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Reading Your Business

Minority and majority shareholders alike may learn valuable information from reading your company’s financial statements on a regular basis. Your financial statements are not just for the accountants and auditors. They can be a great source of information to help you run your business, big or small.

Comparative financial statements reflect current period information for the month or year along with the information for the same period of the prior year. This allows us to compare and contrast the current financial data and look for reasons why the various income and expense categories have changed. Some explanations are obvious. Others can be a bit surprising, requiring more analysis and changes in the way a company does business or disclose the need for organizational change.

A common size income statement takes the various income and expense items and expresses them as a percentage of sales. Therefore when we compare various years or periods of income, the changes in values become more evident since total sales are always the same. Minority shareholders who are not as involved in the day-today operation of the company as his partners may find this an extremely useful tool to confirm or dispel suspicions of fraud. For example, this comparison is an easy way to see if someone is mismanaging or even misappropriating assets through an expense category. Or, such a comparison could show, for example, that utility costs are up due to rising energy rates, that interest rates are rising, or that material costs are up. It provides a quick look at expense categories to determine if you can reasonably explain a change or lack of change when one may be expected.
Basic ratio analysis is another tool to use in reviewing your financial information. Simple ratios like the current ratio and the acid test ratio measure liquidity. The current ratio is computed by dividing current assets by current liabilities. The acid test ratio is current assets less inventory divided by current liabilities. While the ideal ratio will differ for each business, typically a current ratio of 2:1 and an acid test ratio of 1:1 is considered good. Tracking these ratios over time and noting improvement should be the goal.

While there are numerous other ratios to consider, and many are standard in computerized bookkeeping programs, you need to monitor those that will have the greatest impact on your business and those monitored by your banks. The ratios monitored by your banks may be different to those you need to monitor your day-to-day operations. While financial institutions want to know about liquidity and leverage ratios you may need to know about gross margins, costs per square foot or unit and return on capital employed. Your accountant should be able to assist you in determining key indicators for your business that you can monitor on a regular basis.

You should also receive as part of your financial statements a statement of cash flows. The statement of cash flows reconciles the income from the income statement with the cash on the balance sheet by adding and subtracting non-cash and non-income statement items. This will show cash flows coming from increased debt, capital infusions or sales of capital assets as well as decreases in cash from debt principal repayments, capital equipment purchase or other distributions. This snapshot of cash flows can help answer the question of “where is the money?”

Fortunately, most of this information is readily available through most commercial accounting software. You can also find most of the information you need in your annual business tax return. If you are not monitoring these items already you should discuss them with your accountant.