An introduction to financial reports

Do you understand the key financial statements available from your business accounts, as well as the information within each of them? If not, read on.

If you don’t have formal accounting training, financial reports can be quite confusing, and may even deter you from looking at them at all, ultimately meaning that you’re ignoring the information they can provide.

Here’s a simple overview of the key financial reports you should be looking at on a regular basis.

Profit and loss

A profit and loss statement (P&L) is one of the key reports for any business to run. It records all your transactions for a given period, usually the financial year ending on June 30. Your P&L tells you how much you’ve recorded as sales for the year, less what you’ve spent – the difference is your profit or loss for the year.

Balance sheet

Your balance sheet records the assets and liabilities of your business at any given date. It’s the equivalent of listing all the things you own (such as your house, car, other belongings and maybe some investments), less all the things you owe (your mortgage, credit card debts, car loan and so on).

In a business you can’t just list these items, you have to keep records of them to satisfy the ATO. More importantly, knowing how to read a balance sheet can give you lots of information to help you run your business, such as a summary of the total amount of money you’re owed and that you owe others.

"Knowing how to read a balance sheet can give you lots of information… such as a summary of the total amount you’re owed and that you owe others."

Accounts receivable and accounts payable reports

The accounts receivable and accounts payable reports are also sometimes referred to as trade debtors and trade creditors reports. While the balance sheet shows the totals due, these reports tell you who owes money and who you owe money to, plus how old the debts are.

Want more articles like this? Check out the financial management section.

Cash flow reports and forecasts

One of the difficulties with the reports above is that they’re prepared on an ‘accrual basis’, in which sales income is recorded when you raise the invoice, not when you get paid; and expenses are recorded when you enter the supplier invoice into your system, not when you pay it. It’s important to prepare your accounts in this way but it does mean that you can’t use those reports to forecast you cash position.

Your cash flow report contains information drawn from a combination of the P&L and the balance sheet, and tells you where the cash in your business has come from, and where it has gone.

This is one of the most misunderstood reports of all. Whereas accountants traditionally prepare a cash flow report covering the past 12 months, most business owners don’t care about cash flow in the past – they want to know what is going to happen to their cash balance in the future. For this, you need a cash flow forecast – we will look at this in more detail in a future article. In fact, the next articles in this series will discuss each of the above reports in more detail.

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Use financial reports to improve your biz

If you want your business to thrive, look for ways to continuously improve it. Here’s how the information contained in your own financial data can help you.
Previous articles in this series have discussed the importance of running and understanding your profit and loss (P&L) and balance sheet reports, and of comparing these to a yardstick (for example a budget or a benchmark).

To get optimal value from this process, you’ll also need to understand what’s working, and keep doing it or improve; and understand what’s not working, and fix it.

Simply repeating what hasn’t worked in the past and hoping for a different outcome isn’t a sensible option.

A simple way to approach this is to use a model called the Deming cycle to help drive ongoing improvement through a series of steps summed up as Plan, Do, Check, Act. (Note that the word “cycle” is key here, because as soon as you finish one round of activity you start the next, with the goal of creating better and better results over time).
Plan

The first step is to formulate a business plan using terms you can use to measure the performance of your business over time. The most common way of doing this is to create a budget for your business that incorporates all your planned operational activities.

For example, if you’re generating lots of leads but taking too long to issue quotes, add a solution to this in your plan (whether that’s a software solution, hiring a person to fulfil this role or whatever), and include that expense in your budget alongside a target to aim for. In the example above that might be to halve the turnaround time it takes for quotes to be issued after a lead is received.

"Simply repeating what hasn’t worked in the past and hoping for a different outcome isn’t a sensible option."

Do
Next, follow through with the decision you made and implement the actions in your plan by hiring the new person, implementing the new software or whatever else you decided on.

Check

Measure your results by running monthly profit and loss reports, and taking the time to analyse the data they contain so you can determine what’s working and what’s not.

For example, if you’ve managed to reduce the time you take to issue quotes from five days to one, how has it affected your sales? (Keep in mind that this is never an exact science, and there’ll be lots of different factors all at play at the same time).

Act

Identify corrective actions that will improve your performance, and incorporate them into your plans for the future.

In other words, if the actions you took to speed up quoting worked, keep doing it (and try to improve it further), but if not, determine why, and consider other things you could try instead, or as well.

Sometimes you’ll discover that your plan worked, but in doing so has created a new problem. For example, your quoting process might now be so efficient that you’ve got more sales than you can comfortably handle!

That requires a new plan – perhaps another new person in an operational role or an enhanced job management process. In either case this takes you back to the beginning of the cycle.

A tiny minority of small businesses thrive and prosper without any planning or business analysis. For the rest of us, the Plan / Do / Check / Act cycle is a simple but invaluable way to continuously improve business performance – especially when used in conjunction with the data in your financial reports.

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How to prepare a cash flow forecast

Business owners tend to focus on the bottom line: the profit we are going to make. But a business can have $100,000 in profit AND an overdrawn bank account. Why? Because of poorly managed cash flow and no cash flow forecast.

The long-term survival of a business depends on its ability to successfully manage cash, and cash flow forecasting and analysis can help with this. Here are some more reasons you should prepare a cash flow forecast: 

• A cash flow forecast can enable you to meet seasonal commitments and plan for future expenditure, e.g. on equipment.
• A cash flow forecast can show when additional funds might be required in both the short and long term.
• Cash flow problems often catch small business owners unaware and a forecast will guard against this. 

If you have not been established long, your forecast will be driven by assumptions appropriate to your specific industry or business. Industry stats, benchmarking, dealings with customers and supplies and any knowledge that you have will all play a part.

Some of the main items to focus on include: 

• Sales growth estimates.
• If your business/product is seasonal.
• Expenses that you will incur. 

Listing your assumptions within the forecast to show how you derived your figures will serve you well when assessing actual performance against forecast.

Preparing anticipated sales income

Sales can be difficult to predict. If you are in your second or subsequent year the best place to start is to look at sales in previous years to identify trends. However if you’re in your first year you will need to rely on realistic estimates based on industry benchmarks and information we mentioned above. You can also look to identify external and internal items that may affect prices within the first year and adjust accordingly.

"70% of debtors will be received within trading terms and 25% outside terms with the remainder 4% to come thereafter and a 1% provision for bad debts."

Once you have determined a sales figure, we have to look at the break down of how that money will be received and how much of that will be caught up in debtors. It is reasonable to assume the following: 70% of debtors will be received within trading terms and 25% outside terms with the remainder 4% to come thereafter and a 1% provision for bad debts. Yes, most businesses will have these so assume and provide for them so they are not a surprise.

Cash Inflows and Outflows

To complete your cash flow forecast, you need to prepare a list of other incomings and outgoings. 

Some examples of inflows include:

• GST refunds and tax refunds.
• Government assistance – for example diesel fuel rebate; apprentice payments.
• Dividends received.
• Interest received.

Outflows should include direct and indirect expenses. Some examples of these include:
Expense necessary to run the business.

• Cost of materials.
• Wages & Salaries.
• Car/loan repayment.
• Payment to any supplies.
• New equipment needed.
• Superannuation payments.
• Insurances.

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Understanding cash flow forecasting

Forecasting your cash flow helps you determine when you’re likely to be short of cash, giving you time to minimise the problem before it becomes a disaster.

What’s a cash flow forecast?

A cash flow forecast is simply an estimate of future movements of cash in and out of your business over a given period of time. Cash in will include receipts from customers, any tax or GST refunds you receive, and any money contributed to the business by the owner. Cash out will include any amounts paid out to suppliers, the ATO, wages and so on.

Preparing a cash flow forecast is not difficult, although if done manually it can be time consuming.

If your business is in a relatively healthy cash position you might forecast for 12 months looking at monthly balances. If cash is tight, you might prepare a forecast for just the next 30 days, with weekly or even daily balances. 

Preparing a short-term cash flow forecast
For very short-term forecasts (up to 1 month), make a list of what you’re currently owed by your customers and estimate when these amounts will be paid. Add to this any new sales that you expect to be paid for within this period, plus any other receipts from other sources (refunds due, sale of assets and so on).

"If this figure is negative, you’re heading for a cash flow problem. Or if you’re doing this daily, any negative balance days will be a problem."

Next, prepare an estimate of what you’ll spend, including amounts you must pay to suppliers, loan repayments, taxes and net wages (i.e. excluding PAYG). Take care to include all irregular items, such as super BAS and annual insurances that are due.

Finally, bring all of this together: the balance of cash in your bank account now plus your anticipated receipts and minus your outgoings, gives you an estimate of your cash balance in 30 days. If you really need to, you can do this on a daily basis – Excel is a great (though time consuming) tool for this.

If this figure is negative, you’re heading for a cash flow problem. Or if you’re doing this daily, any negative balance days will be a problem. Review the cash flow forecast and decide what you can do about it. Can you increase sales? Collect money from customers faster? Delay payments to suppliers? Though, try to avoid delaying superannuation and ATO payments, it may seem like the easy option, but often causes problems long term.

Want more articles like this? Check out the financial management section.

Preparing a long-term cash flow forecast

The same principles apply when forecasting cash flow over a longer period.

I recommend you start with a copy of your annual budget, and adjust that to take into account the expected timing of receipts and payments. You’ll go through exactly the same process that you would for a short-term forecast, only you’ll do it for each month throughout the year. In my experience, not having a budget is one of the reasons small business owners get themselves into cash flow problems, so if you don’t have one in place, now is a good time to start putting it together.

Excel is an excellent tool to use for long-term cash flow forecasting, but there are also some really good software tools that will extract data from your accounts and help you prepare both cash flow forecasts and budgets. 

How accurate will my cash flow forecast be?

It’s unlikely you’ll ever get an absolutely accurate forecast of cash flow, but that shouldn’t stop you trying. A realistic forecast of cash position allows you to plan with confidence, and removes what for most business owners is their single biggest source of stress.

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Four simple steps to create your budget

Working to a budget maximises the chances that your business will not only survive but prosper. This step-by-step guide will get you started.

In my experience, when it comes to building a profitable and sustainable business, few things are more critical to success than developing and sticking to a budget. 

Think of it as a yardstick that helps you determine whether you’re:

• Achieving your overall financial goals
• Making the sales you hoped for 
• Generating sufficient gross margin to not just cover your expenses but pay yourself a healthy wage
• Controlling your expenses
• Heading for any cash flow problems
• Getting into the budgeting cycle

Budgeting is not something you can set and forget. It’s a set of tasks that you’ll almost always need to cycle through several times and revisit often. I've summarised the cycle, below.

Determine your sales forecast

Start by estimating what you’re going to generate in terms of sales. If your business is new, this can be very difficult to forecast, but if you have some sort of trading history you’ll be better positioned to build a realistic estimate.

Try to work from the ‘bottom up’ – in other words, rather than simply coming up with a dollar figure, estimate how many products or services you hope to sell, and at what price. I recommend using Excel and calculating a different figure for each month of the year rather than coming up with one lump sum.

"When it comes to building a profitable and sustainable business, few things are more critical to success than developing and sticking to a budget."

Calculate your direct costs

Your direct costs are those that vary according to your sales. For example, for every widget you sell there’ll be a cost of having bought it. This is where the ‘bottom up’ approach helps, because if you know how many widgets you’ve forecast you’ll sell, and you know what it costs to buy them, you’ll be able to work out your direct costs (and the same is true if you‘re selling hours of labour).

The difference between your sales and your direct costs will tell you your budgeted gross profit (GP).

Armed with these figures you can start testing different assumptions, such as, “If I increase my sales volume by 10% (without changing my price) what happens to my gross margin?” Or, “What would happen if I increase my sales price by 10% and manage to maintain my sales volume?”

Factor in your expenses and outgoings

Your expenses are the things you spend money on that don’t vary with sales, such as your rent, marketing expenses and insurance. Some (such as rent and the wages of any staff) will be relatively fixed, while others (such as the amount you spend on advertising) can vary. You may also need to factor in outgoings such as the cost of your vehicle, tools or equipment.

In addition, if you’re selling products or offering credit to your customers, you’ll probably need cash (working capital) in order to cover these.

Review all the numbers and make some decisions

Now things start to get interesting! Hopefully your gross profit figure is larger than your expenses, because the difference between these two is your budgeted net profit.

Assuming your budget does indicate a profit, ask yourself whether it’s going to be enough for you to live on. If your budget is projecting a loss or not enough profit for your liking, cycle through the four steps of this process again, starting by reviewing all your assumptions. Can you increase your selling prices? Can you sell more in volume terms? Can you reduce the cost of buying your products (or labour) at a lower price? Can you reduce your expenses?

And if the answer to all of the above is “No”, the next questions to ask are, “Can I sustain a loss for some period of time until the business is generating a profit? And if so, for how long?”

If you work through your budget repeatedly and don’t arrive at a bottom line you can live with, don’t just keep going in the hope that things will miraculously work out okay. Instead, it’s time to revisit your business plan in its entirety and come up with a different approach. This is a critical point in your business planning – getting it right at this stage can save you many thousands of dollars.

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Unlock the secrets in your financial reports

Armed with your profit and loss statement, balance sheet and some simple tricks accountants use, you can unlock valuable information about your business.

Learning how to read your P&L and balance sheet are the first steps in getting a handle on your business financials. But to take things to the next level, you also need to be able to analyse the information those financial reports contain.

Read on to discover some easy ways to analyse your data using the same tricks accountants use every day.

You can analyse your P&L and balance sheet much more effectively by using a few ratios, yardsticks and benchmarks. There are many to choose from, but selecting just a few and looking at them regularly can provide great insights, and might just give you an advantage of competitors who fail to do so.

Gross profit margin as a percentage of sales

Each of the products and services you offer will probably yield a different GP. Measuring the average month by month will give you an idea of how your business is performing. Consider an item you buy for $1.00 and sell for $1.50, giving you a mark-up of 50% on the buying price of $1.00, and a gross margin of 50 cents.

The GP margin percentage on that item is expressed as the gross margin divided by the sales price, (50 cents divided by $1.50 or 33.3%). The same is true if you are selling services where you can compare the revenue generated from those services with the cost (usually wages) of providing them.

"If your business is turning over $200,000 a year, 54 debtor days equate to almost $30,000 of your cash that’s still sitting in your customers’ bank accounts. "

When measuring your GP margin percentage each month, consider why it might have varied from what you expected (for example due to the mix of products sold or discounts offered) and consider ways you can improve it in the future.

Debtor days

In Australia, the average debtor days for SMEs currently sits at around 58 days – that is, it takes an average of 54 days from the date you invoice your client until the date you get paid.

If your business is turning over $200,000 a year, 54 debtor days equate to almost $30,000 of your cash that is still sitting in your customers’ bank accounts. Getting paid 30 days after you issue an invoice rather than 54 would add almost $14,000 to your bank balance.

For many small businesses the situation is even worse, with customers taking 60 days, 90 days or even longer to pay their invoices. So if your accounting software doesn’t include tools to help you manage this, it’s well worth considering switching to a system that does – this feature alone could have a dramatic impact on your cash flow.

Working capital

Looking at your working capital tells you if you’re going to have cashflow problems in the near future – which is much more important than looking at your bank account to see how much cash you’ve got now.

To calculate this, run a balance sheet, and compare your current assets (things you own like bank balance and debtors) to your current liabilities (things you owe like supplier invoices, superannuation payments and payments to the ATO). If your current liabilities figure is bigger than your current assets, this is a forewarning of problems to come.

Yardsticks and benchmarks

The easiest way to analyse the results you’re seeing in the measures above is to use your past performance on them as a yardstick by which you measure your current results. As you track your performance over a period of time (e.g. month by month) you’ll be able to see whether the trend is up or down.

If you have a budget for your business, you’ll also be able to see whether your actual results measure up to your expectations.

Finally, it can be very revealing to compare your own results to that of similar businesses, using benchmarking data available from the ATO.

Previous articles in this series have included a brief overview of the financial reports available from your accounting software, how to read your P&L and balance sheet, and how to prepare a cashflow forecast. The next and final article will wrap things up by explaining how to act on all this information to improve the results of your business.

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Markups and margins: know the difference!

Knowing the difference between markup and margin calculations is essential for your business and ultimately, your bottom line.

When it comes to understanding the difference between markup and margin, the first thing you need to know is this: markup is based on cost, while margin is based on revenue:

Markup is the amount added to third party costs, to arrive at the total amount charged on to your client.

Margin is the difference between the cost and the sale.

So what should your policy be? Should you quote markup? Or margin?

"The classic tip here is: If you don't ask, you don't get. Applying a markup or achieving a margin is about being fair and equitable."

Getting these wrong can be devastating for your business because there is a huge difference between (for instance), 50% markup compared to a 50% margin. Let’s look at that difference:

Calculating the sell price using margin

To illustrate the difference between these two tricky calculations: let’s say that you have an external cost of $1,000 and your policy is to achieve a 50% gross margin.

Your calculation will be: Divide the $1,000 cost by 0.5 = $2,000 sell price.
Calculating the sell price using markup

If, however, your business has a markup policy of 50% on external costs, then you would sell the $1,000 item for $1,500 instead of the $2,000 calculated above.

Your calculation will be: $1,000 x 1.5 = $1,500 sell price.

Let’s put these calculations into a real life example:

We’ve accepted a quotation from our print supplier for $10,000. Now we need to ascertain the sell price to our client, either by adding a markup to the supplier cost, or calculating our margin expectation.

If we apply a 30% markup:Your calculation will be: $10,000 x 1.3 = $13,000.00 sell price.
The gross profit we would earn is $3,000 ($13,000 sell price, less the $10,000 supplier cost)

If we seek to make a 30% margin:
Your calculation will be:
$10,000 ÷ (1 – 0.3)
$10,000 ÷ 0.7 = $14,285.71 sell price.

The gross profit we would earn is $4,285.71 ($14,285.71 sell price, less the $10,000 supplier cost)

Applying the margin policy would mean that we earn $1,285.71 more than if we implemented a markup policy.  

So which should you use? Markup or margin?

Markups and margins are often based on industry norms, what the market will bear, and also take into consideration if you add extra value to the product or service.

It is reasonable to implement different levels of markup or margin for different products or services, for example:

A 10% markup for basic services such as administration supplies (photocopying, stationery etc.).
20% markup if the job is slightly more involved.
30% markup where your IP, expertise and technical skills are required.

Common things you’d add margin to are items you are purchasing from a wholesaler and then on-selling.

Ultimately however, the aim of applying a markup or making a margin is to ensure you’re charging your client/customer enough to cover any supplier costs PLUS:

Your time
Your administration costs
Your intellectual property (IP)
Your knowledge of the product or service
Your technical expertise and know-how
Time pressure and urgency

So, there’s no need to be shy; just pick one method and be confident as to how much you are charging and why.

Double-check your business terms and conditions contracts and agreements to ensure that you have formally communicated your policy to your client, and that the markup or margin policy you choose ensures that you are able to run a profitable business.

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I've been gone but now I'm back

I've been a bit distracted lately.....
Have you ever been like that?
What distracts you?