FINANCIALLY $PEAKING: Now That You’ve Got All The Numbers … What do They Mean?
We recently received a call from an owner of a small business inquiring about our services. His former accountant had retired and he was looking for a new firm to take over his accounting and tax services.
"One special thing about Pete" he said, "was that we always got our monthly financial statements no later than the end of the following month". "Rain or shine, vacation or illness, Pete always delivered".
Following that call we scheduled a meeting to discuss our services and review his requirements. As requested, the prospective client brought along his financial statements and tax returns for the last three years. His statements were a little too basic; a balance sheet and income statement, only dollars, no percentages and only the current month and year-to-date reporting period was shown on each of the thirty six financial statements.
He had a fairly good increase in revenue between the years 1999 and 2000 and his profit increased as well. "Not a bad year of growth", he said. After a few minutes of number crunching I asked him what caused the problems in gross profit and income for 2000. "Problems? What problems?" he said. Sales are up, income is up, what problems? The problem I said, is that your costs increased faster than your sales did.
In order to understand financial statements, looking at one period of time isn’t good enough. To understand how well the company did you have to ask, "compared to what?" Compare yourself to yourself by comparing the current year to the prior year. Try comparing yourself to your competition, to your industry, or other comparisons as long as you can learn more about your business. (Try Robert Morris studies at most libraries for industry comparisons.) If you receive only basic financial statements you too could be missing the big picture when it comes to understanding your true business performance.
Vertical analysis is relating each item of cost and expense on an income statement to total sales through percentages. What percentage is your direct labor or direct materials as a percentage of sales? What were those percentages last year? The same is true of other costs and expenses. Horizontal analysis is comparing your current income statement to the prior year. This also includes showing the dollars of change and percentage of change for each item on the statement from the prior year to the current year.
Had our prospective client done so he would have clearly seen that, while year 2000 sales increased by 28%, costs were up by 38% from 1999. Although profits increased, they might have been 10% higher had the company maintained the same cost relationships as the prior year.
Sometimes you can act to correct the problem, which may be due to increased costs, higher scrap or spoilage, substitution of higher costing components etc. Maybe a price increase is needed. Whatever the cause you can’t act at all unless you’re aware of a problem.
While a little care is required in the analysis, you should also be able to determine the extent of the problem when you find one. Take the cost percentage relationships of your good year and apply it to the sales of a bad year for a proforma amount of what costs should have been. The differences between the proforma amounts and the actual amounts, regarding variable expenses, will approximate the extent of the problem.
If you’re looking at only at numbers ask for a little more. Accounting is more than numbers ... it’s knowing what the numbers mean.
For more information, click on the Author Biography link at the top of this page.