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.
This mini-series looks at the key sections of your financial statements, explains what they’re for and provides some simple methods of analysis to help you understand your actual position and highlight possible growth opportunities.
Profit and Loss Statement:
Your profit and loss report (often called an Income Statement), 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.
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.
- 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:
- 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.
- 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.
- 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.
- 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 it down
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 blogs 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.
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.
So the next time it’s reporting time, 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.
Lauren Steinheueur: L.Steinheuer@uhyhnseq.com.au
Dean Vane: D.Vane@uhyhnseq.com.au
Bill Charlton: B.Charlton@uhyhnseq.com.au