What Your Financial Statements Tell You
As an entrepreneur, one of the things you need to learn is how to analyze your financial statements. Understanding financial statements is critically important to the success of a small business especially during its first two years.
Financial statements can be used as a roadmap on your business journey to economic success. Using numbers as navigation aids can steer you in the right direction and help you avoid costly mistakes. Most entrepreneurs don’t realize that financial statements have a value that goes far beyond their use to prepare tax returns or loan applications.
Any business, whether new or old, has to have updated financial statements all the time. An entrepreneur will have a better understanding of how this business is doing by analyzing the different critical information which financial statements present. By doing so, he can nip in the bud any problem besetting his business before it’s too late.
First, ask your accountant to derive the following financial information from the balance sheet and income statement:
1) Sales Growth on a monthly basis
2) Gross Margins as a percentage of Sales
3) Net Operating Expenses as a percentage of Sales
4) Accounts Receivables (Days)
5) Inventory (Days)
6) Accounts Payables (Days)
The first three data are what we call the Growth and Fundamental Profitability Indicators of an enterprise. These are critical factors that determine whether the business can generate enough cash to be sustainable in the long-term.
The second set of data (Account Receivables Days, Inventory Days and Accounts Payable Days) is called the Swing Factors. They are called swing factors because any small improvement or decline in any of the three variables can result in a significant shift or swing to the cash position of the company.
Now, what’s the implication or importance of this financial information to your operations? First, the analysis of your monthly (annual) sales growth will reveal whether the business is generating enough cash. It is worth noting that any changes in monthly/annual sales will impact on your monthly/annual cash flow. Sales growth is an indication that your business is using a large amount of cash to finance any business growth.
As an entrepreneur, you know that sales is a function of the selling price and the quantity sold. Manipulate these two critical variables to achieve your desired sales level.
Analyze where the bulk of your sales is coming from by deriving percentage of each business unit’s contribution to the total sales. How much is your present gross margin and operating expenses (net of depreciation and amortization expenses) as a percentage of total sales? Procedurally, you will arrive at your gross margin by deducting your cost of sales/revenues from your net sales. Consequently, deducting from your gross margins the net operating expenses will give you your “cash cushion.”
Gross Margin = Net Sales – Cost of Sales
You should remember that by definition, gross margin represents the amount of profit per peso of sales that the company retains after accounting for its cost of sales. It is important for you as a starting entrepreneur to remember that any increase in gross margin is a source of cash flow. A higher gross margin will enable your enterprise to cover your operating expenses.
The operating expenses on the other hand, is the amount of gross margins that is consumed by operating expense. An increasing trend in your operating expenses means a decrease in your cash flow. A higher cushion will enable the enterprise to cover its current operation and make the enterprise liquid in the current term. Being liquid would mean that it would have the ability to pay its overhead expenses including interest and tax payments.
Take a look at the last set of financial information that you should examine. These are your Accounts Receivables Days, Inventory Days, and Accounts Payable Days. As a manager, you can control them through rules and regulations that you will put in place with regard to extending credit, terms of payment and collection policies.
Accounts Receivables (AR) are your credit sales. And here we are looking at the average time your business takes to collect trade receivables arising from credit sales. An increasing trend in the AR days reflects a decrease in cash flow and vice-versa. On the other hand, Inventory Days tells you the average time your business takes to sell its inventory goods. You should remember that a rising inventory (INVTY) is costly to your operation. It is money lying idly in your storeroom or warehouse. Similarly, an increasing trend in your INVTY days also reflects a decrease in cash flow and vice-versa. The Accounts Payables Days is the average time it takes your business to pay its trade creditors or suppliers. An increase in AP days reflects a source of cash. This is so because as long as you can delay payment to your suppliers, you can hold on to our use your cash for other purposes than payment.
Source: Business Line Vol. 2 No. 2 2004