It’s not a particularly sexy topic, but it’s one that could be of crucial importance to the future success of your company. I’m talking about accounting analysis. You might be tempted to stop reading right here and now, so let me give you a few reasons to reconsider:
- Accounting analysis doesn’t need to be difficult with the help of online, automated accounting software.
- It can drastically change the way you look at your business finances.
- Developing a deep understanding of your accounts can help you make better decisions for your business faster and easier.
Maybe you’re pretty good about keeping up with recording your cash flow and glancing over your running totals every now and then, but taking the time to look through the accounting reports could result in both short and long-term benefits for you and your business.
Accounting data can get a bit complex. As an entrepreneur, you may find yourself at some point in the development of your business, with some data regarding accounting that you’re not quite sure what to make of.
We’re humans, not machines, so accounting reports put that information into a format that is easy to understand, process, and use when determining whether any changes need to be made moving forward.
Here’s a little overview of the four main reports and what you can expect to find on each:
- The balance sheet. This report shows what your company owes and is owed. It gives you the value (as a culmination of your total assets, liabilities, and net worth) of your business at a given point in time.
- The profit & loss statement. Your income statement. Basically, it provides details on any losses incurred as well as what your business has earned - the net profit over an accounting period.
- The statement of cash flows. This covers all of the incoming and outgoing cash (transactions) of your business over a given period of time. It’s different from profit & loss in that it includes any and all instances of cashflow.
- The statement of changes in equity. Also known as the statement of changes in owner’s equity for sole traders, this report details the changes that have occurred in the owner’s interest in the company over the accounting period.
If you’re worried about compiling the necessary data for these reports, there’s no need. Online accounting software like Debitoor can automatically generate the most important reports instantly (balance sheet, profit & loss, and VAT). But having the reports in-hand is one thing, interpreting them is another.
So, how do you interpret financial statements?
Financial reports contain a considerable amount of information, which can seem slightly overwhelming without a background in accounting. So for the purposes of this article, we’ll go into the two most important for small businesses: the balance sheet and the profit & loss (also known as the income statement).
The balance sheet
This report is meant to provide you with the figures that will give you a general understanding of how your company is performing.
It does so by breaking down the financial details of the three primary areas that determine the value of your business: the value of your assets (what your company owns, including accounts receivable), your liabilities (what your company owes to others), and your owner’s equity or capital (cash or other assets provided to a company by the owner).
In viewing your balance sheet, you’ll find that no calculations have been done. The balance sheet provides you with the resources to conduct your own analysis, using financial ratios, such as the current ratio (your company’s ability to pay off short term debt). The current ratio is determined by dividing the current assets by the current liabilities.
Interpreting the current ratio: this is important because it provides you with a glimpse into how liquid your business is, and is a crucial factor in understanding the financial health of your company. It varies depending on the industry, but a good current ratio generally falls between 1.5 and 2.
Another figure you might want to look into is known as ‘working capital’. This amount reveals the cash you have at the ready for daily operations. To determine this amount, simply subtract your current liabilities from your current assets.
A negative result should prompt you to examine and improve some of the inner workings of your business. For example, changes to inventory management can help improve this, especially if you have a large amount of product at a standstill. A positive result will allow you to create a more accurate budget moving forward.
The profit & loss report
With a straightforward name, this report similarly serves to help you in determining the financial health of your business over a given period of time. It provides details on your company’s income, as well as the costs encountered for the given period.
Like the balance sheet, these figures can be used in some useful calculations to better understand your financial position.
For example: the gross profit margin. This is determined by subtracting sales from the cost of goods sold (COGS) then divided by the sales. The gross profit margin will give you a percentage that allows you to see how much of your sales are above your COGS.
Another amount to consider is the collection time of your accounts receivable. In other words, the amount of time it takes your business to collect payment owed. This can be noted in the balance sheet as well, but if there are payments that you do not expect to be fulfilled, they should be marked as bad debt. Too much bad debt can severely impact the financial health of your business.
To determine your accounts receivable collection:
- First divide the total net sales by the accounts receivable.
- Then divide 365 by this number. The result is the average number of days it takes for your business to collect on payments it’s owed.
If this is significantly over the standard 30 days, it could be time to start being more assertive about following up with customers who have overdue payments.