How to analyze financial statements
Contents
How to analyze financial statements ............................................................................... 1
Understanding numbers .............................................................................................. 3
Timetables ................................................................................................................... 5
Frequency ................................................................................................................ 5
Seasonality .............................................................................................................. 6
First steps .................................................................................................................... 8
Data collection.......................................................................................................... 8
Basic process ........................................................................................................... 8
Accounting month-end ........................................................................................... 10
Common mistakes ................................................................................................. 11
Categories of expenses ............................................................................................. 13
Chart of accounts ................................................................................................... 13
Arrangements........................................................... Error! Bookmark not defined.
Establishing a base line ............................................................................................. 16
Spreadsheet tools .................................................................................................. 16
Fast track! .............................................................................................................. 23
Analysis process ........................................................................................................ 24
The core of the analysis............................................................................................. 25
Fixed and variable expense ................................................................................... 25
Things to watch for ................................................................................................. 28
Causes of changes ................................................................................................ 29
Problem areas ........................................................................................................ 31
Comparison against budget ....................................................................................... 32
Summary ................................................................................................................... 33
Understanding numbers
This is the second section of the HighSpin manual on finances for small businesses.
Over the last 15 years, I’ve looked at more than a thousand business plans. All of them
include a section of financials projections, sometimes with past history, but all of them
with a detailed balance sheet, income statement and cash flow. Even though they are a
key element in forecasting how the business will develop into the future, I have often
discovered that the owner or manager really does not understand the information that
has been packaged, at least not beyond the fact that the business is showing a profit.
The same is true for their regular accounting. If their accounting is well organized, every
month a business owner will get their financial statements put in front of them, or
perhaps it’s a department head getting his divisional results. In many, many cases,
apart from looking a the profit line, the reader really does not understand the wealth of
information that is being put in front of them. That’s why HighSpin focuses on helping
people ‘figure out the numbers without doing the math!’
Some people are very reluctant to admit that they really do not understand numbers.
The funny thing is that they may readily admit to a lack of knowledge about marketing,
production or human resources. But some reason they think that if they don't
understand detailed financial information, they must be much dumber than the average
person.
Not true!. Lots of people do not understand numbers. Understanding financial analysis
is a skill that can be learned, just like marketing or sales. And although some math
ability may be useful, in fact it does not take a huge mathematical talent or a skill in
manipulating numbers to analyze and so use the data that is being put in front of you.
Understand that numbers tell stories. When you can translate the information you are
being given so that it provides a narrative of what is going on in your business, then you
can learn the financial management skills then you need. And what this section of the
manual gives to you is a systematic method by which you can start to get some vital
information on the day-to-day financial situation of your company.
So let me take you through the process by which I put together a set of data from any of
my client’s financial statements and turn it into an analysis of ups and downs so that I
can really make use of that information. And like all great processes, it is essentially
very simple and repetitious.
Timetables
Before we get into the nitty-gritty of How to do analysis, I just want to address the
question ‘When?’.
Frequency
Your job is different from everyone else’s in the way you prefer to get information, how
often you want it on your desk and how it should be arranged to be of maximum benefit
to you. Undertaking this kind of analysis may be something that you want to do every
month, every quarter, or perhaps, though not recommended, just once a year. Part of it
will depend on the quality of information you can get from your accounting system, part
of it will depend on how much time it will take you to put it all together, and part of it may
depend on the how quickly you must react to the information you examine.
Annual review
Generally, even if things are going well, it is my experience that undertaking this kind of
analysis once a year just is NOT sufficient. If your year runs from January to December
and then it takes a couple of months before you get financial statements, this means
that you may be trying to look at data that may be now up to 14 months old. Even if you
are looking at something that happened just before Christmas, 60 days after the fact
may still be too long to apply the appropriate corrective measures. You should not wait
12 months to find out where things are on track or more importantly where they are
coming off the rails.
Monthly review
Monthly analysis is certainly the best. It becomes a regular routine. You get used to the
numbers and can spot variances more easily. And it allows you to react as soon as you
spot a problem.
At the same time, if you don’t have enough resources to look at everything once every
thirty days, monthly analysis may take more effort than you can afford. There may not
be huge change in your business every thirty days that you need to take a close look at
the numbers. Some of you may have a good ‘gut feel’ for the numbers so you can go a
little longer without following th process outlined below.
Quarterly review
For many businesses, taking the time every ninety days to analyze what is gogin on
financially may be a good compromise. It builds up enough detail to identify some
trends. It may match the seasons of your business (see below). It’s a balance between
doing it eery month (which for a small emterprise may be just too much work) and
waiting too long for the annual statemtns to learn that you are in trouble. So even if you
are really busy, taking a good look at your operations every quarter allows you to stay
on top of the financial information and to identify problems before they become major
issues.
Seasonality
Another factor that will influence how often you look at your company financial position
may come from the seasonality of your business.
For many retailers, the likelihood is that a large amount of your business for the year
may come in the three months before Christmas. If you are in construction, a lot of your
work may be concentrated in the summer months, particularly if you work up north
where the building season is relatively short. You may have another period of the year
that is your busy season. Whatever the case, you may not want to be spending a lot of
time in this kind of financial analysis just at the time of year when you are most busy
with business activity.
So choose a date when you can devote some time to the analysis. It’s too important to
fluff it off with fifteen minutes of casual focus. The process might take you two or three
hours to set up at the start, but it could be a lot less. And I can certainly guarantee you
that it will certainly go a lot faster once you establish it as a routine.
First steps
One of my favourite aphorisms is a saying that goes "it's better to be approximately
right, then precisely wrong". If you start with incomplete information, no amount of
analysis is worth doing, because you may well wind up in a situation where the
conclusions you reach are precisely wrong. So start by being sure that the data you
have is up to date and complete.
Data collection
The first thing you need to do is to assemble all of the data that you want to assess. So
if you are going to look at the past three years results for your company, or for the past
three quarters, then you need to have financial statements representing the financial
position of the business at the end of each of those three periods.
You should check that the three years of financial statements you are going to be using
were all assembled on the same basis for the same time period and essentially using
the same chart of accounts. This may seem obvious, but accounting systems do
change over time, and even if the financial statements were prepared by an accountant,
changes in categorization and how financial transactions are recorded may have
occurred over the last three years.
Basic process
Before you plunge into the process, there are a couple of steps that you must first take
to make sure that the information you are using is complete and up-to-date.
Matching principle
Firstly, are all revenues and expenses matched?
There are a number of principles in the accounting profession, which are generally
summarized under the expression GAAP (Generally Accepted Accounting Principles).
One of the principles that you should follow is called the Matching Principle. This
essentially states that if you have recorded any revenue, you should also make sure
that you have matched it to any expenses related to the revenue, whether or not you
have received detailed invoices. Likewise, if you have recorded an expense item and
there is revenue that is associated with it, this too should be “matched” to ensure that
you are comparing apples with apples.
Following this rule, firms engaged in big projects, such as construction, usually record a
part of each project's revenue each month, and as well its associated costs, regardless
as to whether it has been invoiced or not, or all the specific bills related to it have been
received.
Let’s say that you have "Work in progress" a house renovation you are conducting that
will be a three month long job from the beginning of March to the end of May. You are
planning to bill the client at the end of the project. You will-be incurring expenses for
labour and materials in the first two months, and recording them in the accounting
system. It therefore makes sense that you accrue some of the revenue associated to
these expenses as well.
If you don’t do this, your financial picture will be distorted. March and April will look like
you are spending lots of money for no reason, and then later May will look like it was
fabulous with lots of revenue and no expenses. Not only does this make it more difficult
to manage the project a the time, it also will create problems a year from now when you
are trying to make comparisons between the two years and you have to remember what
projects were happening when and how the financial results would look like if these up
and downs were in fact smoothed out.
Gathering all the data
On a practical basis, this means that all the information relevant to your accounting
period, both pluses and minuses, should be entered into your accounting system. So if
you have monthly financial statements, your bookkeeper should make sure that she
gathers all the pieces of information about both revenue and expenses and enters into
the accounting system in the first few days following the month end.
Accounting month-end
So what does this mean in practical terms?
It's easy enough to gather information from pieces of paper that have arrived in the
accounting office from one source or another during the course of a month. The
challenge in getting an accurate month-end lies in the items where the paperwork is not
yet complete such as the sales invoice that hasn't yet been issued or the bill for the
trade show that hasn't yet come in the mail or the data entry that has been delayed until
the bookkeeper comes in.
So what you have to do is identify where you have missing information and estimate as
closely as possible what the dollar amount will be. In accounting terminology, this is
called making an accrual, where you accrue all of the dollar information that you will
collect in the next little while but for which you do not at present have the paperwork.
The easiest way to do this is using a checklist. You can make up your own, or again,
there is a template that you can download from the HighSpin website.
Common mistakes
When the bill comes regularly on a set date once a month and then one invoice does
not arrive, you are more likely to notice it and so make an accrual for it. But what if the
bill only comes once a year?
Insurance is a very good example. You usually pay the premium only once a year, yet it
covers you for the next 12 months. But to get an accurate picture month-to-month, you
really should take the annual bill and spread it across all 12 months split evenly. After
all, insurance is an ongoing cost, not something that distorts the results in just one
month when the invoice actually arrives. This process also should apply to payments
that may be made quarterly, such as Workman’s Compensation.
So at a set point in financial year, usually at the beginning, you should ask your
bookkeeper to make a collection of all of the bills in the past year that were only paid
once, and then make sure a recurring journal entry is made each and every month, not
just in one big lump sum once a year.
Another simple alternative to this which you may prefer is merely to be told when such
payments are made so you can recognize them when they show up in your analysis
and so be able to immediately identify the cause of that variance! But realize that
although knowing about a single payment in one particular month may help understand
the variance in the month in which the payment occurs, it will still be confusing in future
periods since the average cost in that category will not be consistent and may therefore
lead to confusion.
Categories of expenses
Now, once all of this data has been collected, it will only become meaningful if we
categorize it one or more ways (type of expense or office location for example). And this
leads us to a discussion of what is called the chart of accounts".
Chart of accounts
The chart of accounts is essentially just a listing of all of the categories of the financial
statements for a company, the individual accounts listed on the balance sheet and the
income statement.
In many cases, these categories may have in effect already been decided by the person
who set up your accounting system. But realize that these categories can be changed
as well. There are many ways that the data can be described and presented, and it may
be that one of these methods of presentation will provide you with information that is
more meaningful to you than another.
I have a number of suggestions about the chart of accounts.
Summary information vs. detail
Most of my clients find that it is always easier to gather together detail when information
is already separated, than it is to deal with one large lump sum and break it into its
component parts when an analysis is needed This also means that in general the more
accounts you have, the more you have alternatives as to how arrange your data. If
someone asks for total vehicle costs for the year as well as the expense for vehicle
repairs, it’s a lot easier to add together several accounts (one of which is for repairs) to
get the total, than it is to have the lump sum in one account and then have to go through
all the entries to identify and separate out those related to repairs.
Of course, this has its limitations. There is no sense in tracking every staple and every
paper clip. But it probably does make sense to have for example a "vehicle expense"
account with subcategories, breaking out such items as gas and oil, repairs and other
costs such as insurance into separate accounts. If the period results show a large
change in these accounts in one period, analyzing any ups or downs where you can
focus exactly on the separate categories is much easier than trying to look at one big
lump sum which is then tough to figure out.
Data layout
Arranged alphabetically
Your chart of accounts is probably arranged alphabetically. In addition to the various
expense categories, many companies break out salaries and benefits and put them in a
category by themselves. I prefer it this way. I find it easier to locate the information I
want.
Arranged largest to smallest
I have also seen the information arranged on the largest amount to dollars to the
smallest. This makes a certain amount of sense, since it focuses the discussion on the
revenue or expense line where perhaps management can have the most effect. If you
prefer it that way, then the most important thing is to make sure that the financial
information is presented to you in this way.
However, if the amount of expenditures on different categories change substantially,
some going up while some go down, then the order of the various expenses changes,
something that I think tends to be more confusing. With the techniques I am teaching
you, it would be hard for a large dollar jump or percentage change not to show up.
Breakdown by location or product line
Another set of categories (or more accurately sub-set), you should think about are
usually related to location. If you are in a larger company, which offers several different
lines of products or operates in more than one location, you probably also should think
about how you would break down your information by profit centre or geographic area
(the latter might be done by using the postal code).
Establishing a base line
Most of our clients have accounting systems, usually using QuickBooks or Simply
Accounting, that provide them with reports with some comparisons. Such reports are
always useful and contain needed information. At the same time, many people accept
these reports and their formats as being a rigid and unchangeable outline after being
told that “this is what the system provides”.
Firstly this is usually not true. Secondly, even if it is, I feel strongly that it is an
accountant’s job to get you the information you need in the way that YOU want, not as
dictated by some faceless programmer who happened to design an accounting software
program. Information can always be collected and rearranged. So push to get the
information provided to you in the way YOU want.
The spreadsheet described below gives you a broad and comprehensive look at what is
going on in the financial operations of your company. The example I use covers the last
three years, but it could cover any three period of equal length that can be equally
compared. So if your ‘standardized’ reports are not sufficient to do this sort of analysis
that I'm recommending, it is still easy enough to set up a sheet that will allow you to look
under the hood of your business and see what's really going on.
Spreadsheet tools
Most of this analysis is most easily done using Microsoft Excel or an equivalent
spreadsheet software program. This paper will explain how to lay out a spreadsheet to
perform the analysis you need. If you are not conversant with Excel or want to
accelerate the process, you can find an analysis template on the HighSpin website
under the section on ‘Resources’. Either way, the analysis is best done using a
computer and a spreadsheet program. You can do it on pencil and paper, but it will take
a lot longer and really then does require some knowledge of mathematics, and how to
complete the calculations you could need to make.
Step 1
First, set up a spreadsheet for your income statement. This can probably be most easily
done if you cut and paste the data from your accounting system, or export it to an Excel
spreadsheet. You may have to add some extra rows for categories for some years if
they haven't appeared consistently over the last three years. A simplified version of your
income statement might look something like this:
ABC Company
2009
Revenue
Sales
1,600,000
Other
8,600
Total revenue 1,608,600
Cost of Sales
900,000
Gross margin
708,600
44.1%
Overhead expenses
Advertising and Promotion
Depreciation
Insurance
Interest and bank charges
Office
Professional fees
Rent
Repairs and Maintenance
Salaries and wages
Telecommunications
Travel
Vehicle operating
Total expenses
46,600
58,100
10,700
15,100
7,600
17,300
89,300
10,200
274,600
18,700
27,800
12,900
588,900
Profit (Loss) from Operations
Current income taxes
119,700
(3,200)
Net Income (Loss)
116,500
If you don’t have a Cost of Sales, then it might look even simpler, such as the following
ABC Company
Revenue
Sales
Other
2009
700,000
8,600
Total revenue 708,600
General and administration
Advertising and Promotion
46,600
Depreciation
58,100
Insurance
10,700
Interest and bank charges
15,100
Office
7,600
Professional fees
17,300
Rent
89,300
Repairs and Maintenance
10,200
Salaries and wages
274,600
Telecommunications
18,700
Travel
27,800
Vehicle operating
12,900
Total expenses 588,900
Profit (Loss) from Operations
119,700
Current income taxes (3,200)
Net Income (Loss)
116,500
The tables following presume that there is a Cost of Sales for each year
Step 2
Now add a column and set up exactly the same sort of information for the previous
fiscal year.
ABC Company
Revenue
Sales
Other
2009
2008
1,600,000 1,400,000
8,600
6,600
Total revenue 1,608,600 1,406,600
Cost of Sales
900,000
800,000
708,600
44.1%
606,600
43.1%
Overhead expenses
Advertising and Promotion
Depreciation
Insurance
Interest and bank charges
Office
Professional fees
Rent
Repairs and Maintenance
Salaries and wages
Telecommunications
Travel
Vehicle operating
Total expenses
46,600
58,100
10,700
15,100
7,600
17,300
89,300
10,200
274,600
18,700
27,800
12,900
588,900
48,000
60,100
6,500
16,100
14,500
38,800
84,900
34,400
258,500
19,200
30,700
17,100
628,800
Profit (Loss) from Operations
Current income taxes
119,700
(3,200)
(22,200)
15,400
Net Income (Loss)
116,500
(6,800)
Gross margin
Step 3
Add two columns to the calculations: one with the dollar difference between the two
years, the other with the percentage change representing the change from the numbers
of last year to where they are today. The formula for the percentage calculation is (in the
example below) the number for 2009 divided by the number for 2008 and then
deducting 1 (e.g. the formula on Line 5 might read +B5/C5-1).
ABC Company
Revenue
Sales
Other
2009
2008
Change
$
%
1,600,000 1,400,000 200,000
8,600
6,600
2,000
Total revenue 1,608,600 1,406,600 202,000
Cost of Sales
14%
30%
14%
900,000
800,000 100,000
13%
708,600
44.1%
606,600 102,000
43.1%
17%
Overhead expenses
Advertising and Promotion
Depreciation
Insurance
Interest and bank charges
Office
Professional fees
Rent
Repairs and Maintenance
Salaries and wages
Telecommunications
Travel
Vehicle operating
Total expenses
46,600
58,100
10,700
15,100
7,600
17,300
89,300
10,200
274,600
18,700
27,800
12,900
588,900
48,000 (1,400)
60,100 (2,000)
6,500
4,200
16,100 (1,000)
14,500 (6,900)
38,800 (21,500)
84,900
4,400
34,400 (24,200)
258,500
16,100
19,200
(500)
30,700 (2,900)
17,100 (4,200)
628,800 (39,900)
-3%
-3%
65%
-6%
-48%
-55%
5%
-70%
6%
-3%
-9%
-25%
-6%
Profit (Loss) from Operations
Current income taxes
119,700
(3,200)
(22,200) 141,900
15,400 (18,600)
-639%
-121%
Net Income (Loss)
116,500
Gross margin
(6,800) 123,300 1813%
Step 4
Finally, add another column for the financial results of two years ago. Again add two
more columns showing the dollar change and the percent change, this time between the
results of two years ago and the results of last year.
When complete, your complete table spreadsheet should look very similar to the table
on the next page
ABC Company
2009
2008
Revenue
Sales
1,600,000 1,400,000
Other
8,600
6,600
Total revenue 1,608,600 1,406,600
Change
$
%
2007
Change
$
%
200,000
2,000
202,000
14%
30%
14%
1,250,000
9,000
1,259,000
150,000
(2,400)
147,600
12%
-27%
12%
900,000
800,000
100,000
13%
750,000
50,000
7%
708,600
44.1%
606,600
43.1%
102,000
17%
509,000
40.4%
97,600
19%
Overhead expenses
Advertising and Promotion
Depreciation
Insurance
Interest and bank charges
Office
Professional fees
Rent
Repairs and Maintenance
Salaries and wages
Telecommunications
Travel
Vehicle operating
Total expenses
46,600
58,100
10,700
15,100
7,600
17,300
89,300
10,200
274,600
18,700
27,800
12,900
588,900
48,000
(1,400)
60,100
(2,000)
6,500
4,200
16,100
(1,000)
14,500
(6,900)
38,800 (21,500)
84,900
4,400
34,400 (24,200)
258,500
16,100
19,200
(500)
30,700
(2,900)
17,100
(4,200)
628,800 (39,900)
-3%
-3%
65%
-6%
-48%
-55%
5%
-70%
6%
-3%
-9%
-25%
-6%
49,100
64,900
7,700
8,600
14,900
35,100
78,700
8,600
238,000
17,900
31,900
8,300
563,700
(1,100)
-2%
(4,800)
-7%
(1,200) -16%
7,500
87%
(400)
-3%
3,700
11%
6,200
8%
25,800 300%
20,500
9%
1,300
7%
(1,200)
-4%
8,800 106%
65,100
12%
Profit (Loss) from
Operations
Current income taxes
119,700
(3,200)
(22,200) 141,900
15,400 (18,600)
-639%
-121%
Net Income (Loss)
116,500
Cost of Sales
Gross margin
(6,800)
123,300 1813%
(54,700)
32,500
26,200 (10,800)
-59%
-41%
(28,500)
-76%
21,700
In the examples above, I have set up the formatting in Excel so the negative amounts
show up in brackets and in red. This makes them much easier to identify. To do this in
Excel, go to Format Cells and select Custom: you will see a variety of format options to
allow you to do this.
This sounds more complicated than it really is. If you go through the steps methodically,
you will find that it is straightforward enough.
But there is a quicker way!
Fast track!
Although building it yourself may help you get a better understanding of the
methodology as well as allowing you to customize it to your specific business, it does
take some time and it certainly helps if you know Excel.
But not everyone has the time, and perhaps not the specific skills. So rather than
building it yourself, if you would like to get a free copy of this spreadsheet, please visit
www.HighSpin.com and click on the "free spreadsheet" tab in the downloads section of
the website. Besides the layout as described above with separate worksheets for the
balance sheet and also the income statement and the calculation of the variances, I’ve
also included a set of statistics and ratios useful in your analysis.
Analysis process
Now you're in a position to start your analysis.
The overall approach that you should take is "management by exception", that is, you
focus on the items that show the biggest and most ‘exceptional’ change, either from a
dollar point of view, or percentage point of view, or both.
If I have a choice as to how I first focus on the information, I will probably look at large
dollar changes even if they do not amount to much from a percentage point of view.
Similarly, I may ignore percent changes if the amount of dollars involved is not very
substantial (a 200% change from $100 to $300 does not warrant a lot of investigation).
The core of the analysis
Now you're ready to look at the information that the numbers reveal (remember, data is
the raw numbers, information is the meaning that you are able to get from the
interpretation of data).
Fixed and variable expense
First, let’s look at the types of expenses you will be analyzing There are essentially two
types, variable and fixed.
Variable
Variable expenses are those that change with every dollar of sales. For example, if you
are in retail, every time you sell a tin of tomatoes for $1.50, you will have a variable cost
of $.50 that you will have to spend in order to buy a replacement tin of tomatoes from
the wholesaler. If you sell two tins, your variable cost will be $1.00, three tins and your
variable cost will be $1.50, and so on.
Gross margin is the description of the difference made between the revenue you have
brought in and your Cost Of Sales (also so-called Cost Of Goods Sold). In the example
above, on the sale of one tin, the gross margin would be one dollar. It is also important
to express it as a percentage, in this case, 66.6% (dollar profit divided by the selling
price).
Why is it critical to express the gross margin as a percentage? When you look at
variable costs the dollar amounts will always be different month to month, as it is certain
that this will change every time your sales figures change. What becomes important is
the percentage change.
If you have the results mentioned above in one month, and then the next month your
margin drops to only 60%, you know you have an issue that needs to be addressed.
Maybe the cost has increased, and you have not increased your selling price. Perhaps
you had a discount in your purchase price in the previous month and this has now
expired. Another possibility is that there has been a certain amount of theft of goods for
sale, in other words you got no revenue at all from the stock of tins of tomatoes
although naturally you had to pay for them from the supplier.
Whatever the result, the fact that you can identify a percentage change gives you
information on which you can take action. You may want to increase your selling price,
you may choose to find a supplier whose wholesale cost is cheaper, you may decide
that you want to increase your security measures. Whatever steps you take, it is the
financial information that has helped to identify problem area. This is why doing financial
analysis on a regular and consistent basis will help you improve your business
operations.
Fixed
Fixed costs on the other hand are those expenses which remain essentially the same
regardless of how many sales you make. For example, you will pay a certain amount of
rent whether you make $1.00 worth of sales or $10,000 worth of sales. In the tables
above, there are such things as office supplies, professional fees, telecommunications
and vehicle costs that will all have to be paid no matter whether you have a good month
or a bad month in terms of sales.
In point of fact, some “fixed” costs are semi-variable. For example, every time you make
a sale, your office costs will probably not increase. But if over time, your sales rise from
$10,000 a month to $20,000 a month, it is likely that your overall office supplies
expense will go up, because you will be using more paper, toner, staples and other
supplier if your volume doubles. if you have one salesperson for each $50,000 worth of
revenue you are earn, then your salary expense will go in a step process, as you
gradually add staff when your sales increase.
In this section of the financial statements, you should be looking at both the dollar
amount of increases as well as the percent calculations. You want to manage every
dollar of expenditures here, so large dollar changes will be red flags to indicate that
something may be a problem. But you will also look at the percentage changes. If you
have $200,000 worth of salaries each year and they go by $10,000, the dollar amount is
large but on a percentage basis it is only 5%, perhaps a reasonable amount in the
circumstances. But if your travel costs go up from $50,000 to $60,000, the $10,000
increase is not only a large amount but it also represents a 20% increase, and that is
probably something that warrants more investigation.
Remember that a decrease maybe an indication of a problem or an opportunity, just as
much as an increase. It may also indicate that some information is missing.
Remember in the earlier section of this report when I talked about the importance of
making sure that all of the costs had been gathered into the accounting system before
the financial statements were prepared? A sharp drop in the category of one of the
expenses, fixed or variable, could indicate that there are some invoices missing or other
accruals that should have been made that are not in the financial figures. Once you
make a list of the items to be investigated, you may find that this is an explanation, and
means that you need to help your bookkeeper be more careful when he puts together
the numbers in the first place.
Things to watch for
The way in which you want to focus on the analysis results is called ‘Management by
Exception’. What that means is that you want to focus on the exceptional amounts,
large changes in either dollars or percentages for which you require some explanation.
As you become more experienced in the analysis process, you will find that you will be
able to look down the financial statements quite quickly and be able to spot the problem
areas, or at least items for which you require more information or reason as to their
large increase (or decrease).
There is a concept called the 80:20 rule, also called the Pareto principle after the Italian
who invented it in the 16th century. The rule says that you can divide business
operations and financial figures into two segments, one of 80% and the other of 20%.
80% of your customers will cause 20% of your problems. 80% of your expenses will be
straightforward, while 20% may need to be investigated. 80% of your sales will come
from 20% of your product line. 80% of your purchases will probably come from 20% of
your suppliers. The rule can be applied to all sorts of business operations and areas.
So Management by Exception means focusing on the 20% of the numbers in your
financial analysis that tell you that more information is needed.
Causes of changes
So what can cause changes in the numbers that you have now identified in the financial
statements? Note that just because the numbers changed. There may be a variety of
explanations for increases or decreases in either the dollar amounts or the percentages.
Note that they may not be ‘problems’ per se, but the analysis will tell you that you need
more information to tell you one way or the other.
Change in revenue
As discussed above, some of the “fixed” costs are semi-variable so if your revenue has
changed a lot so may some of the fixed costs have gone up or down Or if you had a
sale, while you may have sold more volume, you may have done so at a low unit selling
price which would decrease your gross margin.
Change in personnel
Did you add an extra employee to your staff? Besides the jump in salary costs, that
could produce additional increases in office expense, phone charges and/or travel
costs.
Mix of business
Do you have more than one product line in your retail business, each with different
margins? Do you offer both individual consulting as well as group classes (like HighSpin
does), at different costs to the individual? If this is the case, then there could be
changes in both the gross margin or fixed expenses due to an alteration in the mix of
business, in other words in the amount of sales you have in one product versus another.
This may require some additional financial tracking, or it may be something that you
understand quickly and intuitively because you know what special events happened in
your business in the previous month or the previous quarter.
Change in other items
Did you trade in a vehicle, or add another truck to your fixed assets? Is this the month
that your auditors came in so that your professional fees have a one time bill? Did you
have a lot of extra snow last month so that you had to pay something extra for snow
clearance? Was it your busy season so that you had to bring in extra part-time staff?
All of these could be issues that explain why your expenses went up or went down. In
other words, the process of analysis does not necessarily identify problems, it may also
just require some research into the reason why the numbers changed.
Problem areas
After all of these explanations have been considered however, it may be that the
analysis does in fact identify a problem. Are your phone costs going up because there is
an employee who is talking all the time to his mother in Indonesia? Have the costs for
your office supplies increased because someone is taking paper home for their own
computer? Are costs for repairs and maintenance up because no one is monitoring
what is going on, or alternatively does it indicate that a piece of machinery is starting to
wear out and should be replaced? Are heating costs going up because your office is
poorly insulated, or is it because winter is starting (you can tell I live in a colder climate!)
Comparison against budget
In the example above, I have done a comparison between the actual results for the
current year and the actual results for the previous year. But this may not always be the
most meaningful comparison, and instead, you may want to compare the actual figures
to a budget that you prepared at the beginning of the year.
If the revenue for your business is going up sharply (as I hope it is for everyone reading
this), then comparing this year’s fixed costs against last year’s may not have a lot of
meaning. If you have moved into new offices, or hired new employees, or opened a new
sales territory, all of these will obviously have an impact on your financial results.
If that is the situation, then a comparison with the budget amount for the month may be
a better form of analysis to undertake. And the process identified above is still exactly
the same. You are still looking for either dollar or percentage amounts that are out of
line with what usually would be considered “normal”, and so will require some
investigation.
For a paper on how to build an effective budget please go to the website at
www.highspin.com to see this report as well as other material that can help you run your
business better.
Summary
There are two steps in the financial analysis process. The first is to identify items or
areas where there may be problems. The second is to find the explanation as to what
caused the changes in these figures and whether there are steps that you have to take
to make sure that the problems don’t occur again, or that you can get the figures back
on track in another way. You cannot take action on items until you have found those
that have a problem. Likewise, it makes no sense to have the financial analysis
presented to you and not understand the figures enough to take action on areas that
need your attention.
The process I have identify above may seem complicated at first, but like a lot of
unfamiliar processes, once you have started to do it regularly it will become very quick.
in fact it does not take a long time to set up, and when you have done so, you will find
that the analysis itself becomes quite straightforward. While they may not come in the
exact format laid out above, you may find that very similar financial reports can be
obtained directly from your accounting system.
Whatever method you use, setting up the spreadsheet as defined above, or
downloading it from my website is not a very long process when the result is that you
will have a procedure that will not only allow you to look at your business in a different
way but also to manage it a lot better overall!