How to analyze financial statements Contents
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........................................................... 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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!
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