SCORE Column: Use financial statements as a foundation for planning
Having a well thought out and written business plan will be a valuable tool for you. A good starting point to writing your business plan is to analyze and understand what your financial statements can tell you.
Fiscal year 2022 is ending. Next year is going to be a challenge. We hear more projections there will be a recession.
Having a well thought out and written business plan will be a valuable tool for you. A good starting point to writing your business plan is to analyze and understand what your financial statements can tell you. I’d like to share some of the techniques I’ve been taught to better use my financial statements.
Income Statement/ Profit and Loss
My starting point is to take the statements for the past two years and year to date (YTD) 2022. Using net revenue/income as a base, compute the percentage for each line item, both below revenue and above. The 2022 statement can be annualized by adding on the November and December. forecast or by dividing the October statement by 10 and multiplying by 12. The next step is to apply the Pareto Principle (20% of accounts explain about 80% of the results/expenditures.) Learn what is included in each of those accounts. Are they what you forecast and what will it take to make the results 5%-10% better.
The next step is to compare each line-item on the last two years and the 2022 YTD statements. Both dollars and percent. What has been the trend from Fiscal Year 2020? Are you OK with those trends?
Things to watch closely
- Revenue growth. Is the organization growing and gaining more business in your market? If not, why not?
- Customers gained and those who leave. Is the reason for the losses valid?
- Gross profit. Cost of goods sold divided by total income. You can check this for each customer or product line.
- Net pretax income. This number is developed by subtracting sales, administrative, research and development from the gross profit. Are those expenditures giving you a good return for the investment?
- Sales per employee. Divide total sales by number of employees. This is a measure of efficiency. You can also break this down by department. What’s the three-year trend.
The balance sheet details assets, offset by liabilities and equity assets shows where you invested your money. Liabilities and equity show where the money came from to buy those assets.
Things to watch closely
- Accounts receivable. Break down the accounts receivable in 30-60-90 plus days. Any account with funds over 90 days will be reduced from your collateral. Another measure of efficiency is accounts receivable turnover (net credit sales/average accounts receivable). The turnover reflects the organization's efficiency in collecting credit given to customers.
- Inventory. Calculate inventory turnover (cost of goods sold/average inventory). That’s a measure of the number of times the inventory is sold in a year. My target was at least four times a year. We also aged the items in inventory and those over 90 days (not the result of lead times) were used where possible or if possible returned to the vendor.
- Debt service coverage ratio. Debt service is the amount of cash available to pay principal and interest on loans. The ratio is net operating income/debt service. A ratio of 1.25 -1.5 is probably in the range your lenders want. Less than 1.0 could indicate financial troubles. What is your banker’s target?
- Return on Assets. Return on assets is income divided by assets. I’ve found it more useful to develop return on assets by multiplying percent operating profit (net sales/net income) by asset turnover(sales/assets). This calculation includes sales, profit and money tied up in assets. You can play “what if” when you change each of the three numbers. Is this the best place to put your money?
- Statement of cash flow. This document measures the inflow and outflow of cash. In troubled times this statement is probably the most valuable of the three. Your banker will be focused on this. Typical inflows are profit, depreciation, loans, reductions in both inventory and accounts receivable. Cash outflows would be losses on operation, pay down debt, capital expenditures, reduced accounts payable and increase in accounts receivable.
Your financial statements tell a story to your team and banker and are the foundation to move forward and be secure. Your accountant should be required to supply and interpret these documents for you.
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