Financial statements: Those thick boring packs of paper that you pay your auditor way too much to go over every year. The ones that come out six months after all the action has happened. Yes, the packs that collect dust in your cupboard because they are full of complex words and numbers that can only be understood by the partner that signed them off and the bank manager.
But what if this could be different? What if you could read and analyse your financials in a way that enables you to clearly recognise the past, understand the present and see the future?
Seeing into the future
Financial Statement Analysis is the process of analysing a company’s financial statements to gain an understanding of the financial health of the company and to enable better decision-making.
Financial statements only record data; proper financial statement analysis makes the data useful to the entrepreneur. It enables you to understand profitability and its drivers, to foresee cash flow and liquidity problems, to better manage your assets and resources and to identify and mitigate risk.
Sound a bit complicated? It doesn’t need to be. Starting with the basics, an entrepreneur can already gain invaluable information about trends and risks in his business.
Comparative Financial Statements: Calculating increases and decreases year on year
This enables one to see growth patterns clearly, and see the difference in growth of specific line items when compared to that of others.
Index Analysis : Choosing a basis year as 100% and stating all other years as a change in percentage
This is another simple way to clearly see growth patterns over various years.
Common-Size Analysis: Stating total assets in the balance sheet as 100 and showing all other line items as a portion thereof.
The same goes for revenue in the income statement.
This helps one identify line items that are material when compared to total assets or revenue. It is a nice tool to identify risk areas.
The above three methods can be applied equally effectively to both the income statement and balance sheet.
Once we understand the trends in our business and the composition of our financial statements we can get to the juicy stuff:
Ratio analysis is a number of different calculations that one can apply to financial information to obtain useful information and make valuable conclusions. They can predominantly be classified as and use for the following:
Liquidity ratios: Measuring the company’s ability to meet short term obligations (whether or not current assets are enough to pay for creditors and tax in the short term).
Solvency ratios: Measuring the company’s ability to meet its long term obligations (whether or not the company will be able to pay off its long term loan to the bank).
Profitability ratios: Measuring the company’s ability to generate profit from its assets (whether or not assets are being used to generate adequate revenue and profit).
Activity ratios: Measures how well a company performs its daily activities (inventory turnaround, debtors’ collection, etc.).
Examples of these ratios and pointers on their interpretation can easily be found with a quick search and have been excluded for the purposes of this article. But let’s make ratio analysis practical with one thorough example, using the net profit ratio (one of the basic profitability ratios).
Consider the following extract from an income statement:
At the first glance, the entrepreneur sees a healthy increase in income of around 40% per year. He also sees that profit has increased with 19% in 2013 and 31% in 2014, leaving him feeling quite content. But let’s dig a little deeper, using the net profit ratio.
Net profit ratio = Net profit/Income
Doing the calculation as above, the net profit ratios for each year, starting with 2012, decreases from 7,3% to 6,4% in 2013 and to 5,9% in 2014. This shows a negative trend, alerting the entrepreneur to look closer. He’ll see that his expense increase is stable at around 34% (less than increases in income), but that his cost of sales has actually increased by more than income (around 47%). Upon investigation, he has found that his cost of sales have grown so fast because his suppliers are asking higher prices, in turn because of their higher import costs due to the weakening of the rand.
Our entrepreneur realises that if he does not do something about his cost of sales structure, his business will soon be making losses because of the increases in cost of sales, even though his revenue is growing. This foresight will enable him to find better suppliers or to start importing himself in order to cut cost of sales, ensuring that his business’ bottom line will keep growing in future.
It’s no crystal ball, but good solid financial analysis has enabled him to see the future and adapt ahead of time in order to drive his profits in 2015 and beyond.
For some first-hand experience in financial statement analysis, come join one of our FREE financial function workshops hosted at the Bandwidth Barn on a monthly basis.
Financial Metrics In The Business World – Keeping An Eye On KPI’s
The results and findings after each analysis, using the relevant metrics, then create a premise for strategising and executing specific tactics needed to improve, uplift, as well as highlight where increased attention should be directed.
Monitoring sustainability and the condition of a company’s business model plays a key role in the overall performance and success of an organisation. If these are given the required attention, it would enable easy identification and corrective protocol to eliminate or curb potential problems or detriments.
One of the accounting metrics serving this functionality are Key Performance Indicators, better known as KPI’s. Metaphorically speaking, you could say that just as an Electrocardiogram would monitor your heart, so to would specific KPI’s measure up the health and activity of particular areas of a business. This ultimately leads to a fine-tuned route to achieve financial success.
The two main relative KPI’s would be Financial and Non-Financial. The former would assist in portraying a full view landscape which proves critical when it comes to competitive advantage. These provide quantifiable accounting metrics that are simple to analyse, hence easy to act upon.
An example would be the Debt to Equity Ratio – a ratio calculated by looking at a business’s total liabilities in contrast to the shareholders’ equity. This indicator is vital, helping to keep focus on the financial accountability.
The latter, being Non-Financial KPI’s, are measures not quantifiable in monetary units. Typical non-financial KPI’s would range from product and service quality to human resource management. Also an essential avenue to keep a consistent tab on in order to maintain an ardent image.
A critical element in forming these metrics would be ascertaining what is important to the organisation at hand. The development of KPI’s should be part of an overall strategic management process that connects the mission, vision and strategy of a business. Keeping in mind the goals, both in the long and short term.
Aside from the metrics relating to KPI’s, the most crucial aspect in financial management would be accuracy. Processes that aren’t efficiently controlled along with inaccurate data input, will inevitably have an adverse effect on the business and also leave a window open for measurement inversion. Imagine executing massive plans based on incorrect results and information. This could jeopardise any business severely. Furthermore, the most advanced metric structure proves futile if the information used to ascertain a desired result lacks accuracy. Hence, any enterprise must ensure that there are always effective controls in place with heightened scrutiny over accuracy levels. Regular checking procedures and reconciliations at set intervals need to be structured to maintain this.
Small Business Has A Critical Role To Play In The Economy – But Entrepreneurs Need Better Financial Skills
While government is stepping up to support small business more than ever before, the sector will not thrive unless entrepreneurs are also equipped with the financial tools to optimise their organisations – UCT Associate Professor Mark Graham.
The role of small business in promoting growth and development has shot to the top of the agenda this year with both President Ramaphosa in his inaugural SONA and Minister Malusi Gigaba in his budget speech highlighting the critical role of this sector of the economy.
Globally, SMMEs are recognised as one of the key drivers of economic growth and job creation – and it is clear that the small business sector has led the world out of several global recessions – but in South Africa, the sector is under-performing.
Entrepreneurs need help to become sustainable
Recent data from the Global Entrepreneurship Monitor shows that South African entrepreneurship lags behind that in similar economies. And for every 1.5 people who were engaged in early-stage entrepreneurial activity in SA in 2016, one was exiting a business.
According to Mark Graham Associate Professor in Accounting at the University of Cape Town, typical reasons for business failure include: insufficient start-up funding, incorrect pricing for products or services, growing too quickly or prematurely, and inadequate cash flow.
“We need entrepreneurs to run their businesses successfully so that they can be sustainable,” he says. “Most of these issues can be addressed through a proper understanding of financial and accounting principles and concepts to help entrepreneurs run their businesses better.”
A growing understanding of financial principles
Graham, who runs the Finance for Non-Financial Managers programme at the UCT Graduate School of Business (GSB), emphasises that finance and accounting terms are really just a language that uses numbers to tell a story about a business.
“If you understand the fundamentals of financial principles you will be able to analyse what is happening in any organisation,” says Graham.
“Concepts like profit and cash flow are basic to business. However, people are often surprised to find that while a business can be extremely profitable, there may be a cash flow problem that will soon bring it to its knees.
Most people don’t know the basics of financial reports, what the right capital structure (i.e. the mix of debt and equity) might be. By getting to grips with concepts like working capital management and cash flow vs profit, business owners and managers can give themselves the best chance of success.”
Financial literacy is key to entrepreneurial success
Jannie Rossouw, head of Sanlam’s Business Market, agrees that financial literacy is key to entrepreneurial success and has argued that it should be integrated into the school curriculum so that future business owners can understand critical concepts like the time value of money.
“It is imperative that SA starts to spend significant time and resources to address the need for access to quality education aimed at those who want to pursue entrepreneurship and business ownership. We shouldn’t only start teaching these skills at the tertiary level,” says Rossouw.
And it is not just entrepreneurs that would benefit from a better grasp of the basics of finances, says Graham. All businesses should invest in developing the financial skills of their people – especially those in managerial roles.
“It is important for everyone working in business to understand the basic language of business and demystify the jargon – which is one of the things that the course I run at the GSB seeks to do,” he says.
“Feedback from previous course participants shows that people really appreciate being able to see how the numbers are telling a story about the health – or lack thereof – of a business and that this helped them make better business choices.”
Financial tools are needed to optimise businesses
“Sustainable small businesses have big potential to make a significant contribution to the SA economy and put a dent in the unemployment figures. So when Gigaba said that by enabling new businesses with new ideas to emerge and thrive, ‘we are radically transforming patterns of production in the economy’ he is not wrong.
But unless serious steps are also taken to equip owners and managers with the financial tools to optimise their companies, we will find that despite more proactive government policies and funding, the small business sector will still not thrive.”
Build A Financial Model
Start-ups often struggle to develop a suitable financial model for their new businesses. Here are some of the most important financial modelling considerations.
All budding entrepreneurs spend long hours typing up a well versed strategy document for their new entity, as expected. However, very often there is insufficient time allocated to the crux of the business, the numbers.
Definition: Financial modelling is the process by which a firm constructs a financial representation of some, or all, aspects of its business.
For any new start-up entity the initial necessity for assessing potential returns on new investment or seeking external funding can be a daunting process. Whether you are soliciting funds from an institution, or a high net worth individual investor, the financial projections could make or break your deal.
Although you as the founder are naturally optimistic about the new venture, be mindful that most investors would rather see the worst case scenario. This allows the potential investor/banker to take a realistic view on the maximum potential losses, should the business fold in the first 12 – 24 months. As such, it is recommended to produce a low, middle and high road model, for a three to five year period.
Inputs and outputs
Most importantly, always keep in mind that your financial model is nothing more than certain inputs producing certain outputs. By designing the model correctly, a user should be able to change certain inputs to assess the impact of these changes on the related outputs (commonly referred to as a ‘what if analysis’ or ‘stress testing’ a model).
By way of a simple example, your sales revenue line for any specific month should be a function of the number of products sold, at a specific sales price.
For ease of use, both you and a potential investor should be able to adjust either of these variables in order to see how resilient the business model is, should your assumptions be incorrect.
Other basic recommendations when building your model:
- Create an assumption page, clearly defining any assumptions on which the model is built. By linking certain variables to the assumption page the model becomes robust and user-friendly.
- Be as transparent as possible, showing all formulae that lie behind calculations. This allows the user to easily follow logic through the model.
- Aim for simplicity and ease of understanding. Over-complicating a financial model with unnecessary worksheets can confuse and overload the reader.
- When inputting projected overheads, deal with each line item separately, without consolidating. This demonstrates detailed thinking, and allows discussion around each expense if necessary.
- The model should evolve with the business. You should be looking to check the assumptions made at the inception of the business, with the reality of what is achievable, after having the benefit of hindsight. By tweaking the numbers accordingly, the model becomes a more accurate prediction of the business in the future. This should be an ongoing process.
- Beware of attempting to use a generic template that may not apply to your business. Trying to customise these generic models could complicate a would-be simple model. Building your own bespoke model from scratch is the cleanest approach, even if assistance is necessary. This forces you to learn the intricacies of your model, which will hopefully stand you in good stead.
- Many books and websites recommend a myriad of options when it comes to building financial models. As a principle, lean towards the concept of simplicity, provided you are able to integrate your model into regular projected income statement, balance sheet and cash flow statements.