Why is this important

There is a wealth of information in your financial statements but many business people don’t know how to read them, let alone understand them.  Financial statements provide you with much of the key information you need to run your business and make informed decisions.
They are a critical component in your set of tools to run your business as they show how the business has performed in the past and can be used to plan the way forward to the future.
This document will highlight the key things to look for and how to better understand your financial statements. It will first of all explain the key items in the financial statements then explain how to interpret and understand the numbers.

What to do

Financial Statements essentially contain two key reports, the Profit and Loss Statement and the Balance Sheet. As most people are fairly familiar with the Profit and Loss Statement we will start with that one.

Profit and Loss Statement

Most people are fairly familiar with the Profit and Loss Statement. It seems to make sense, and we tend to understand it more intuitively. We understand what income is, and we know that expenses represent money we have spent. We will now go through it step by step.

Sales

This shows the sales made by the business during the year. Most business people have a good understanding of their sales as they often check this figure on a regular basis. Many business owners check their sales on a daily or weekly basis. You should check your sales at least monthly as a minimum.

Cost of Goods Sold

This shows the cost of the goods or services you have sold. It is made up of a number of components:
Opening Stock: this is the value of the stock you have on hand at the beginning of the year.
Purchases: this is the amount you paid for goods for sale during the year
Closing Stock: this is the value of the stock you have on hand at the end of the year.

Gross Profit

Sales less Cost of Goods Sold leaves you with Gross Profit. This is what’s left to run the business after paying your suppliers for the goods you have sold.

Expenses

Most expense items are self explanatory, they represent the costs incurred for that particular expense item. However, we will highlight a number of unusual items you may come across:

Depreciation: This is the amount which is written off the value of the assets each year. Assets are shown in the Balance Sheet, and their value reduces over time. The amount of this reduction is called Depreciation, and is shown each year in the P & L statement.
Amortisation: This is similar to depreciation and relates mostly to intangible assets, such as goodwill, licences, patents and trademarks.

Net Profit

This is what’s left over after paying all business expenses. It’s the amount which is available for the owners.

The objective for most businesses is to operate at a profit. This allows the owners to make a return on their investment. Depending on how the business is performing, the owners may decide to re-invest the money back in the business, they may pay off some debts, or they make pay themselves a bonus or dividends.

If expenses exceed income, there will be a loss. Losses are usually shown in brackets e.g. $(8,416.34). Losses are not sustainable and sooner or later, the owners need to make decisions on how to eliminate, or reduce the losses.

A loss represents a reduction in the Owners’ Equity in the business and needs to be funded. As there were more expenses than income, the expenses still need to be paid. This means the owners will need to either contribute their own funds into the business, or borrow money to pay the expenses.

Balance Sheet

While many business people understand their Profit & Loss statement fairly well it is the Balance Sheet that makes their eyes glaze over!

For most people, the balance sheet is a mysterious page full of strange numbers which seem to have little relevance to the day to day running of their business.

But here’s the rub: when you apply to the bank for a loan, the first thing the bank looks at is the Balance Sheet! Then they look at the Profit and Loss to see if the business can afford the loan. This shows just how important the Balance Sheet is, so we better take some time to understand it.

The balance sheet can be summarised in a simple equation:
Assets – Liabilities = Owners Equity

Put in more simple language: 

'What I Own' less 'What I Owe' = 'What’s mine'

Let’s look at each of the components of the Balance Sheet.

Assets

Assets are those things the business owns. They are usually classified as Current Assets and Non Current Assets.

Current Assets

Current Assets are those assets which are expected to be converted into Cash within 12 months. These typically include Stock, Accounts Receivable, Prepayments and Cash.

Non Current Assets

Non Current Assets typically include Machinery, Plant and Equipment, Motor Vehicles, and Furniture and Fittings. They will usually be grouped together and shown under their respective headings.
As mentioned above, non-current assets get depreciated each year. The value of the depreciation charged over the years is shown in the account called Accumulated Depreciation.

Non Current Assets can also include some unusual items such as Intangibles. Intangibles are those items without form or substance. They include Goodwill, Patents, Licences, Brand names.

Liabilities

Liabilities are the financial commitments the business has to third parties. They are also classified into Current Liabilities and Non Current Liabilities.

Current Liabilities
Current Liabilities are those financial commitments which the business expects to pay within the next 12 months. Typically, these include Bank Overdraft, Trade Creditors, Lease payments and Hire Purchase payments due in the next 12 months. They also include the Tax Office, other regulatory expenses and employee entitlements.

Non Current Liabilities
Non Current Liabilities are all other financial commitments which are to be paid after 12 months. These include Bank Loans, Leases and Hire Purchase agreements, and longer term employee entitlements.

It is important there are more Assets than Liabilities in the business. Simply put, the business must Own more than it Owes.

It is also important that Current Assets are greater than Current Liabilities. This means the business has more assets which will convert to cash than liabilities it will have to pay in the next twelve months.

How to understand the figures

Now we have described the main figures and categories on your financial statements, we will now give some guidance on how to understand and interpret this information.
We will first look at key Balance Sheet items.

Balance Sheet

The Current Ratio

The current ratio is one of the most important financial indicators for a business. It is a key measure of liquidity. It indicates how well positioned the business is to meet its short term financial obligations.

The current ratio compares Current Assets to Current Liabilities.

The formula is: Current Assets / Current Liabilities

The target position for the Current Ratio is 2.00, which means for every dollar of current liability, we have $2.00 of current assets to pay for it. This is the target level the business should aim for.

The Quick Ratio

The quick ratio takes liquidity one step further. It is often referred to as the ‘acid ratio’ and is a measure of short term liquidity. It compares Cash and Accounts Receivable with Current Liabilities. It shows how quickly the business can up with cash to meet its short term financial obligations.

The formula is: (Cash Accounts Receivable) / Current Liabilities

Debt to Equity

This is a measure of risk. It compares the level of total debt of the business with the funds retained in the business by its owners.

The formula is: Total Debt / Owner’s Equity

The target position for this ratio is around 4:1. What this means is that for every four dollars of debt the business has, the owner have one dollar of equity retained in the business.

Profitability

Sales

Sales are one of the key indicators for any business. It is important to compare sales for each year against the prior year to track growth.

Gross Margin

Gross Margin is an important indicator as it shows what is left to run the business after paying for the goods which have been sold. It takes the Gross Profit figure and divides it by that sales figure.

The formula is: Gross Profit /Sales = Gross Margin %

This shows that for every $1 of sales made you have $X dollars left to run your business. This is an extremely important figure and needs to be watched carefully.
It should be tracked on a monthly basis and compared against prior years. It should also be compared against budget and comparative benchmarks where available.

Net Margin

Net Margin is another important indicator. It shows what is left for shareholders after paying all business expenses.

The formula is: Net Profit /Sales = Net Margin %

This shows that for every $1 of sales made the business has $X dollars left for the owners. They can then decide how to use this money, to either re-invest in the business, or repay debt, or take as a dividend or bonus.

Asset Management

Asset Management is an area where we measure how efficiently the assets of the business are being utilised.

Sales to Assets

This indicator shows what level of sales were generated for every dollar invested in assets. It is a measure how efficiently the business utilised its assets.

The formula is: Sales /Total Assets = Sales to Assets $

It answers the question, for every dollar we invested in assets, how much did it return in sales?

Inventory Days

This is an important indicator because it measures on average how long stock has been sitting on the shelf. This is important, because the quicker we can turn it over, the quicker it converts into cash.

There are two steps involved in this calculation:

Step 1: Calculate Inventory Turnover:

The formula is:      Cost of Goods Sold / Inventory = Inventory Turnover

This measures how many times inventory ‘turns over’ during the year. Use this figure in the next calculation.

Step 2: Calculate Inventory Days

The formula is:      360 / Inventory Turnover = Inventory Days

This tells you how many days your money is tied up in stock. To the extent you can reduce this number, the faster your inventory will be converted into cash.

Debtor Days

This is an important indicator because it measures on average how long it takes debtors to pay their accounts. Clearly the quicker you get paid the quicker you can fund more stock and run through the cycle again!

There are two steps involved in this calculation:

Step 1: Calculate Accounts Receivable Turnover:
The formula is:      Sales / Accounts Receivable = Accounts Receivable Turnover

This measures how many times Accounts Receivable ‘turn over’ during the year. Use this figure in the next calculation.

Step 2: Calculate Debtor Days

The formula is:      360 / Accounts Receivable Turnover = Debtor Days

This tells you how many days your money is tied up in Debtors (Accounts Receivable). The faster you can reduce this number, the faster you will have the cash.

Average Payment Period

This indicator shows how long the business takes to pay its suppliers on average. If we pay our bills in a reasonable time, it tends to help the relationship with suppliers. It usually also highlights where we may be able to gain early payment discounts. These should always be taken where possible.

There are two steps involved in this calculation:

Step 1: Calculate Accounts Payable Turnover:

The formula is: Cost of Goods Sold / Accounts Payable = Accounts Payable Turnover

This measures how many times Accounts Payable ‘turn over’ during the year. Use this figure in the next calculation.

Step 2: Calculate Accounts Payable Days

The formula is:      360 / Accounts Payable Turnover = Creditor Days, or Average Payment Period

This tells you how many days the business takes to pay its bills. To the extent you can pay your bills faster, the more likely you are to be able to negotiate better payment terms, or early payments discounts.

Dividend Payments

Dividends are an important indicator of how much the owners draw from the business. The timing of when dividends should be taken is very much dependant on the cash requirements of the business. In times of high growth, it is best to leave cash in the business for funding purposes.

Other key indicators to review

There are also other useful indicators to also measure. These include:

Revenue / Full Time Equivalent
Product Costs
Units produced/ Wages
Average Per Unit Cost
Average months fixed running costs
Cost to run business every day
Unfortunately we don’t have space to discuss each of these in greater detail, but we recommend you discuss their applicability to your business with your accountant.

As can be seen, there are a wide range of tools to use to better understand your financial statements. We will now use the above measures in a real life example to show how they are applied. (Please note the name of the business has been changed).

See how it’s done

ABC Co. has been trading as retailer for a number of years. An analysis of its figures reveals the following details:

Current Ratio

The Current Ratio is one of the most important financial indicators for a business. It is a key measure of liquidity. It indicates how well positioned the business is to meet its short term financial obligations.
The Current Ratios for ABC Co. over the period are:

30 June 2006	30 June 2007	30 June 2008	30 June 2009
0.90	1.04	0.89	1.57

The Current Ratio compares Current Assets to Current Liabilities. Essentially it says this:

At 30 June 2009, for every dollar of current liability, we had $1.57 of Current Assets to pay for it
At 30 June 2008, for every dollar of current liability, we had 89 cents of Current Assets to pay for it
At 30 June 2007, for every dollar of current liability, we had 1. 04 cents of Current Assets to pay for it, etc

This means that liquidity for the business has been getting tighter over the last couple of years, but has bounced back quite dramatically over the last 12 months.

The position at 30 June 2008 highlights how tough 2008 was for the business, and it is clear the owners of the business took steps to address the situation.

The target position for the Current Ratio is 2.00, which means for every dollar of current liability, there is $2.00 to pay for it. This is the target level to aim for.

The Quick Ratio

The Quick Ratio takes liquidity one step further. It is often referred to as the ‘acid ratio’ and is more a measure of short term liquidity. It measures Cash and Accounts Receivable against Current Liabilities. It shows how quickly the business can come up with cash to meet its short term financial obligations.

The Quick Ratios for ABC Co.  over the period are:

30 June 2006	30 June 2007	30 June 2008	30 June 2009
0.64	0.75	0.61	1.13

The quick ratio compares Cash and Accounts Receivable to Current Liabilities. Essentially it says this:

At 30 June 2009, for every dollar of current liability, we had $1.13 of Cash and Debtors to pay for it
At 30 June 2008, for every dollar of current liability, we had 61 cents of Cash and Debtors to pay for it
At 30 June 2007, for every dollar of current liability, we had 75 cents of Cash and Debtors to pay for it, etc

Again, this shows that liquidity has been tightening up over the last few years, but has bounced back over the last 12 months.

In relation to on these two ratios it appears that the business has turned the corner in regard to liquidity. The business would have been under cash stress throughout 2008 but it appears that steps were taken to address this.

Liquidity management is an ongoing issue for all businesses and is certainly no exception here. This needs to be a constant agenda item for management meetings and continue to be a key focus of the accounts team.

Profitability

Sales

Sales are one of the key indicators for any business. It is important to compare sales for each year against the prior year to track growth.

The sales turnover for ABC Co. over the period is:

30 June 2006	30 June 2007	30 June 2008	30 June 2009
$3,626,776	$3,857,723	$4,201,537	$4,078,500

Growth on prior year:

30 June 2006	30 June 2007	30 June 2008	30 June 2009
	6.4% growth	8.9% growth	3% drop

The key points to be gained from the above tables show that the business has been tracking along in the high $3 Mill range and broke through the $4 Mill in 2008.
This indicates the business has a strong trading history and obvious goodwill. A review of the client list also indicates a good number of strong businesses which need to be maintained. The business should consider specific strategies to develop these client relationships.

Gross Margin

Gross Margin is an important indicator as it shows what is left to run the business after paying for the goods which have been sold.

The Gross Margins for ABC Co. over the period are:

30 June 2006	30 June 2007	30 June 2008	30 June 2009
37%	37%	40%	36%

These gross margins are fairly healthy, and fit within the target range. 
Clearly, 2008 jumps out. This is the year where ABC Co. appointed a general manager, who subsequently did not work out. However, it does indicate that in that year, the business achieved higher gross margin than the two previous years, and the period since.

This shows that it is possible to achieve the 40% margin in the ABC Co. market. We need to continue focusing on this to lift it back up to this level.

Net Margin

Net Margin is another important indicator. It shows what is left for shareholders after paying all business expenses. The table shows the actual net profit figure in real terms, and also as a percentage in Net Margin terms.

The Net Profit and Net Margins for ABC Co. over the period are:

30 June 2006	30 June 2007	30 June 2008	30 June 2009
$247,123	$210,360	$141,710	$187,768
7%	5%	3%	7%

These are not particularly strong margins and were clearly headed in the wrong direction. The result in 2008 is particularly disturbing given that was the year of highest sales and highest gross margin. It indicates that expenses blew out and as we now know, the owners took significant action and sacked the general manager.

This appears to have had an immediate impact with net margin back to the 7% level.

However, this represents only an average return. It has provided a fair return for the owners but I would expect this can be increased. It indicates that expenses have not been vigorously reviewed, and possibly that wages are too high.

Asset Management

Asset Management is an area where we measure how efficiently the assets of the business are being utilised. The key area to check is against sales.

Sales to Assets

The Sales to Assets Ratio for ABC Co. over the period are:

30 June 2006	30 June 2007	30 June 2008	30 June 2009
3.25	3.04	3.58	2.93

This ratio is easier to understand when we put it into a sentence, as we did before.

Essentially it says this:

At 30 June 2009, for every dollar of asset, we generated $2.93 of sales.
At 30 June 2008, for every dollar of asset, we generated $3.58 of sales.
At 30 June 2007, for every dollar of asset, we generated $3.04 of sales.
At 30 June 2006, for every dollar of asset, we generated $3.25 of sales.

In other words, for every dollar we invested in assets, how much did it return in sales?

Even though there is some variation it certainly looks like the business can achieve over $3.00 in sales for every dollar it invest in assets. This is quite a good result.

Inventory Days

This is an important indicator because it indicates on average how long stock has been sitting on the shelf. This is important, because the quicker we can get it off the shelf, the quicker it converts into cash!

The average Inventory Days for ABC Co. over the period are:

30 June 2006	30 June 2007	30 June 2008	30 June 2009
30 days	37 days	35 days	57 days

These figures indicate a real spike for the June 2009 position. This seems unusual and may relate to the tidy up of the stock that ABC Co. is undertaking as part of getting their business in shape. It will be a concern if it stays at this level.

Debtor Days

This is an important indicator because it indicates on average how long it takes debtors to pay their accounts. Clearly the quicker the business gets paid the quicker it can fund more stock and run through the cycle again!

The average Debtor Days for ABC Co. over the period are:

30 June 2006	30 June 2007	30 June 2008	30 June 2009
42 days	42 days	43 days	46 days

These are good figures, and represent two key points. First, it indicates the business has good debtor management procedures in place. Second, it indicates good client selection and education. It is clear the business deals with good clients, who pay their bills reliably.

Average Payment Period

This indicator shows on average how long the business takes to pay its suppliers. If we pay our bills in a reasonable time, it tends to help the relationship with suppliers. It usually also highlights where we may be able to gain early payment discounts. These should always be taken where possible.

The Average Payment Periods for ABC Co. over the period are set out below:

30 June 2006	30 June 2007	30 June 2008	30 June 2009
60 days	70 days	75.5 days	104 days

There is nothing particularly good here. These are long payment days. It also indicates the business is not taking advantage of early purchase discounts. This ties in with previous indicators which showed that liquidity was an issue. This clearly shows that as liquidity was getting tighter, there was less working capital to pay the bills, hence the business took longer to pay.

This is an area which must be addressed.

Dividend Payments

Dividends are an important indicator of how much the owners draw from the business. This timing of when dividends should be taken is very much dependant on the cash requirements of the business. In times of high growth, it is best to leave cash in the business for funding purposes.

The dividends paid to shareholders of ABC Co. over the period are set out below:

30 June 2006	30 June 2007	30 June 2008	30 June 2009
$198,000	$105,000	$108,000	$100,000

These are quite healthy dividends, and represent good returns to the shareholders.
However, these dividends have also been paid during the period in which the liquidity of the business was getting tighter, and the payment terms to suppliers were getting longer.

It appears that the desire for the owners to access the cash from the business was given higher priority than helping the business pay its debts on time and fund its growth. This is an area which should be reviewed, as the strength of the business is of paramount importance. If the business is not in strong shape, there will be no dividends to access at all!

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