Financial statements are important to a small business owner like you because they can help you to both uncover problems and identify corrective action. The most important financial statements are the balance sheet, the profit and loss statement, and the cash-flow statement.
Understanding these statements is crucial, since they all tell you what’s happened in the past. But more important from a management perspective is what’s going to happen in the future..
Statements
It is recommended that you (or your accountant) prepare your financial statements as frequently as possible, with monthly statements usually being the most useful. If your accounting system allows you to generate your financial statements internally, it is better you generate your statements monthly. If monthly statements are impossible for some reason, quarterly statements will do, but don’t fall into the trap that many small businesses do by generating your statements only once or twice a year.
The following sections discuss the profit and loss statement and the balance sheet.
The Profit and loss statement
The profit and loss statement (P&L) add all the revenues of your business and subtracts all the operating expenses, thereby providing you with a figure that represents what’s left over: the profits. (If the total expenses exceed the total revenues, your business would have a loss rather than a profit.) The P&L measures the results of operations of your business over a given period of time - typically a month, a quarter, or a year.
Choosing a P&L format
When you sit down with your accountant to design your financial statement format, always remember the cardinal rule of business numbers: Any given number is meaningful only when compared to another number. In this page, we offer a sample P&L to help you understand how to construct one and how to effectively use it in managing your business.
Our sample is a 4-column format, this year’s figures and percentages and last year’s figures and percentages. You can use a wide variety of formats in presenting a P&L.
Deciphering P&L information
Deciphering important information from a P&L is easy: you can do it yourself or let your accountant help you. In the figure, detailed explanatory notes are indicated about the increases or decreases of income and expense.
Once you do that, you can easily determine what your business has done and where it currently needs to improve. For example, as a result of comparing the columns, the P&L allows you to quickly answer the three questions that define any business’s profitability:
Have you controlled your costs?
Have you maintained or improved your gross margin?
Have you maintained or increased sales?
Although the answers to these three questions provide significant help in managing your business, the answers aren’t the only information the P&L provides.
The balance sheet
The Balance Sheet provides a snapshot of a company’s financial position at any given point in time. As with the P&L, the concept behind a balance sheet isn’t complex. Quite simply, the balance sheet is a list of what your business owns (assets) minus what your business owes (liabilities), with the resulting difference being what your business is worth (net worth). This net worth figure is also commonly referred to as book value.
The P&L is designed to analyse profitability issues: sales, margins, and expenses. The purpose of the balance sheet, on the other hand, is to analyse an entirely different issue: resource allocation. Did you decide to allocate your Rupees to increasing inventory, to paying off loans, or to accumulating cash?
The small-business owner makes many asset-allocation decisions over the course of the year; the balance sheet provides a year-end snapshot that summarizes the history of those decisions. We have provided a sample balance sheet to help you understand how this important financial statement works.
Understanding key ratios and percentages
Before you can take the numbers generated by the P&L and balance sheet and turn them into meaningful management tools, you need to consider two overall points about the numbers, ratios, and percentages that come from those financial statements:
Your company may have what appears to be a respectable percentage of net profit on its sales, but if that percentage is less than it was during the same period the preceding year, danger may lie ahead. Numbers are most effective when you can use them to identify trends - and identifying trends always requires a comparison of numbers over time.
The industry matters. Acceptable numbers in one industry may not be acceptable in another. Industries vary widely in the numbers they generate. For example, if you’re in the software business, you may be disappointed with a 15 percent profit return on your sales. If you’re in the grocery store business, however, you’d probably be happy with a 5 percent profit return on sales.
Make some research about the acceptable ratios and percentages in your industry.
Ratios
In the following sections, we explain the most common percentages and ratios that a small-business owner needs to consider.
Return on sales (R.O.S.)
Return on sales (R.O.S.) is a percentage determined by dividing net pre-tax profits (from the P&L) by total sales (also from the P&L). The resulting figure measures your company’s overall efficiency in converting a sales Rupee into a profit Rupee. R.O.S. very much depends on what type of business you operate. It’s relatively easy to track, understand, and explain
Return on equity (R.O.E.)
Return on equity (R.O.E.) is a percentage determined by dividing pre-tax profits (from the P&L) by equity/net worth (from the balance sheet). The resulting figure represents the return you’ve made on the Rupees that you’ve invested in your business (your equity).
Over several years, if your return on equity isn’t higher than 10 percent or thereabouts (which is the average return on money invested in such secure investments as short-term, high-quality bonds), you may want to consider selling your business and investing the proceeds in bonds. Your return would be similar, but your risk and the work involved would be much less.
This assumes, of course, that you’re in business to make money. If, however, you’re motivated by something else - creativity, growth, independence - or if you simply like owning your own business, you may be content with small earnings despite the fact that you could make a similar or better financial return elsewhere.
Note: Both R.O.S. and R.O.E. are impacted heavily by the amount of money the owner decides to take out of the business in the form of salaries, bonuses, and benefits. Obviously, the more taken out, the lower the R.O.S. and R.O.E. percentages will be.
Gross margin
Gross margin is a percentage determined by subtracting your cost of sold (from the P&L) from total sales (also from the P&L). This figure represents your business’s effective overall mark up on products sold before deducting your operating expenses.
How good your gross margin is depending on your industry, your business, your pricing strategy, and the products or services you’re selling.
Current ratio
Current ratio is a ratio determined by dividing current assets (from the balance sheet) by current liabilities (also from the balance sheet). The resulting figure measures your business’s liquidity (the ability to raise immediate cash from the sale of your assets); thus, this ratio is of great interest, especially to your lenders.
The higher the current ratio, the more liquid your business. As a general rule, current ratios in excess of 2 to 1 are considered very healthy; anything less than 1 to 1 is in the danger zone. Again, trend is especially important here. Over any period of time, you want to see an increasing rather than decreasing current ratio.
Debt-to-equity ratio
The debt-to-equity ratio is a ratio determined by dividing equity/net worth (from the balance sheet) by debt/total liabilities (also from the balance sheet). The resulting ratio indicates, in effect, how much of the business is owned by the owners (represented by equity/net worth) and how much is owned by its creditors (represented by debt/total liabilities).
As a general rule, a 1-to-1 ratio is considered healthy; anything less is questionable.
Keeping the debt-to-equity ratio within the healthy 1- to-1 parameter is of paramount importance. For example, when the debt-to-equity ratio falls below 1 to 1, such cash-draining options as adding inventory, hiring new employees, and buying new equipment should be put on hold until the ratio becomes more lender friendly.
Inventory turnover
Inventory turn is the number of times your inventory turns over in a year. You determine the number by dividing your cost of goods sold (from the P&L) by your average inventory (beginning inventory + ending inventory, divided by 2). For example, if your beginning inventory on January was Rs.10 million and your ending inventory (on December 31) was
Rs. 15 Million, your average inventory would be Rs. 12.5 million. Your inventory turn shows how well you’re managing your inventory. The higher the number, the more times your inventory has turned, which is always preferable.
The number of times your inventory turns is highly dependent on your industry
Number of days in receivables
You determine the number of days in receivables - that is, the average length of time between selling a product or service and getting paid for it - by first computing your average sales day. Divide your total sales for the (from the P&L) by the number of days in that (for a year, use 365). Then divide your average sales day into your current accounts receivable balance (from the balance sheet). The resulting figure gives you the number of days in your receivables.
Generally speaking, fewer than 30 days in receivables is considered excellent, between 30 and 45 days is acceptable, and more than 45 is cause for concern.
(Lionel Wijesiri is a retired company director with over 30 years’ experience in senior business management. Presently he is a business consultant, freelance newspaper writer.)
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