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How to deconstruct financial statements

By 29/09/2021October 19th, 2021No Comments

Deconstructing financial statements

As a business owner you are used to seeing your financial statement from your accountant, but little time is spent on what each reporting metric means, its significance and what the business should aim for.

An understanding of these key performance indicators (KPIs) will keep you ahead of the game, improve efficiency and offer insights to help you make smarter decisions.

Here we deconstruct the financial statement and look closely at what each section means.

KPIs for businesses to measure

Revenue (Sales)
Having a sales/revenue target focuses the business on a common goal that can be planned for and communicated across the organisation.

So how do you set a sales target? Firstly review your current income/sales and start by adding 10% in the next quarter and gradually ramp up.

Next, measure your sales performance against the target monthly. During your monthly management meetings check if you are hitting sales targets. Who is accountable and who is owning it? If there is a plan to increase the sales target, then what activity is the business doing to help achieve that target? Is there an investment in marketing, sales teams, sales training, customer service, client retention, and what is the business doing to achieve it? Is the business focussed on the most profitable revenue lines? Do you need to rationalise the number of services and products and focus on the most profitable ones?

Gross Profit Margin
This is the percentage of your gross profit over sales. First you need to find your gross profit which is the sales to cost of sales ratio. It’s really important that if you sell time, that the wages of this time is included in the cost of sales.
The formula to find this is gross profit to sales ratio. As a rule this should be between 50% – 70% gross profit margin, but this will vary depending on the sector.

Administration Salaries Margin
This is the percentage of administrative salaries over sales. The administrative expenses to sales ratio should be between 10% – 20%, but this will vary depending on the sector.

Are you as efficient as you can be with your admin costs? Are there ways of automating or devolving administration tasks to others to reduce costs? A great example here, is HR administration using online portals where employees can manage their affairs without having to rely on office administrators.

Overheads Margin
This is the percentage of overheads (not including any salaries) over sales. The overheads to sales ratio should be between 10% – 20%, but this will vary depending on the sector.

Operating Profit Margin
This is the percentage of your operating profit over sales. First you need to find your operating profit which is the gross profit from all overheads (including admin salaries).

To calculate the operating margin, divide operating income (profit) by sales (revenues).

As a rule this should be between 10% – 20% operating profit margin, but this will vary depending on the sector.

Debtor Days
This measures the total amount of days it takes for your customers to pay you and can massively impact cash flow. The formula for this is (debtors/sales) x 365. This will vary depending on sector, but generally you should aim for a maximum of 30 days.

Tighter controls on cash collection is a quick and easy win to improve your debtor days. This would be tightening up of contract payment terms, clear communication with clients, processes to request payment, to remind customers payment is due or overdue.

Creditor Days
This measures the total amount of days it takes you to pay your suppliers. The formula for this is (creditors/purchases) x 365 – again this will vary depending on sector, but you should look to pay to term to keep a good relationship with your suppliers so this would usually average at 30 days.

While longer payment terms may seem attractive you can lose sight of your credit commitments and bills or invoices can catch you unawares.

Stock Holding Days
This measures how long you hold stock before it’s sold – the longer you hold stock the more cash you have tied up. To work this out the formula is (stock/cost of sales) x 365. This will vary massively depending on sector, but assuming the business does not sell perishable goods a good target is six months.

Processes for good stock management include stock rotation, implementing lean or just in time processes to minimise stock and cash tied up in stock.

Current Ratio
This is a measure of how many times the business can cover its current liabilities with its current assets – or in non-accountancy speak how many times a business can cover upcoming payments to suppliers/staff/the bank with the current money owed to them. The formula for this is current assets/current liabilities. The minimum all businesses should show is one as this means it can cover all its current liabilities with its current assets – the higher this number the better.

Liquidity Ratio
Sometimes called a quick ratio or acid test – this is a measure of how many times the business can cover its current liabilities with its cash – or in non-accountancy speak how many times a business can cover upcoming payments to suppliers, staff or the bank, with the current cash available.

The formula for this is cash/current liabilities. Again all businesses should aim for one as a minimum – the higher this number the better, this gives the opportunity to re-invest in the business – people, equipment, research and development etc.

Financial forecasting
These metrics are great indicators. They are your barometer on the health of the business now and in the short-term future ahead. By keeping a close eye on key metrics the business can plan and forecast ahead – you are less likely to be caught out and can take corrective action in advance before problems arise.

They also indicate when the financial health of the business is such that investment and strategic planning should be on the agenda.

Managing cash flow

Cash flow is one of the most feared and common challenges that catch you out. As the business grows, cash flow can become difficult to predict. Generally this is because the number of customers paying you increases, you have suppliers to pay, but lead times shift, so you could have a false reading on your cash position if you’re not managing your debtors and creditors effectively.

Peaks and troughs happen in business and we recommend having four cash ‘pots’ – ready if you need to dip in and stabilise a time of lumpy income.

Pot 1
Keep enough cash in this pot to pay the day-to-day operating expenses, but no more.

Pot 2
A second savings pot with funds put away each month to cover the corporation tax and VAT bills each quarter.

Pot 3
After cash pot two is where it should be, this pot should hold two months of operating expenses as a backup – just in case you have a few bad months.

Pot 4
This savings pot is for investment for the company to grow or for dividends to be issued to the shareholders (or a mixture of the two).

Understanding financial statements is fundamental for a healthy business and our aim is to help you use the information from your financial statements to help your business grow.

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    Karl Newman

    Author Karl Newman

    Karl is the owner and founder of Direct Peak and is our Xero Management Accountant in Peterborough. He has over seven years of experience as a Xero Specialist and Management Accountant and a strong background in accountancy, having dealt with financial forecasts, three acquisitions and business plans for multi-million pound companies.

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