Annual financial statements arrive from the accountant, get signed, and go in a drawer. That is a waste of the most useful management information a small business produces, and it is usually because nobody explained what to look for.
Start with the profit and loss, but not at the bottom
The net profit line is the least informative number in the statement, because it is the end of a chain rather than an explanation of anything.
Read it in this order instead:
- Revenue, compared with last year and with what you expected. Then ask whether the change came from volume, price or mix — three very different situations that look identical at the revenue line.
- Gross profit and gross margin percentage. This is the single most important number in most businesses. It tells you what you keep from each sale before overheads, and a percentage that moves without an obvious cause is the earliest warning of a pricing or cost problem.
- Overheads, as a percentage of revenue rather than in dollars. Overheads that grow faster than revenue are how profitable businesses become unprofitable during growth.
- Net profit, last, as the consequence of the three above.
A margin that fell two points on higher revenue is a more urgent finding than a small drop in net profit, and only one of those is visible at the bottom line.
The balance sheet tells you about survival
The profit and loss describes a period. The balance sheet describes a position, and it is where solvency lives.
- Working capital — current assets less current liabilities. If this is negative, you owe more in the next twelve months than you expect to receive, which is a problem regardless of profitability.
- Debtors, and how many days of sales they represent. Divide debtors by annual revenue and multiply by 365. If that number is climbing, you are financing your customers.
- Stock, and how many days of cost of sales it represents. Rising stock with flat sales is cash converted into shelf.
- Creditors, on the same basis. Stretching suppliers is a funding source with a limit and a relationship cost.
- Term debt and what it is secured against.
- Shareholder current account — whether the business owes you money or you owe it. An overdrawn shareholder account has tax consequences and is a common surprise.
Profit is not cash, and the gap has a name
A business can be profitable and run out of money. The difference sits in three places: money tied up in debtors, money tied up in stock, and money spent on assets and loan principal, none of which appear as expenses in the profit and loss.
The practical test: compare the profit for the year against the movement in your bank balance. Where they diverge sharply, the explanation is in the balance sheet, and it is usually debtors or stock.
Ratios worth calculating once a year
- Gross margin percentage, tracked over several years. Trend matters more than the absolute number.
- Debtor days and stock days, as above.
- Current ratio — current assets divided by current liabilities. Below one warrants attention.
- Return on the money invested in the business. If it is lower than a term deposit, that is worth knowing even if you would carry on anyway.
- Revenue per employee, which is a crude but useful productivity indicator over time.
What annual statements cannot do
They are historical and they arrive months after the period ends. By the time you read them, the problems they describe are old.
That is an argument for monthly or quarterly management accounts rather than against annual statements. They do not need to be perfect — a reliable revenue, gross margin and cash position each month is worth more than year-old audited precision.
Questions worth putting to your accountant
The annual meeting is more valuable if you arrive with questions:
- Which direction is our gross margin moving, and what is driving it?
- What is our debtor days figure, and how does it compare with our payment terms?
- Where did the cash go this year, if profit and bank movement differ?
- Is anything in these statements that would concern a lender or a buyer?
- What one number should I be watching monthly?
Accountants generally welcome these. Most of their clients ask nothing.
business.govt.nz publishes practical guidance on reading financial statements and on cashflow, free and written for owners rather than accountants.
General information only, not financial advice.
