It’s time to talk about financial statements. Whoa, whoa, whoa - don’t click back or close the window. Admittedly, it’s not the most interesting topic and, yes, it is risky writing an article about it. After all, you don’t like reading your financial statements, so why the heck would you want to read about them!
The answer is because your financial statements could make you millions.
And the best thing is you don’t have to become an accountant to read them.
By the end of this article, you will know how to quickly analyze a financial statement and then use the information to correct underlying issues in your business or spot emerging trends.
It takes five steps – they are fully explained below, but here is the quick-read version:
1. Make sure your financial statements are relevant
2. Read your financial statements
3. Focus initially only on the totals
4. Understand what the totals tell you
5. Drill down to areas identified as being an issue
The Difference Between Success and Failure
The key to financial success involves using financial information to laser target issues that you need to address.
To explain the process of reading financial statements, let’s use a restaurant business as an example. This particular business is struggling. It has plenty of customers, a brilliant chef, and an excellent front-of-house team, but there are months when it barely has enough money to cover payroll.
A different restaurant in a similar situation could be making enormous profits, however. If the level of service, number of customers, and reputation of both businesses are about equal, why is one close to collapse while the other is thriving? The answer could be because the restaurant owner with the thriving business reads and understands financial statements.
Here are the five essential steps to help you understand your financial statements.
Step 1 – Get the right type of financial statement
If you use a generic accounting tool set up to run on its defaults, you won’t get very far. This is because there will be too much noise and not enough of what is relevant. To borrow a cliché: you won’t be able to see the forest for the trees.
Don’t settle for a “standard” format that came pre-packaged with your accounting software. Instead, your format should be specific to your business and your industry. If the expenses on your income statement are simply listed in alphabetical order, that may not give you the appropriate measures to look at when determining how to improve your business. Once you have the appropriate format, comparing results across periods and to industry norms becomes possible.
In short, you need an accounting tool geared to your industry so your financial statements are properly formatted and relevant. In the example of the restaurant owner above, that would mean an accounting tool designed or configured for the restaurant industry.
You might need an accountant to help you put this in place, but it will be worth it in the long run.
Step 2 – Accept that you have to read your financial statements
Let’s be honest about this one:
· Financial statements are boring
· You would prefer to get on with running your business
· They are often difficult to understand
· It is particularly difficult to know what information is important as there is so much of it
What follows in the steps below is not going to change these points, with the exception of the last one. You will know how to identify the important elements of your financial statement, and you will learn how to use that information.
The whole process starts with accepting that financial statements must be read.
Step 3 – Focus on the TOTALs
This is the nitty-gritty of the process, but make sure you don’t get into the details of your financial statements too early. Most of it is not relevant to the task at hand. Remember, we are identifying the important information that will help you substantially improve the profitability of your business.
This requires mental filtering, and that means focusing only on totals.
In the restaurant example, the totals we would look at would include:
· Prime costs
Step 4 – Understand what the totals mean
Now you have to understand what the totals are telling you. In other words, you have to separate the significant from the insignificant, inconsequential, and coincidental.
For example, is your revenue down this week compared to last week? If so, is it up or down compared to the same week last month and the same week last year? By how much is it down (or up) on each of these comparisons?
Now look at the significance of these comparisons. On a scale of 1-10, how significant is it?
If your revenue is down one percent compared to last week, you would probably score it low on the scale. A fall of 20 percent, on the other hand, is significant and means you will have to move on to the next stage.
Step 5 – Drill down
In this step you should focus your efforts only on the significant observations you made in the previous step.
As an example, let’s go back to the restaurant owner. She might find that her prime costs increased by 10 percent last month compared to the month before. There is no obvious or simple explanation for this, so it is time for the drill down.
That means going deeper into the numbers, but remember you are targeting your efforts and narrowing your focus with each level.
So, the restaurant owner would look at the totals within her prime costs. There she sees the cost of sales (food, drink, etc) is fairly static. The cost of labor, meanwhile, has jumped by nine percent.
Now it’s time to drill down further, focusing only on the labor costs. For example, has the extra cost come from back-of-house staff or front-of-house staff? Once that is discovered a further drill down will probably reveal the root cause.
With this information, the restaurant owner knows where to focus her attention.
Ignore the Noise and Make More Money
Financial statements are fantastic tools but there is way too much data in them for any small business owner to make sense of and still have time to run the business. The way to deal with them is to focus on the major totals, identify potential issues, and drill down from there to get to the primary cause.
Doing this will give you a better understanding of your business. You will find and correct problems before they become unmanageable, you will spot business opportunities, and you will make more money.