Investopedia gives a basic definition as “written records that convey the business activities and the financial performance of a company”.

What Accountants and Business Experts look for in your Profit and Loss Statement

One of your key financial statements is the profit and loss statement (often called an Income Statement), which is a summary of your revenue, expenses and net profit over a given period of time usually monthly, quarterly, or annually). The profit and loss report will indicate to business owners which aspects of the business are excelling and which aspects need improvement.

What’s in it the profit and loss statement and how can it help you?

• Revenue streams. This lists all your sources of income for the period of reporting. Ideally, it not only details your revenue, but breaks down your individual revenue streams (product lines, services offerings) so you can identify what are the major contributors to your gross revenue.

• Expenses. Cost of goods sold, such as wholesale price (if you’ve purchased the product for resale), labour costs or material supplies/resources you use to manufacture the product. Additionally, this shows you your operating expenses such as indirect costs transportation, marketing, advertising, styling, rent, utilities.

 

Ratios

Distinguish profit from turnover

• Gross profit = revenue – cost of goods sold — Essentially it’s the difference between your takings and what it cost you to make/stock the product (or provide the service).
• Gross profit margin = (gross profit ÷ revenue) x 100  — This figure tells you how much profit you keep for every dollar of revenue you make. This is another way of evaluating your efficiency and growth. Click here for more information.
• Operating profit = gross profit – operating expenses — Profit generated from core operations. It does not include expenses from interest or taxes (often called ‘earnings before interest and tax’ or EBIT).
• Net profit = operating profit – (taxes + interest) — also known as the ‘bottom line’,  net profit is the total amount earned (or lost) after paying all expenses.

 

Key uses for your gross profit ratio and gross profit margin ratio:

1. To provide you with an overall indicator of production efficiency. 

It sounds so elementary, but efficiency is easily overlooked by many business people who operate their own business. It is easy to misjudge your success when business is  busy and overlook wastes within your business. It’s a good idea to apply this evaluation separately to each product line, so you can actually identify unnecessary wastes or inefficiencies. Are you paying above market for certain supplies? Your gross profit and operational profit ratios could indicate that your operational costs are very high, and prompt further review of your methods of manufacturing or service delivery to weed out inefficiencies.

 

2. Review of your gross profit prompts an evaluation of your pricing and sales targets. 

You may feel you’re limited by what your customers are willing to pay, but it may be time to re-evaluate the tier of market you’re aiming for. Consider:

Who is your market audience and am I selling to the right people?

For example you may be positioned to sell luxury products to a niche ordinance who can afford your high prices, but only make a small number of sales in that niche. If you have a low gross profit margin, you may want to increase the units you sell by rebranding or developing budget versions of your product lines that appeal to a wider audience and attract higher sales volumes. It seems so elementary, but it’s surprisingly hard to see these opportunities when you work in your own business and don’t take the time to frequently review your financials.

 

3. Year on year growth/regression on Gross Profit

Has your gross profit grown or contracted? If so, understand why. Consider what the variables that affect your profit are. Have your supply costs increased? Have your customer relationships carried over into this year or have you lost crucial accounts, and why? These questions force you to become very granular in your analysis of your accounts. You’re likely to generate a long list of things that work and didn’t work such as losing a customer to a competitor or sales dipping due to bad weather. The goal here is to avoid creating a long list of separate problems, but identify overall trends. Some of these trends are ones you can directly control (such as improving your client relations) and others you can’t (increased unemployment rates in your city). But what you can do is factor them in to your planning by working on the weaknesses you can directly control and protecting your position against the threats you can’t.

 

4. Year on year growth/regression on Net Profit

Maybe your tax bill this year took the wind out of the sails of your operating profit. It could be because you moved into a new sector, changes in policy or entering a new tax bracket. Whatever the reason,  it is wise to carefully approach tax planning to ensure you only pay as much as you have to and maintain a healthy cash flow that your business needs to grow.

 

Breaking down Business Improvement and Accounting opportunities in your Statement of Cashflows

You’ve only looked at the first section of your financial report, and you’ve already gained not only a snapshot of where your business is and how it compares with the previous year, but a variety of insights to influence your strategic planning and operational management… not bad. Even with a brief analytical review of your financials can highlight areas to improve. Applying a general principle like the 80/20 rule to these alone (focus on 20% of the most important problems will create an 80% improvement) could bring strategy that gives your business what it needs to succeed over the coming year.

In the coming sections we will investigate what strategic gold we can divulge from your Assets and Liabilities, Statement of Cash Flows and forecasting components to help you maximise the value of your financial statements.

Cashflow trouble comes in many forms. Increasing the sales of your product or service is not the only key to ensuring your business thrives. As we’ve discussed, perhaps there is wiggle room in your inventory management to create a budget for paying down debt or expansion. Or perhaps you’re tired of taking a personal hit to your wage by unpaid accounts receivable (or you’ve got supplies on your back with overdue notices). Our experts are here to help you not only climb out of the hole, but set in place better systems to ensure you don’t end up in the same cashflow woes again. Of course cashflow statements are not the only insightful resource in your financial statements to understand the long-term health of your business that is reflected in asset management and profitability of your business.

That’s why in this next section we explore some crucial insights within your balance sheet that are frequently missed:

The reality is most business owners don’t have weeks up their sleeve to dedicate to review of their financials and planning. As seasoned accountants, we’re able to rapidly identify the ‘tells’ of the health within the financials of a business and advise proven solutions that are the right fit for your industry and business. As business specialists, financial statements are a cornerstone resource to analyse and optimise businesses, and often the information within can be undercapitalized by SMEs.

This next section unpacks some of the key indicators a financial consultant or investor will look for in your statement of cashflow that will allow you to better plan ahead, grow and protect your business.

 

Why Do We Bother With Cashflow Statements?

I hear you say “Incomings and outgoings are essentially the same as profit and loss in a SMB – right? What are the actual benefits of time spent monitoring cash accounts?”

First off, it’s important to understand that the cashflow statement is just part of the depiction of your company’s position contained within your financial statements. It matters because it contains specific insights that other statements do not. Determining how to identify a healthy cashflow isn’t just about staying solvent and meeting your obligations, but identifying a healthy balance of stability, growth and liquidity for contingencies. Actual percentages will look very different from one industry to another, but the principles remain the same. Cashflow management is about planning as well as monitoring.

The profit loss statement shows the overall revenue and profit. However, these figures are often reflective of sales and not necessarily payments. Depending on the method of payment and management of accounts receivable, a sale isn’t actually visible on the cashflow statement until the payment is received which can significantly lag the sale date (provided you ever actually get paid by the client). Working capital is essentially the margin between your accounts receivable (to be clear – money that has actually cleared in your account that you can spend) and your accounts payable. Thus your profit loss statement is useful for understanding company sales whereas your cashflow statement reflects your actual capacity to pay debts owed and invest.

Definition: Capex:
Capital expenditure often referred to as capex, is another primary health indicator for your company. As discussed above, it is the margin of cash available to cover costs (maintenance capex) and reinvest (expansionary capex).

 

Credit Control: Solving Invoice Delays 

One indicator to observe on your cashflow statement is how well your current business processes can recover outstanding invoices. How close to the line does your business run each month? How much is left over each month once you’ve paid your bills? This is very analogous to your personal finances, with the exception of the severity of legal consequences for insolvent trading for businesses. Ideally, as a business owner you want to pay yourself and have enough cash left over to grow your business. If your cashflow statement is showing you are barely doing this, even when your profit loss statement looks good, it’s a good sign your payment recovery systems may need improvement such as narrower due dates on invoices, more controls on extending lines of credit to clients and stronger follow-up systems for overdue accounts.

You can monitor this with a metric that compares overdue accounts payable to sales. It’s a simple formula defined as overdue accounts divided by total sales multiplied by 100 to give a percentage value.

This becomes easier if you ensure due dates fall within the month by sending out billing at the start of the month.  This way by the time the month is up, all due dates have passed and it’s easy to calculate. Alternately your accounting software will be able to perform this analysis if your accounts receivable due dates are dispersed throughout the month. Be sure to chat with your bookkeeper or account if you need help setting this up.

 

Inventory Management of your Business

Many SMBs have much of their working capital tied up in inventory, especially if you are in retail or manufacturing. The past few years have presented numerous disruptions to supply and demand levels, so this is a big area to watch for many businesses right now. As lockdowns have affected supply lines and either drastically increased or decreased demand on goods, it’s challenging to know how much to restock.

On the one hand if your supply network is slow or at risk of getting cut off in a quarantine scenario, you may consider purchasing additional stock now while you can get it. On the other hand, this may eat up your working capital and leave you exposed in consecutive months by low sales or even a lockdown scenario. Scenario planning for the worst-case scenario will give you greater confidence in how you manage your capex by taking some of the mystery out of what investment and reserve cash margins would protect your company in a downturn.

 

The Balance Sheet – What do Accountants and Business Analysts look for?

A business that is early in its life-cycle is likely to grow fast and will require capex to grow. In this scenario, you’re likely to see low or even negative cash flow, as it’s being reinvested into the business for purchases of assets, wages and inventory etc. This is likely a good thing. The signs of health an investor may look for is growth in the net volume of cash in and cash out indicate if the business is expanding its customer base and/or turnover. However this negative cashflow can only be sustained for so long, and sooner or later the invested capex must begin to return a positive cashflow in future quarters.

A more mature business will likely have an established customer base and steady cashflow rates should be expected (accounting for seasonal/market changes if necessary). If a company is selling off assets to top-up cashflow holes – that is a sure sign the company is contracting and it is a good time to re-evaluate the business plan. If there is cash accumulating month-on-month, perhaps there are opportunities to reinvest or upgrade assets.

Key Balance Sheet Metrics to Watch:

Net Operating Cash/Sales

The net operating cashflow figure that appears in your cashflow statement is where you start. It can be useful to (divide) this by the net sales to better understand how much cash is generated for every dollar in sales. There is no ideal general figure, but the higher this ratio the better.

Inflow/Expenditure Ratio

This metric used for understanding how close a company is to running out of cash before the end of the month. Each industry is different, so benchmarking is prudent when evaluating what ratio is suitable for your business. In general, the lower this ratio sits to 1:1, the more exposed a company is to a downturn in the market.

Free cashflow

Often defined as the net operating cash minus capital expenditure, the free cashflow metric is essentially cash that a company is free to do whatever it wants with. This figure can be of interest to investors as free cashflow is often used to pay dividends. As an owner of an SMB, you might not have any other shareholders other than yourself (yes – wouldn’t a cash surplus be nice for once?).

TIP: Make sure you look back in time further to see the trend over time in case you see seasonal trends or recognise the same trends in comparative markets. Such trends are useful to factor into your cashflow planning.

Chat to your accountant about reporting on these metrics to help guide your strategic planning. Regular review of such metrics is key to ensuring you’re tracking toward your short and long-term goals.

For many business owners growing equity in the business is a big part of their long-term goals. All the hard work you put into your business ultimately has to have a reward, beyond just providing you income – otherwise you’re effectively the same as an employee. Taking a wage from your business is fine for the short term, but the additional burden of owning a business deserves a payday – whether your goal is to sell or pass the equity in your company onto your children as an inheritance.

Understanding what your equity is from the information in your Balance Sheet is pretty straight forward: Your equity in your business is simply the sum of your assets minus your liabilities.

Equity = Assets – Liabilities 

At a glance, your assets include your Current Assets (Things you keep for less than 12 months such as stock, outstanding accounts receivable, and short-term investments) and the Fixed Assets (plant equipment, vehicles, real estate, etc). Your short-term liabilities include accounts owed, overdraft accounts, or purchases on credit. Your Short-Term and Long-Term Liabilities will also be listed.

However – its just a snapshot at one point in time. These values are always in a state of flux, such as payment delays, upcoming expenses or a myriad of other events. That’s why to really grasp the true value of a business and gauge equity, you need to look at how multiple snapshots tell a story over time. Perhaps that story may be the company is struggling to pay

So how can you use a balance sheet it improve your business?

1. Optimize your accounts receivables.

   Are your sent invoices being paid on time, and could you shorten the payment period to improve your cash on hand? or are clients paying too slow for you to cover costs? Then you may consider the implications of extending this period. Be sure to read our  Credit Control resources for more on improving this.

2. Optimize asset performance.

   Are your assets generating income? Low-performing assets could be sold or leased to free up capital to reinvest in assets that generate higher returns. Consider if outsourcing the function of your asset is more beneficial.

3. Limit bloated inventory.

   Generally, reducing unused or stock that sits for long periods before the time of sale will hurt your balance sheet. Reducing the time-on-shelf will inject more cash flow into the business.

4. Improve your staff planning.

   Staffing costs likely contribute to a large portion of your liabilities. Maximizing hidden skills and talent is a key feature in optimizing your workforce (and your balance sheet).  Careful management of when to hire is as important is who to hire. Our staff planning specialists are always more than happy to help you plan your hiring.

Improving your balance sheet for valuation

If you wish to improve your equity from a valuation perspective, one area that the casual observer may overlook is how your intangible assets contribute to your equity. Your intangible assets include

• intellectual-property — knowledge, information or processes that set your business apart from others
• trademarks and patents — formally registered concepts that bring value to your business
• goodwill — the amount you pay for the reputation and performance of a business if you buy one, sometimes called ‘business value’.

It may surprise you the value of your intellectual property within your business. Taking the time to well document internal processes, systems and knowledge bases not only indicates what sets you apart, it also may cast light on where there are gaps or wastes within your systems. It may also highlight there are outmoded systems that could be improved or even reimagined. Taking an innovative approach to these areas could provide a competitive advantage and increase the performance of your business.

Accurately gauging how much your intangible assets and actual business value is a multifaceted process in which you will benefit from engaging a Valuations specialist. That said, all of your financial statements can deepen your understanding of the equity in your SMB and certainly will help you understand the fundamentals.

So the next time your receive your financial statements, remember – it’s a golden opportunity for planning and development. Yes – we can help prepare financial statements for you, but we’re also here to help you grow! Our specialists come with a wealth of business advisory knowledge – Dean Vane and Lauren Stienheuer are our business specialist partners, and Bill Charlton is our senior business advisor. Don’t hesitate to get in touch – we’re here to help.