When businesses’ financial results are completed, as is currently the case with many small to medium sized enterprises (SMEs), too often they are simply filed with a sigh of relief that it’s another task finalised for another year.
But Mr Simon James, partner with accountants and advisers HLB Mann Judd Sydney, says that business owners should review their annual results, particularly the annual trends, to better understand how the business is tracking and how it could be made more profitable.
“Really knowing how sound a business is financially, and identifying trends and potential problems, is particularly important in times of difficult trading conditions, such as those we have now and which are widely predicted to worsen.
“Even business owners who have established management reports, such as monthly or quarterly progress against budget, can learn more from annual accounts.
“End of year accounts deal with what actually happened, not what might have happened, or what someone else thinks did happen, or indeed hoped would happen.”
Mr James said that he finds too many business owners take a position that they don’t really understand accounts so it’s pointless for them to try and analyse them – and anyway, they rely on others to do this for them.
“Apart from anything else, business owners who take an interest in the business accounts are likely to reduce the chance of fraud, whereas those who broadcast they don’t understand figures are almost inviting fraud.
“Those that are on top of their financial reports are also more likely to take early correcting action to resolve emerging problem areas so that they are more likely to survive any economic downturn.
“A great deal of value can be gained by spending as little as half an hour or so looking at a few items in the P&L and balance sheet in the annual accounts in a logical way. Owners don’t need a degree in accounting to make sense of a few key areas and identify potential problems,” Mr James said.
He suggests owners should look at five basic areas, even if they are not particularly financially literate. They are:
This is a critical comparison every year. How does the profit compare with the year before? Is it in line with what was expected? If not, look at the total income to see if there is a big difference from the year before. If income has dropped in an unexpected way, find out why. Which customers are buying more or less and what is the reason for this trend? If income hasn’t varied significantly from the previous year and is in line with expectations, any profit fall must be because of increased operating costs and the owner needs to check expenses.
Growing areas of cost
Rather than analysing each expense item, which can take a lot of time, a better approach is to look at anomalies or exceptions. For example, if “cost of entertaining” has risen dramatically over the previous year, ask why. Are there good reasons for it or is it an area where more control is needed? Is someone using a company credit card on non-company items or spending too lavishly, and unproductively, on company entertaining?
Similarly, if staffing costs have increased more than expected, find out why and be satisfied it’s appropriate for the business. Are all employees really necessary or is the business growing soft? Looking at changes in costs year-by-year can be a very good reality check – and all increases in expenses will have impacted on profitability.
By taking this approach, the reasons for any significant difference between last year’s profit and the previous year can be identified, and strategies to correct any problem areas implemented.
Year end is a good time to look at significant costs in the business, such as telephones, insurance etc and get updated quotes from your service providers.
When owners are satisfied that the profit is as expected, there are a couple of other checks to make before they look at ways of spending it. They should understand the difference between profit and cash-flow and the importance of the latter on the health of the business.
Source of funds
This area of a balance sheet can take a bit of understanding, but it is worthwhile for business owners to know where the funds that run the business are coming from – and what they cost.
If there has been an unexpected increase in borrowings, find out why and try to take correcting action.
The best source of funds is always from sales but if the debtors’ list is getting longer, it means the business is providing cheap funds to customers, which means their own cost of funds through borrowings is likely to be growing.
Problems with the source of funds and having sufficient liquidity is often an early warning sign that not enough sales are being made to cover operating costs, that profit margins are not good enough, that there are unnecessary costs, or that there are potential bad debts.
All business owners and managers should be keeping an eye on debtors in the current trading conditions. If not already in place, make sure that current debtor reports are provided regularly so the aging of debtors can be monitored. Prompt action must be taken on any slow paying or, even worse, non-paying customers. Continuing to supply non-paying customers is almost certainly throwing good money after bad no matter how important the customer is. Bad debts are a loss of capital and a drain on liquidity and can send a company out of business.
This is another area for potential problems that is often overlooked or not recognised. Rising inventory levels could mean sales in some lines are slowing or that over-ordering is taking place.
In either case it means capital is being tied up unnecessarily and that there is increased potential for obsolete, and perhaps unsuitable, lines being held. Investigate stock levels and try to liquidate old or unwanted lines. Inventory is also an area of potential fraud – purchasing goods through dummy companies that are not delivered, in addition to theft, is a common feature of ongoing fraud in a business.
For more information please contact:
Simon James – 02 9020 4212
10 October 2011