by MHolland | Apr 18, 2024 | Accounts Payables, Accounts Receivables, Business Tips
Your monthly financial statements tell you a story….in the language of numbers…
Every business has three main financial statements:
- The Balance Sheet
- The Income Statement
- The Statement of Cash Flows
The Balance is the main statement. What? Not the Income Statement?
Yes, it is true that most businesspeople will focus most of their attention on the Income Statement.
They do this because the Income Statement shows the results of activities over a period of time – a month, a quarter, a year.
The Balance Sheet has all the information to determine the heath of a business at a specific point in time.
Did you know that the Income Statement and Statement of Cash Flows are each derived from the Balance Sheet?
The Balance Sheet is the fulcrum of the three statements.
The Big Picture
The story that your financial statements are telling you starts with the big picture.
Let us break it down…
Your Balance Sheet has three main sections:
- Assets
- Liabilities
- Equity
Assets are what you own.
These can be further segregated into Current Assets, Fixed Assets, and Investments and Intangible Assets.
Liabilities are what you owe.
They can be segregated into Current Liabilities (due within one year), and long-term liabilities.
The difference between your assets (what you own) and your liabilities (what you owe) is your equity.
A simple way to envision this – imagine all you own is a house. You paid $300,000. This is your asset, what you own. You have a mortgage of $210,000. This is your liability, what you owe.
Your equity is simply the difference between the two, or $90,000 in this example.
You sell your house for $300,000 and pay off your mortgage of $210,000 and you pocket $90,000.
Simple!
Your Income Statement is made up of two main sections – revenue (the inflows into your business), and expenses (the outflows from your business).
The difference between the two is your Net Profit.
Recap
So, now we have a Big Picture emerging – by knowing these five main sections of these two financial statements.
By looking at the Balance Sheet, we can determine what we own (assets), what we owe (liabilities), and the difference between the two (equity).
In examining the Income Statement, we can see what revenues flowed into our business, and what expenses flowed out of our business, and lastly how much profit we made.
That is the Big Picture…
Now let us get more detailed…and talk about ratios…
Ratio Analysis Deepens the Story
By looking at ratios in your business, we can start to interpret the “story of your business.”
Ratios come from the main sections of your financial statements. They tell us specific details about your business that we cannot glean from just looking at the five main sections…
By understanding exactly what they mean we can determine the overall health of our business.
From there we can make decisions to improve it.
What are the main ratios we should be looking at for most businesses?
Liquidity Ratios
Liquidity Ratios provide an early warning for a business unable to meet its current liabilities when they come due.
A current liability is defined as something due within one year. These include things like wages payable, accounts payable, taxes payable, and loan payments.
A current liability is paid with a current asset. Current assets are either cash in the bank or things that will convert to cash quickly. For example, accounts receivable collected and inventory when sold.
The current ratio is simply your current assets divided by your current liabilities.
One rule of thumb is that a current ratio of 2:1 or greater is extremely healthy.
A 2:1 current ratio means that for every $1 in current liabilities you have $2 in current assets to pay them. It means you are liquid.
Another way to think about it is that by being liquid you have enough current assets to pay your current liabilities as they become due.
By having $2 for every $1 in current liabilities means you are well covered.
Now let us look at…
Profitability Ratios
Three important profitability ratios are:
- Gross profit margin
- Net profit margin
- Return on equity.
Gross Profit Margin
Gross profit margin is the amount of profit left over after deducting your direct costs of producing or purchasing your goods and services.
Gross profit is needed to pay for your operating overhead. It needs to be high enough to cover all your overhead plus a profit.
Every industry will have a different gross profit margin percentage that will be normal in that industry.
Things that can lower your gross profit margin to a dangerous level include:
- Sales discounting
- Inefficient production costs
- Venders for your purchases that are charging too much.
- Venders delivering goods with poor quality.
Every business must measure their Gross Profit Margin by product line. In this way, you can monitor which product lines are most profitable in terms of both sales volume and the gross margin percentage.
Things that can increase your Gross Profit Margin include:
- Price increases especially when there is no loss in sales volume.
- Outsourcing manufacturing especially to a low-cost jurisdiction.
- Eliminating quality issues in either production in house or from your venders.
Next, we will look at…
Net Profit Margin
Every business needs to have overhead to run. These are indirect costs that are usually fixed in nature.
Some examples of overhead include:
- Management salaries.
- Rent.
- Insurance.
- Office Supplies.
Your Gross Profit must be enough to cover all of these fixed overhead expenses plus your profit.
Ways to increase your net profit include:
- Turn fixed expenses (as much as possible) into variable expenses.
- Find venders who will give you the same result for less money.
- Outsource as much as you are able to low-cost jurisdictions.
One of the things that happens to all businesses over time is that the fixed costs creep upward. And they also can be sticky.
By “sticky” I mean when businesses enter into longer term contracts that bind them to certain requirements that may no longer be needed.
What can happen is that you incur a fixed cost that you needed in the past, and now no longer do.
By not frequently examining your vendor relationships and agreements you may find you have fixed costs that are no longer even being used.
These can include things as expensive as office leases (more people are now working from home for instance) or software subscriptions for former employees that were not cancelled.
Now we will examine…
Return on Equity
Return on equity is expressed as a percentage of how much the business is earning in relation to its owners’ equity.
It is calculated by dividing the Net Profit by the Shareholders Equity and then multiplying this by 100 to represent it as a percentage.
A higher percentage is of course better, and a measurement of the reward being earned for the shareholders’ investment risk.
In Summary
Looking only at the larger numbers in the five main areas of your financial statements – Assets, Liabilities, Equity, Revenues, and Expenses – can be difficult to see patterns.
By expressing them as ratios, often a percentage, and understanding what they mean you can start to guide your business better.
A great accountant is someone who will interpret the numbers for you. He or she is like your co-pilot and they can help you see things that are otherwise incomprehensible.
Next week I will talk about Activity Ratios and Leverage Ratios.
Thanks for reading….
by MHolland | Feb 22, 2024 | Accounts Payables, Accounts Receivables, Business Tips, Cash Flow
An often-overlooked ratio to track is a combination of three other ratios…
Once you calculate the other three you simply add the three to get this Turbo Ratio that I recommend all businesses with accounts receivable and inventory track.
So, what is it called?
It is called…
Your Cash Conversion Cycle
It is the measurement of how many days on average it is taking your company to convert sales into cash.
It is the combination of three separate ratios:
- Days Receivable – the number of days on average it takes to collect your accounts receivable.
- Days Inventory – the number of days on average it takes to sell your inventory.
- Days Payable – the number of days on average you take to pay your bills.
Let us go through each of these three ratios…
Your Days Receivable
Here the lower the number of days the faster you are converting your receivables in cash.
You need the following numbers to calculate your days receivable ratio:
- Opening balance of your accounts receivable, at the beginning of the month
- Closing balance of your accounts receivable at the end of the month
- Your monthly sales on credit (non-cash sales)
Add your opening accounts receivable balance to your closing accounts receivable balance and divide by 2.
Take that number and divide by your total credit sales for the month.
Multiply that number by the number of days in the month.
Accounts receivable opening balance = $100,000
Accounts receivable closing balance = $200,000
Average accounts receivable balance = ($100,000 + $200,000)/2 = $150,000
Sales for the month = $300,000
Days in the month = 30
$150,000/$300,000 x 30 = 15 days
Now let us look at the next ratio…
Your Days Inventory
Here as well, a lower number of days is better for your cash-flow.
You need the following numbers to calculate your Days Inventory ratio:
- Opening balance of your inventory, at the beginning of the month
- Closing balance of your inventory, at the end of the month
- Your Cost of Goods Sold for the month.
Add your opening inventory balance to your closing inventory balance and divide by 2.
Take that number and divide by your total Cost of Goods Sold for the month.
Multiply that number by the number of days in the month.
Inventory opening balance = $300,000
Inventory closing balance = $600,000
Average inventory balance = ($300,000 + $600,000)/2 = $450,000
Cost of Goods Sold for the month = $750,000
Days in the month = 30
$450,000/$750,000 x 30 = 18 days
On average it is taking you 18 days to turn your inventory over. In other words, to sell it.
Now let us look at the next ratio…
Your Days Payable
For this ratio, a higher number is better! Why? Because you are taking longer (i.e. more days) to pay your bills on average which means you are preserving cash for a longer period.
You need the following numbers to calculate your days payable ratio:
- Opening balance of your accounts payable, at the beginning of the month
- Closing balance of your accounts payable at the end of the month
- Your monthly Cost of Goods Sold
Add your opening accounts payable balance to your closing accounts payable balance and divide by 2.
Take that number and divide by your total Cost of Goods Sold for the month.
Multiply that number by the number of days in the month.
Accounts payable opening balance = $250,000
Accounts payable closing balance = $350,000
Average accounts payable balance = ($250,000 + $350,000)/2 = $300,000
Cost of goods sold for the month = $900,000
Days in the month = 10
$300,000/$900,000 x 30 = 10 days
Now, let us put it al together…
Your Cash Conversion Cycle
The formula for your cash conversion cycle is:
- Days receivable
- Days inventory
- Less – Days payable
Using our numbers from above we have:
Days receivable = 15 days
Days inventory = 18 days
Days payable = 10 days
Your Cash Conversion Cycle is 15 plus18 minus 10=23 days
Although this is a very crude measurement what it tells you is that on average you will convert your sales into cash in about 23 days.
In Closing
Remember the lower the number the better. Why? Intuitively you will want to convert accounts receivable and inventory to cash as quickly as possible. Less days to do so means cash is hitting your bank account more rapidly.
One other thing to keep in mind is that the Days payable number is more beneficial the higher it is! That is why it is subtracted in the Cash Conversion Cycle Formula.
The longer you take to pay your bills the more cash you have available to run your business. Here you will want to operate with integrity and not take too long to pay your suppliers. After all, they are essentially your partners in your business.
That said, it is fair if you take advantage of longer payment terms and wait as long as possible to pay.
Thank you for reading….
by MHolland | Jan 27, 2021 | Accounts Payables
Cheques are becoming less common now. But not uncommon enough. Here are 5 reasons to wean your business from the cheque addiction (for those still afflicted) …
Reason No. 1 – Con Artists
Cheque fraud is bigger than online fraud by a country mile. A cheque circulates in physical reality. Thieves can acid wash your cheque, print their name on it, and cash it.
Reason No. 2 – Cost
The Canadian online bill payment service we use is inexpensive. Yet I have had business owners balk at the price. It is about $1.50 per payment for 20 payments.
A stamp is $1.07 now. Then there is the paper and envelope.
How about the time to print, get a signature or two, and stuff the envelope?
Then your bookkeeper has to record that cheque in the accounting system.
This adds up to $20 or more per cheque.
Check out this article on the true costs of cheques:
The Hidden Cost of Check Payments
Reason No. 3 – Convenience
When you need two signatures, and one person is away what do you do?
Mail it from person to person? Yikes! With Canada Post that could take weeks. Courier? Please see reason 2 above.
Some people pre-sign cheques when they will be away to avoid this problem. This opens up fraud. Please see reason 1 above.
Reason No. 4 – Covid
With Covid, the rules of engagement have changed. Your office may be closed. Where are the cheques? Can your bookkeeper get into the office? Yes?
Great! How about the signers? Both of them? Are all three working from the same office?
You get my point…
Reason No. 5 – Controls
With a solid online bill payment service, you set an accounts payable approval matrix. Vendor bills can be routed to as many people as you like, working from as many places as you can imagine.
This makes for a great audit trail. You can see each person who approved the payment.
Oh, and a really cool feature – you can see the actual vendor bill attached for easy reference!
So, what are you waiting for?
Want to know what we use? Kindly email me, and I will let you know…
by MHolland | Oct 9, 2020 | Accounts Payables
When was the last time you wrote a cheque?
For me, I cannot remember. I have an ancient box of business cheques somewhere in my office, collecting mold. They are so old that the address is incorrect.
Think of it, dear reader, it is Covid 19 times. You are a mid-sized business. Perhaps multiple locations. Cheques need to be signed by at least two people.
The problem is hardly anyone is working at the office anymore.
What do you do? Sign the cheque and mail it to the next signer? Yikes!
This is just so wrong.
The Entire Cheque Cycle is Slow
That cheque, with one signature, is now in the physical Canada Post eco-system.
How long will it take to get to second signer? And then to the supplier? A week? 10 days? Two weeks? Oh my.
But wait! You have solution! Just pre-sign a stack of cheques and leave them with second co-signer. That will solve the problem, right?
Some of you may be either laughing (thinking of the obvious – the controls of 2 signatures have just been broken). Others, are thinking, “would anyone actually do that?”
It is done all the time.
Never Pre-Sign Cheques
A company we knew had the business owner pre-sign a stack of cheques for the bookkeeper to pay bills.
They were kept in the safe. “Safety first”, correct?
The bookkeeper had a new baby. The costs of giving her sweet baby everything she deserved was high. Toys are expensive on a bookkeeper’s salary.
These signed, blank cheques were sitting there, a severe temptation. Like wine in the fridge to an alcoholic.
Would the owner even notice if a few cheques ended up supplementing her low wage?
She secretly filled out some cheques payable to her credit card, not the owner’s. This went on for years.
She coded the “expense” to inventory. (Perhaps she was thinking how fitting – inventory of toys and things for her baby).
The owner never discovered the fraud. Finally, (and this is usually how these things are revealed), she took a holiday. The relief bookkeeper could not reconcile the bank. She got suspicious, and uncovered the fraud.
The morale of this story is – never pre-sign cheques.
Why Do You Trust the Physical and Not the Virtual?
When a signed cheque leaves your office, it can be intercepted.
Think of all the stops along the way. Your office (before it is mailed). The mailbox. The routing stations at Canada Post. The office where it is being sent to.
It is a crap shoot.
Cheques intercepted are acid washed. The payee changed. You would not recognize your signed cheque when you see it.
Compare This to an Online System
We use a Canadian company called Plooto for online bill payments.
Bills approved for payment in the accounting software are synced to Plooto. The source documents move with the bill.
Inside Plooto you can set a simple or complex payment approval matrix.
Payment approvals can be set to require multiple approvals. Dollar amounts can be set so that the owner is not having to sign everything.
Everything is approved virtually, online.
There is an audit trail.
The payments go through the Canadian payments approval process, just like a cheque would.
The supplier can receive the payment via email. They log into their bank using their own bank credentials and deposit the money you are sending.
Some Interesting Stats
Australia has virtually eliminated cheques. The banks charge about $50 to process a cheque. Not much of an incentive to use cheques!
The overall numbers are interesting – 5% of payments are paid by cheque in Australia.
In Canada?
In 2019, 39.38% of all payments were by cheque. If you remove personal payments, the business cheques are significantly higher.
My coaching – stop writing cheques.
You will save time, money, and reduce risk of fraud.
And in Covid 19 times, online bill payments just make sense!
