It’s no myth financial statements have lots of numbers, causing panic and confusion to many entrepreneurs and even non-financial managers. This fact alone is enough to make most people kick down the road the responsibility of reviewing financial statements of a project, division or company. That said, you can’t depend on your CFO alone to do this, as a startup entrenpreneur you need to be genuinely interested in the numbers to make your company work. This is the only way you will know if you have a good business or not… and this you know if you know your pricing, your costing, your ROI (return on investment) of you marketing dollars, your expected tax liabilities, etc. Analyzing your numbers – with or without your CFO – is crucial for your success.
In order to make the issue a lot easier, we will simplify the process today, and eventually, post a series of articles to make the process more welcoming.
First step: make sure that everything is accounted for.
This means that we must account for things that have happened outside of our bank and not reflected in our bank statements. This is commonly referred to by accountants as “accrual”.
- So, you worked your back off this month, but don’t have the money in your bank account. How do you call this? Invoicing! (Simple, right?)
- So you hired a freelancer to help you with that proposal or project, but you haven’t paid him? That’s called accruing your expenses (‘accounts payable’)
- You bought a computer, but want to make sure that you’re accounting for its wear and tear? You record a “depreciation expense”. This is based on the theory that the computer’s state depreciates (decreases) as you use it.
In summary, your bank account is very important, but equally important is recording all the activities that have not yet happened in your bank account but that eventually will.
Second step: Bank reconciliation
A bank reconciliation makes sure of two things:
- That you verify all the charges made to your account… and catch on time anything funny going on (improper use of funds, unauthorized transactions, “magical banking fees”, etc.)
- That you can account for checks that you’ve sent to suppliers but that haven’t been cashed yet. This is very important, because sometimes suppliers take weeks to cash a check. The problem lies when you don’t remember you issues more checks and then both suppliers cash the check at the same time and you run an overdraft, or worse, one of them cannot cash the check because of insufficient funds.
Thirds Step: Analyze activity and balances
Notice that I didn’t use the terms Income Statement and Balance Sheet, which actually refer to activity (income statement) and balances (balance sheet).
- The Income Statement records what happened during the month. How much revenue (sales) did your business achieved. Also, how much did you spend? This is extremely important because as you might anticipate, you must compare how you’re doing with the previous months. If you don’t measure this, you don’t know where you’re going… and if you don’t know where you’re going, you might end up in dark alley alone at midnight. Nobody wants to end up there.
- The Balance Sheet lets you know how much run way you have and where are your assets (future benefit) and liabilities (responsibilities to pay up). In a balance sheet you will know how much cash you have left, how much money your clients owe you, how much you have invested in equipment, how much inventory you’ve bought… and equally important, how much you owe your suppliers, to the Treasury Department and how much you’ve put in the business of your own money.
The most important part of this step is uniformity:
- You need to be uniform in how things are accounted for. In other words, you need to compare things to another period of equal duration. If you compare the result of one (1) month versus two (2) months you won’t really derive any meaningful insight out of your statements. So, again, use the same time period when comparing your financials. For example: Last Month versus Prior Month, Last Quarter v. Previous Quarter, Current Year-To-Date versus Last Year-To-Date.
Fourth Step: Calculate ratios
Ratios are a quick way to use easy to remember metrics each month.
- Divide a particular number in the financial report by another. Financial statement ratios are also useful because they enable the reader to compare a business’s current performance with its past performance or with another business’s performance, regardless of whether sales revenue or net income was bigger or smaller for the other years or the other business. In order words, 10% of Net Income on $1,000,000 in sales is more efficient than 9% of Net Income on $2,000,000 in sales. (That’s efficiency… In the end you get more Net Income in absolute terms, but each additional dollar you sold was more expensive than the previous first million).
- There aren’t many ratios in financial reports, you need to have 3 to 5 ratios at most, so you don’t end up with a soup of numbers nobody wants to review. Ratios don’t provide definitive answers, however. They’re useful indicators, but aren’t the only factor in gauging the profitability and effectiveness of a company.
- We will soon provide a link to the most useful ratios.
Fifth Step: Repeat
- This is the shortest but most important step. If you don’t repeat month after month, you won’t be able to gauge the health of your business. No doctor can work properly without measuring your pulse and other vitals, what makes you think you can operate a business effectively without knowing yours?
If you need assistance setting up your financial dashboard, feel free to send me an email to the contact information below.