Small business owners face a minefield of challenges in running their business, from staffing and systems issues to marketing and dealing with new competitors. 60% of small businesses cease their operations within their first three years, which goes to show that it’s not easy! So it’s not surprising that many entrepreneurs leave their business financials in the ‘too hard’ basket – the numbers are just numbers – and not that interesting or meaningful.
Reading the signs in your financial statement
But with just a little understanding of what your financial figures represent and how they inter-relate, you can gain great insight into your business at a big-picture level. This is vitally important when business owners, often by necessity, are focused on the day-to-day management of their business.
Your financials can help you identify issues within your business long before they become major problems. Understanding the five key terms and inter-relationships below should enable you to make a start on deciphering the numbers.
1. Cash and its connection to profit and debt
We all know the saying ‘cash is king’, and for good reason. Having cash enables a business to live and breathe, operate, keep liquid and pay its debts. But it is not just about looking at how much cash you have in the bank (which to many is the extent of their business analysis). Understanding the connection between cash and other key items within the financials is vitally important.
For example, if a business is making great profits yet increasing its debt and not able to meet its loan repayments, the financial statements can show where else the cash is being tied up – and whether that may be due to holding too much stock or not being able to receive payments from debtors. Understanding these connections will tell you where you need to improve or focus your efforts to make your business successful.
2. The ‘Current Ratio’ explained
Cash is just the tip of the iceberg. Another great insight into your business is to compare its current assets to current liabilities (the ‘Current Ratio’) on the business’s Balance Sheet. This simple review is one of the first checks you can perform to know if a business is trading insolvent.
If a set of business financials repeatedly, or drastically, shows that current liabilities outweigh current assets, the financial health of your business needs serious attention. Generally, it means the business is screaming out for more cash and needs to be more liquid. If trade creditors are the leading cause for this imbalance, the business may be too heavily relying on its suppliers, have poor cashflow management, or be generating an insufficient level of profit. The business needs a serious review once it’s heading down this path.
3. Your Profit and Loss Statement – what to look for
Understanding the Profit and Loss Statement is central to understanding how your business operations are performing. The first eye-catcher on the P&L should be your Gross Profit, as this is the core performance of the business. Yes, sales are important, but the Gross Profit is crucial.
The Gross Profit will drive a business either straight along the highway or straight into a ditch. Businesses often aim to increase their sales, thinking this will be what makes them successful, but it’s controlling the Gross Profit that really makes business owners money. If a business’s Gross Profit is too low compared to sales (the ‘Gross Profit Margin’), this could be a sign that the business is off the bitumen. Either costs are too high or the sales price/volume is inappropriate and requires a considerable review.
4. Retained Earnings – a financial history snapshot
The ‘Retained Earnings’ account provides a great snapshot into a business’s history. A large negative value is a clear sign that a business has a history of losses, and a large positive balance shows that owners are constantly reinvesting into their business. Investors looking to buy a business should always check the balance of this line item on the Balance Sheet.
Where a good accountant can help
Business owners need to have a good grasp of what their financials are telling them to make the right decisions and implement measures to ensure their business is successful. Accountants are naturally attuned to this, and a good one can help you understand what your business’s numbers are telling you so you become better equipped in this area.
To find out more about how Accru can help, please contact your local Accru office.