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Better Business Idea #7

Financial Analysis--Reading The Vital Signs Of Your Business

Many closely held businesses don't give sufficient attention to good financial management. The principal reason is probably that the owner is too involved with day-to-day fire-fighting and the bookkeeper is focused on accumulating accounting information, collecting accounts receivable and paying bills. No one is involved with ongoing financial analysis to interpret how the business is doing and how it can be improved.

More and more CPAs are helping their clients on a regular basis, monthly or quarterly, to understand and improve the performance of their clients' businesses.

The financial statements--balance sheet, income statement, and cash flow statement--include information that indicate trends in the health of the business, especially when they are studied on a comparative basis from month to month and from year to year.

Financial ratios are tools that can be used to help make sense of the financial statements by reading the "pulse" and "temperature" or vital signs of the business. The ratios of the company may be compared from period to period to determine trends. The ratios may also be compared to industry statistics or a "best of industry" performer for a "benchmarking" comparison. If the business management discovers that a ratio is on a negative trend or is not a good benchmark, strategies may be developed and implemented to improve the ratio.

Here are a few of the vital statistics that a business owner should watch:

  • Gross margin on Sales. The percentage determined by dividing the gross profit by total sales. In some cases, the sales of a business may increase, but the profit of the business may decrease. The reason? Prices may have been reduced to increase market share or because of competition. Unless there is a corresponding decrease in the cost of the merchandise or services sold, the profit per sale will decrease. For example, if your present margin is 20% and your reduce your price by 2%, your sales volume must increase by 11% to produce the same profit.
  • Accounts receivable collection rate (in days). Accounts receivable times 365 divided by credit sales. If accounts receivable increase because customers take more time to pay their accounts, less cash is available for financing the business and paying distributions. More clear agreements up front about payment policies, different payment policies (such as requiring an advance deposit or cash on delivery), and improved customer credit evaluation are a few steps that can be taken to improve this ratio.
  • Inventory turnover rate (in days). Inventory plus work in process times 365 divided by cost of sales. An increase in the days of inventory turnover indicates that more cash is being required to carry the increased inventory. Some components of inventory may be overstocked. Can they be returned? Ordering practices and procedures may need to be reviewed. Is any of the inventory unsellable or obsolete?
  • Sales per person employed. Total sales divided by equivalent full-time employees. This is a measure of productivity. Many times employees are hired that don't contribute value to the customer or to the business. Companies often go through reengineering efforts to try to identify how to more effectively accomplish their mission, improving customer service and delight while using fewer resources and less effort. New technology can help in this effort. A study of activities within the organization may reveal that a lot of time is wasted performing procedures that really serve no useful purpose.

Are you studying these statistics in your company on a regular basis? If you aren't, maybe it would be worthwhile to invest in a business monitoring and improvement service. Please give us a call to discuss the details.

For new articles about how to improve your business, subscribe to our newsletter, Michael Gray, CPA's Tax & Business Insight!

Read the vital signs of your business to interpret how the business is doing and how it can be improved. Michael Gray, CPA explains what the most vital signs are, and why they are so important.

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Michael Gray, CPA
2482 Wooding Ct.
San Jose, California 95128
(408) 918-3162
Fax (408) 938-0610
email: info@profitadvisors.com
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