Clients ask accountants quite often questions around the condition of their numbers. Business owners want to know what their financial statements are saying. There is a desire to understand what is going on with their business numerically, and how to make decisions based around that. Are my numbers good or bad? Do I need to be concerned or celebrate?
Look at the past to understand what’s coming
Your typical basic financial statements are an income statement and balance sheet. An income statement is more like a movie to show what happened during a period of time regarding revenue, costs, gross profit and net income.
A balance sheet is a picture at a specific point in time to show financial health by using components such as cash, liabilities and equity. There are many factors that impact these numbers so at face value, the most natural answer to the question if my numbers are good or bad is to say “I don’t know”.
In order to make an informed decision we need to understand the company’s expectation, strategic direction or timing (at a minimum). We may be in a seasonal industry during a slow time of the year, or we would be underperforming in a really busy time of the year.
One thing to watch for is false positives or negatives. As a result, to tie it all together, one of the first questions an accountant needs to ask is how did we do before? That way we can test ourselves against history.
Where to start looking
We often will ask for either the previous month’s income statement and balance sheet. Or maybe all previous months over the last three years if it is available. The more historic context, the better. That being said, we have to be careful to put too much weight into historic performance as that is only one aspect to look into.
In addition, we need to keep in mind that an annual set of financial statements are very different from interim financing statements produced during the year. For example, a first quarter income statement and balance sheet can tell you one story while looking at the full fiscal year can tell you something different. One reason for the distinction between the two is now the full business cycle has completed and the business went through the peaks and valleys that it may experience.
With all this in mind, one tip in reviewing an interim set of financial statements is to look at the income statement first because it will show you how the business is performing and if there are any adjustments that need to be made. Similar to how a director of a movie may review previous scenes to decide on any adjustments to future scenes, the income statement shows if our revenue or costs need to be addressed in future months.
On the other hand, when looking at an annual set of financial statements, reviewing the balance sheet first can provide context of how we did. It will tell you if the company is financially healthy or not through the lens of assets, liabilities and equity after the year has completed.
Please note that these tips are only meant to serve as a starting point in the variety of items you need to review to build the full picture.
Knowing what questions you are seeking to answer can help lead you to what needs a deeper analysis.
How to determine if the company’s financials are healthy
First thing to look at is cash. Cash is tied to many different parts of the balance sheet. When looking at cash, also look at accounts receivable and inventory. If cash is in a decent place, but receivables are low, then you may have an issue with sales volume. On the other hand, if cash is healthy but inventory is low, then the company may not be positioned well enough to satisfy future revenues.
Fixed assets and Liabilities are other sections to review. Are our liabilities going up or going down? How does that align with company strategy? Am I comfortable with the type of debt we have (Accounts Payable, Credit Cards, Line of Credit, Long Term Debt to name a few)? You may be in a season where you are okay with higher debt to buy more inventory to grow the business. Or you may have suffered through long periods of high debt balances that you really want to bring down.
There are many other factors that take part into understanding the numeric health of your business. If you need any help or would like an independent review, please feel free to contact us.