Why Reading Your Financial Statements Is A Lot Like Eating Kale
Let’s be honest. Your monthly financial statement is like kale: you know it’s good for you but it’s awfully hard to digest.
Sadly, if you’re not thoroughly digesting your company’s financial statements—I mean really getting in there and understanding what they are telling you—then you’re missing most of the benefit.
Fortunately, it’s not hard to get more out of your income statement, balance sheet, and cash flow report. Here are three easy-to-swallow ways to use your financial statements and improve your business.
1. Introduce Finance to Operations
Let’s say you have top-line sales of $200,000 this month. Is that good or bad? How do you know for sure?
You might know that sales increased during the month, but that only tells half the story. Are they are up because of other changes in your business? To know that you have to introduce an operational number and create a ratio.
For top-line sales, I like to know how many resources it took to make those sales. That might be number of employees, number of total hours worked, square feet (for a retail store, perhaps), the number of miles driven, or whatever. Pick any operational metric that is important to your business.
Now divide. Divide top-line sales by the metric you’ve chosen to create a ratio: “Sales per Employee” or “Sales per Man Hour.”
Ratios like this help measure efficiency and give you something to compare across multiple time periods. If February sales are double January sales, but you tripled head count, is it a win? Try the same calculations using Gross Margin or Net Profit to see how efficient your whole operation is.
2. Mix and Match
Keep going with the idea of using ratios. But this time match numbers from the balance sheet against data on the income statement.
Some of the most important business ratios take one number from each of the two financial statements to measure “Days.” In other words, how many days of inventory do you have on hand? Or how many days does it take you to collect an invoice? Your financial statements already have the answer!
For example, divide the value of your inventory at the end of the month by the total value of your Cost of Goods Sold (COGS) for the month, then multiply the result by 30 (the number of days in a month). The result is “Days of Inventory on Hand,” which can help you control the amount of inventory you carry.
For other “Days” ratios, look up the terms “Days Sales Outstanding” and “Days Payables Outstanding.” Together with inventory (if you use inventory) you’ll get a complete picture of your “Cash Cycle” and begin to see ways to improve your cash flow.
3. Look Forward by Working Backwards
Financial statements are descriptive—they describe what happened last month. But they can also be prescriptive and tell you what you should change for next month.
One thing your data can prescribe is better pricing. Take the example of a landscaper (or any company that sells man hours). In a labor-intensive business it is vital to charge an hourly rate that pays not just for the employee, but also the total overhead of the company.
Our financial statements can tell us our labor costs (usually in Cost of Goods Sold) and our fixed costs (usually called “Total Expenses”). Add those together and divide by the man hours in each month to find a minimum hourly price for labor. Note that “minimum” in this case means “break-even.”
If the price you sell labor at is below that minimum, you need to either raise prices or supplement your income by selling materials at enough markup to cover the difference.
By “working it backwards” in this way, you are using last month’s numbers to tell you how to price things better in the future.
Track It and Compare It
Don’t let all this good work go to waste. The best advice for using financial statements constructively is to track the trends. By comparing the best ratios over multiple months, you can start to see what direction the company is headed. And by comparing your ratios to those from other more successful companies, you can see where you should aim!
So, just like eating kale, it’s not enough to do it once. Make digesting your financial statements a monthly habit and begin learning what is really happening at your company.
To your (financial and personal) health,
David Worrell, FuseCFO
PS – for more healthy bites of finance tips and advice, visit the FuseCFO YouTube channel. Thanks!
