How to understand your financial statements?
This is the time of year, the financial results!
The majority of businesses select the end of the year as the end of their financial year, and public companies announce their financial results. If you notice, a profit or a loss is never announced in an absolute value. They always add a percentage next to it. For example, Microsoft will announce a net profit of USD2 billion for 2020, a 20% decrease for 2020. Why is that? Because an absolute value doesn’t mean anything. A profit of USD2 billion or a loss of USD5 million isn’t a proper representation of the financial situation of a company.
You need to compare this figure with your last year' net profit, is it more or less? You need to look at your total revenues, is it more or less than previous years. The next step is to look at your expenses. Have they increased? By how much? Which costs increased more than last year? You need to compare your financial statements of 2020 and the two previous years. The comparison and interpretation of the financial ratios are crucial in understanding what went wrong or well. This will allow you to rectify what when wrong and continue doing what went well. If in 2019, you had a loss of USD5 million, and in 2020 a loss of USD1.9 million, we can clearly see an improvement. It means that there was a strategy or some modifications that lead to this improvement.
By conducting a horizontal financial analysis, you will be able to know which strategy was successful. Your financial statements are like medical results, they will inform you about your business health. You will know which area is not performing well.
By conducting a vertical financial analysis, you will further investigate the causes and reasons for bad or good performance. As an example, if you have recorded a net loss in 2020, you will need to conduct a vertical analysis to know if it is resulting from lower sales or higher expenses. That is the first level of investigation. Then you need to dig deeper to know if, for example, the decrease in sales is due to high prices or products/services not meeting the customer needs. It might be external or internal factors like bad customer service. By understanding the real problem and not the symptoms, you can start creating strategies to improve your current situation. If it is a pricing issue, you can conduct a competitor analysis. If it is a product/service not meeting your customer needs, you can conduct an innovation session to create a new product or service for your customer needs. If it is a customer service issue, you can map your customer journey and conduct surveys.
The financial statements are used to calculate the financial ratios to provide a deep-dive analysis of your business health (past & future). The financial ratios help you recognize your successes, identify your problems, and solve them. The interpretation of the results is an important step. In the table below, we provide a list of recommended financial ratios for small businesses.
Key ratios analysis for small businesses:
You should conduct a financial analysis every month, especially during uncertain times. This will allow you to be aware of changing trends in your business. This process requires a good knowledge of your business, your sector and being able to identify the reasons and the problems behind the fluctuations. We are here to help you and offer advice and support to improve your financial situation. Please feel free to contact us to further discuss the ways we can help you.