Financial Reporting: 6 Simple Ways to Understand Your Financial Statements

The operation of a family business is difficult.  And the ability to understand the financial performance and money flows inside a family business is critical to achieving long term success.  This is true for every small, medium or large business.   Every family business should make the effort to analyse financial information within their business, by learning to read financial statements and reports.

Sadly, reading financial statements, understanding and analysing them is a skill that takes time and effort to learn. A great business accountant can help you along the way, but it is also important to get a grasp on the basics of financial reporting to help you analyse future investment decisions in your business.

The goal is for a family in business to understand the cost of a decision before they make it.

Is it really important to read financial statements?

At a micro business level, the founder and operator will typically know every transaction inside of the business. And if there are around 5 to 10 transactions a month, the chances are that the head of the family is so closely attached to the financial performance of the family business that financial statements are not so important.

The financial statements of the business could probably be recalled by the business owner on the spot.

However, as the business grows so does the volume of the transactions – and the ability of the family business owner to understand every transaction becomes even more important.  The ability to read financial statements will become the only real way to understand business operations.

A universal language

In every well-run family business – from Perth to Sydney to New York – a family business has three parts to their financial statements: a balance sheet, a profit and loss and a cash flow statement.

The way that money moves, the financial reports, is the same worldwide.  And the language of money – accounting – is also the same worldwide.

Getting the big picture

However, simply seeing a number by itself in any one of these financial reports is largely meaningless. Understanding financial reports take a bigger view. If you looked at a family business and the client monies due in had doubled, is that bad?  What if you found out that sales had tripled? The tripling in sales with only a doubling of client receivables might indicate that the business is managing its cash receivables really well.

  1. The net profit ratio

The comparison of your net profit to sales will give you a net profit margin for your financial statements.  It can be shown mathematically as:

Net Profit / Sales = Net Profit Ratio (%)

The ability to compare your net profit ratio to a forecast net profit ratio, industry benchmark or prior year results will give you an understanding of the efficiency of your business.

  1. The gross profit ratio

The gross profit ratio is a close relative of the net profit ratio as part of the financial reports.  However, the primary focus here is on the costs of doing business that is directly related to the sale itself.  The business overhead (which is typically independent of sales) is ignored.

Sales less Direct Costs / Sales = Gross Profit Ratio (%)

The benefit of the gross profit ratio is that it gives family business owners an insight into their controllable costs within the financial statements.  Well run family businesses will typically track their gross profit ratio at least monthly to help them understand financial reporting.

  1. Return on capital employed

The Return on capital employed (ROCE) of the business gives you a key business insight within financial reporting. It looks at how well the assets you own are being used to make profits.

Factors like financing and funding in the business – which do not impact the workings of the factory floor – are ignored.

Earnings before Interest and Tax / (Debtors + Stock + Plant – Creditors) = ROCE (%)

The ROCE of a family business is a great indicator to understand the efficiency of the assets used in a family business.

  1. Quick ratio

If a business cannot pay its debts, bad things will happen.  A highly profitable business can incur a cash shortage if it invests too much back into the business assets, pays down debt too fast or if it declares big dividends to the owners.

The quick ratio is a key ratio to determine the ability of the business to pay its immediate debts.

Cash + Debtors / Debts due to payment in 12 months = Quick Ratio

The quick ratio is typically quite harsh as it ignores things like inventory. However, it is a great acid test to see how a business will go.

A general rule of thumb for a business is that the quick ratio should be at least one.

  1. Average days to collect debts

The time to collect cash from its sales is a key indicator of a well-run business.  If a business takes a long time to get paid, the level of finance needed to operate the business increases significantly.

(Average Monthly Sales / Average Accounts Receivable) x 12 = Average Days to Get Paid

If the average days to get paid is increasing it can also indicate that the accounts receivable might not be factual.  There might be a lot of bad debts (which will reduce profits and ultimately cash).

  1. Times interest earned

In a world of low-interest rates, almost every family business should stress test the business.  And a review of how many times the business profit can pay the interest costs within the business is a key ratio on how likely your business can withstand an increase in interest rates.

Earnings before Interest and Tax / Interest Expense = Interest Coverage

If your interest cover ratio is 2: your interest costs can double and the profit of the business will be sufficient to pay the businesses cost of servicing debt.

A final word

The interpretation of financial reports is a complex task that requires knowledge and insight.  Just as no one number will help you understand financial reports, no one ratio will give you a complete understanding of the financial performance of a family business.

If your family has a deep understanding of the financial performance of your family business, with strong communication, you are much better placed to resolve any future conflict.  This is true for every family business or family office that a family in business might have.

The variations and complexity of a family business and the financial reports underpinning the family business requires the application of a huge range of statistics together with business acumen to turn the numbers into value.

A truly great family business advisor can balance the financial performance of the business with the needs of the family. Independent, trusted advice on business operations is a great start to balancing the delicate needs of the family against the needs of the business.

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