Analyze Financial Statements: Know Your Numbers

Numbers and business are inseparable. However, numbers aren’t just a requirement for keeping track of your company’s history when you analyze financial statements. More importantly, numbers can be used to steer the trajectory of a business. You can trigger a profound ripple effect that can bring wide-scale change by tweaking just a few numbers here and there.

Ultimately this can create a massive change in the number that really matters: the bottom line.

Also, having a grasp of your business numbers will help you to be more resilient by planning for every contingency along the way. Knowing your business numbers could also help you grow faster by allowing you to reinvest the money you make in savvy ways.

While you might prefer not to deal with these facts and figures, you must get over it. With a basic understanding of key numbers, you could start earning much more in your business.

This report will act as an excellent jumping-off point by outlining some of the key numbers you need to know and how they relate to one another.

Specifically, we’ll look at just four numbers and briefly review their role in defining your success.

1. Revenue

Revenue is a helpful indicator of how much your product or service is ‘worth’. Your revenue is the amount of money you make on sales of your main products and services.

This number is calculated before you take your expenses into account – it’s the top level on your income report and the amount you have earned – regardless of how much you get to take home with you.

Your profit comes out of your revenue.

Gross profit is your revenue minus ‘COGS’ or ‘Cost of Goods Sold’. Your net profit is your revenue minus COGS and minus overheads/expenses.

Revenue is a good number to focus on because it is the concrete amount coming in and one of the most straightforward ways to increase your profits. There are generally only four ways to increase revenue:

1. Increasing the number of customers
2. Increasing the average transaction size
3. Increase the frequency of transactions per customer
4. Raising your prices

Of course, there are many ways to accomplish those ends. Some examples include lowering prices to gain more sales, investing more in advertising to find more potential customers, ‘up-selling’ to your existing customers or creating more products and services to have more revenue streams.

Revenue is one of the most important numbers you can track in your business.

2. Cash Flow

Your revenue and profit tell you essentially how well off your business is and how well you’re doing – but that isn’t particularly useful if you can’t access any of that money.

Cash flow is all about how much money you have here and now. You can figure this out by assessing the cash going into your business versus the amount going out using the Cashflow Statement we discussed in last week’s article on the three financial statements you need to know.

In that article, we also covered the Balance Sheet, which you can use to calculate your Cash Ratio. It evaluates a business’s capacity to settle its short-term liabilities using only its most liquid assets.

The formula for a company’s cash ratio is:

Cash Ratio = Cash + Cash Equivalents / Current Liabilities

A cash ratio of 1 or higher means your company has adequate cash and cash equivalents to cover all short-term liabilities. On the other hand, a ratio under 0.5 is dangerous because the firm has twice as much short-term debt as cash.

A positive cash flow (meaning you bring in more cash than you spend) is vital.

Cash flow problems might lead to:

• Late payments to suppliers that damage relationships,
• Late or missed debt repayments that negatively impact your credit scores,
• The need to use personal funds or credit to pay for business expenditures, and
• Late wage payments to employees reduces workplace morale.

You want to ensure you have enough money to pay your bills each month and, ideally, a little extra to save (or payout to yourself).

You might even need to ‘liquidate some assets’ if you don’t have the cash to pay your bills.

3. Price Point

‘Price point’ refers to a point on a scale of possible prices. Out of these possible points, some yield higher profits.” https://prisync.com/blog/price-point/

The price point is important because it is one of the critical ways to increase your revenue and profit margins.

Selecting the right price can be tricky though.

The general objective of any business should be to provide value. You need to provide this value at a price point where you can profit.

You need to consider the expense of creating each unit of your product (or service). This is your ‘Cost Per Unit’. Your price point needs to be higher than your cost per unit because that’s the only way you will make a profit. The difference between your cost per unit and price point is your margin. The higher your margin – the more you make per unit. You can make up for a lower margin with increased volume.

When marketing your products or services, it’s essential to focus on where the real value proposition lies. How will your item or service improve life for your customers and clients? And how much do you think this is worth to them? If you can get this right, you can find an attractive, profitable price point.

Price too high and you won’t be competitive, but price too low and you won’t maximize your profits (and you might make your offering seem less desirable too!).

The price point you settle on is really up to you and will depend to a large degree on your industry and what it is you’re selling.

For example, a ‘1-5’ rule of thumb is often used if you are manufacturing something physical. This means the eventual retail price should be five times the cost per unit to manufacture.

Resellers often use a “keystone strategy” to determine their pricing. This means they will double their purchase price to calculate their selling price.

4. Expenses

Earlier, when discussing ‘price point’, we discussed the importance of monitoring the expenses that make up your cost per unit as it affects the margin. These are termed ‘direct expenses’ because they vary directly with the volume of units available for sale.

When you deduct these direct costs (Cost of Goods Sold) from revenue, the result is the gross profit. In other words, the gross profit is the profit portion of sales after allowing for the direct costs of those sales.

This profit must then fund the operating expenses.

Your operating expenses (overheads) are crucial because they reveal how much it costs to run your organization.

Operating expenses include marketing and administration costs, such as:

• marketing and advertising,
• staff wages,
• rent and occupancy costs,
• insurance,
• office costs,
• and more.

Review your expenses regularly in your Profit & Loss Statement. As well as looking at the actual numbers, divide each expense by the total revenue and multiply by 100 to calculate it as a percentage of income. Often, industry information is available so you can compare your ratios to industry averages.

You can also find a compehensive list of financial ratios, how to calculate them and how to use them in the Self Employed Business Manifesto section on ‘Analyzing Your Finances’.

Consider ways you might decrease these expenses by finding less expensive alternatives or eliminating items you don’t need.

Marketing expenses

Although marketing and advertising are generally included in operational expenses, it is essential to ensure that the costs are producing a return on investment (ROI) and assisting in the growth of the business. Here are some common ways to measure the effectiveness of marketing expenses for a small business:

1. Return on investment (ROI): This metric compares the revenue generated by a marketing campaign to the cost of the campaign. If the revenue exceeds the cost, the ROI is positive, indicating the campaign’s effectiveness.
2. Conversion rates: This measures the percentage of people who, after being exposed to a marketing campaign, respond by taking a desired action, such as making a purchase. By tracking conversion rates, you can determine the marketing channels and campaigns that are the most effective at driving conversions for your business.
3. Customer acquisition cost (CAC): This measures how much it costs to bring in a new customer through your marketing efforts. You can assess whether your marketing efforts are generating a positive ROI by comparing the CAC to the lifetime value of a customer.

Overheads

Using tools known as ‘force multipliers’ is an effective strategy to lower overhead costs in your business.

Anything that accepts input and boosts output is a force multiplier. The most straightforward illustration of this is a hammer, which increases the output by converting the force applied.

Another excellent illustration is a forklift truck, which enables one person to move hundreds more boxes than they could without it. Both computers and specific software programs act as force multipliers.

These are amazing for your business because you can increase your revenue by improving productivity without paying more staff or increases in expenses. Automation goes one step further by fully automating some of your revenue creation processes, e.g., automating social media.

Making it All Work for You

Now that you know the four numbers to monitor, it’s time to start applying them.

Reviewing your P&L Statement is a great way to start, as you will quickly see your profit margin at the end of a month.

Look ahead to when you’ll have money to invest or otherwise grow your company, or when your cash flow will be tight so you know when to exercise caution. By doing this, you can protect your business from a catastrophe and ensure that it keeps moving forward.

From there, you can also try looking at what might happen if you were to tweak your price point or if you were to introduce a new revenue scheme. How does this impact your revenue? And what does that do for your overall profit? Likewise, try using different force multipliers to reduce your overheads.

This is the final article in this month’s series on essentail small business finance skills. Other articles in this series include:

The 3 Financial Statements Small Business Owners Must Understand
Understanding and Managing Small Business Cash Flow
How to Hire a Bookkeeper