STOP THE FAIL

Financial statements summarise the historical performance and position of a business, yet many business owners do not know how to analyse figures, let alone identify potential issues.

How to find your way through financials.

Not all financials are equal, so it is important for business owners to read the entire document when reviewing financial statements. These documents may include sections such as management commentary, notes on accounting policies, and financial itemisations such as revenue by product or a breakdown of plant and equipment by class.

Also, the rigor with which the documents are prepared can vary significantly, for example:

• Management accounts – generally subject to limited scrutiny, these are prepared for internal reporting purposes and have significantly less disclosure requirements

• Special-purpose f inancials – generally prepared for small and private companies, these are not audited

• Published f inancials – f or listed companies, these are independently audited and must comply with relevant accounting standards.

There are also many different t ypes of users of f inancials, such as business owners (to assess performance and to inform s trategic decisions), prospective investors/owners (to assess performance, calculate how much to invest/ pay, and to gauge potential), lenders (assessing debt ser vicing and security) and the ATO and other t ax authorities (to assess stamp duty and ensure the appropriate amount of t ax is levied).

To understand financial statements, they f irst need to be defined. Financials generally include:

• a statement of profit or loss and other comprehensive income, which summarises historical financial performance over a p eriod of time (the reporting period, generally a financial year, but possibly shorter or longer in certain circumstances).

Typical line items include revenue or sales, cost of goods sold (known as COGS and being costs directly attributable to s ales), gross profit (revenue less COGS), operating expenditure (overheads such as advertising, rent, utilities, s alaries and wages), net profit (gross profit less overheads), t axation and net profit after t ax (also known as the bottom line).

• a statement of financial position (balance sheet), detailing assets and liabilities at t he reporting date (generally 3 0 June).

Typical c ategories of assets and

The first thing to understand is profitability and how that of the business compares to industry players or competitors.

liabilities are current assets (assets readily convertible into c ash within a 12-month period, and t ypically trade and other debtors, inventory and c ash at the bank), non-current assets (those intended to be kept for longer than 12 months such as buildings, plant and equipment), current liabilities (amounts payable within 12 months such as trade or other creditors and an overdraft account), non-current liabilities (those payable after 12 months, such as long-term f inancing and loans), and equity (should equal the sum of all assets less all liabilities, and generally comprises retained earnings, which are the sum of all profits/losses since the start of the business, and the shares in the business, such as c apital invested.

• a statement of cash flows, summarising physical receipts and payments over the reporting period. This differs to profit and loss, which may include revenue not actually received, such as a s ale with 3 0-day credit terms, or expenditure not yet paid, such as an increase to employee provisions).

There are three key c ategories of c ash flow – o perating activities (transactions associated with the primar y activities of the business, such as receipts from sales, payments to suppliers and employees), investing activities (the purchase or s ale of assets used to generate income, such as plant and equipment) and financing activities movements in borrowings like bank loans or f inance lease liabilities, and equity.

FIRST STEPS

Before s tarting your analysis, the f irst thing to understand is profitability and how that of the business compares to industry players or competitors. For example, a company may be making a profit, but the margins may be lower than the industry norm or benchmark.

The profit and loss and c ash-flow statements show the profitability of a business, but to compare different sized businesses, margin or r atio analysis is required. These revenue multiples are often used:

• earnings (net profit) before interest and t ax (EBIT) as a p ercentage of revenue. Note, a positive number does not necessarily mean the business is making money at its bottom line, as EBIT excludes certain expenses like f inancing (interest and principle repayments), tax and c apital expenditure.

• gross margin ( gross profit divided by revenue). For example, if the gross margin is 20 per cent and overheads are $100, the break-even sales point is $500.

Other revenue ratios to consider include employee costs, rent and depreciation. These ratios can be benchmarked against industry data to identify areas of concern.

Liquidity ratios are used to assess the health of the business, in other words, the ability to pay its bills. These ratios are often used: current ratio (current assets divided by current liabilities), working capital ratio (debtors plus inventory divided by creditors) and quick ratio (current assets less inventory divided by current liabilities).

The liquidity ratios of a “healthy” business should be greater than 1:1 and in line with or above industry norms. Generally, a ratio of 2:1 is accepted as the benchmark for a healthy business, but this varies by industry and the specific needs of a business. A ratio of 1:1 indicates no surplus funds are available af ter p aying liabilities.

BE OBJECTIVE

It is important to maintain objectivity when doing a f inancial analysis of a b usiness. Review the detail but

Review the detail but remember the big picture.

remember the big picture. Some common mistakes include:

If you are proposing to invest, sell, improve

performance or identify problem areas, obtaining good-quality advice is essential.

• failing to consider recurring and non-recurring revenue/expenditure, such as the current year’s profit being the result of one-off revenue such as a g ain from an insurance settlement (increasing p rofit) or litigation costs relating to an employee dispute (reducing profit)

• ignoring potentially unrecorded or misstated costs or liabilities such as related party arrangements that are lower than market r ates (like rent when the property is owned by the business owner or related party and offered for use at nil cost or at a discount) or the use of equipment not owned by the business but needed for production (maybe at little or no cost when owned by a related party). There c an also be legal actions or an understatement of liabilities such as employee leave provisions

• not identifying profit manipulation, such as early recognition of revenue (the early receipt of funds from a s ale when the service has

not been offered or the product has not been provided), rundown of stock to improve margins, absence of provisions for commitments such as employee leave balances, income tax payable or warranties (estimated cost of having to repair or replace products provided) and deferral of purchases such as restocking raw materials, inventory purchases, or the servicing or repairs of assets. • not considering the basis of preparation, such as the supporting data for management’s estimates

• ignoring supporting commentary (perhaps the auditor has drawn attention to something important)

• not considering risk that may impact on performance, which can be internal (such as overreliance on a key customer or key management), industry related (emerging technologies making products obsolete) or economic (like the Reserve Bank increasing interest rates).

Obtaining expert advice can be invaluable when looking to make important decisions. If you are proposing to invest, sell, improve performance or identify problem areas, obtaining good-quality advice is essential. E xperts often do reviews so know where to look, which questions to ask and what factors to consider outside the financials.