By Larry and Jane McGrath
To guide your business in the financial direction you want to take it, you must know where you’re making money and where you’re spending it. This requires keeping meticulous records and analyzing financial reports regularly.
Your two most informative reports are profit and loss statements (P&L) and balance sheets.
A P&L details your profitability. It reports your financial activity—income and expenses—over a given period of time. It restarts from zero at the beginning of each fiscal year.
A balance sheet details your financial health. It reports the value of your business—assets, equity and liabilities—at a specific point in time. It started at zero when you opened your business and will continue to accumulate until the business closes.
Individually, the reports give a limited view of your finances. For example, a look at the P&L can reveal a healthy profit, but will not show if you are running out of cash as you increase stock. For this information, you’d need to look at your balance sheet.
Used together, in consultation with your accountant, the reports are a valuable management tool and the source for building a realistic and helpful budget. Because, as Trent Hamm, author of The Simple Dollar says, “a budget plots your financial path to where you want to be.”
The P&L is also referred to as an income statement, earnings statement, revenue statement and operating statement. It details how much money you made and how you made it, and how much money you spent, over a period of time.
The time period could be a month, a quarter, a half-year, or a year. For example: “For the Four Weeks Ended August 4, 2012” (the time period July 1 through August 4, 2012) or “For the Fiscal Year Ended June 30, 2012” (the time period July 1, 2011, through June 30, 2012).
While the format of the P&L will vary depending on your accounting system, the sections are arranged in a standard order. Within those sections, most retailers recommend using consistent revenue streams as your categories.
The first section displays your gross income (all money that has come in) minus any discounts, allowances, refunds, and returns, resulting in your net income.
As an example of the categories within the gross income section, Eric Anderson of Vroom Network recommends separating out three revenue streams: Parts (items needed to keep things running or racing), Accessories (items wanted to add the look or sizzle in racing), and Garments (dressing the driver and fans). If your shop provides services such as tuning services, chassis adjustments, and parts installations, that income would also be categorized.
The last entry in the first section subtracts the cost of sales, such as packaging and delivery, from the net income, giving your gross profit.
One caution: Don’t confuse “revenues” with “receipts.” When using the standard accrual basis of accounting, sales revenues are shown in the period they are earned, not in the period when they are collected. In other words, revenues occur when money is earned, receipts occur when cash is received.
For example, if you sell merchandise in December and give the customer 30 days to pay, the revenue occurs and is reported on the December P&L. When you receive the check 30 days later, you have a January receipt, not January revenue.
The next section of the P&L details your operating expenses, sometimes called fixed costs. Operating expenses are your basic overhead costs, such as utilities and insurance, which do not vary with sales or production. Subtract these operating expenses from your gross profit and you have your operating profit.
Next, variable expenses are factored in. Variable expenses are your production-related expenses, such as raw materials and shipping, that are directly affected by sales. On the P&L, they are listed as “Cost of Goods Sold” (COGS) and are probably your largest expense category.
Finally, any other income, such as interest, is added in to give your profit before tax. Subtract the tax from that profit-before-tax amount and you have your net profit or loss.
The balance sheet, also called a “statement of financial position,” is a snapshot of the financial health of your business at a certain point in time. It shows how the profits listed in the P&L have been used.
Typically, a balance sheet is prepared on the last day of a profit period, such as at the end of a month, quarter, and year.
Matt Quinn of the Wall Street Journal’s corporate finance blog says a balance sheet is “intended to be a gateway to understanding a company’s financial position.” But, he advises, “there are lots of places on one for valuable information to hide.”
A balance sheet is presented in two sections: 1) Assets such as property, equipment, stock, cash, and money owed to you, and 2) liabilities such as loans and other money you owe.
Within each section, the items are often organized by how current the account is: in assets, accounts from most liquid to least liquid; in liabilities, from short- to long-term borrowings and other obligations.
But it’s what the numbers can tell you that’s important. Some numbers are uncomplicated. For example, if receivables are increasing significantly faster than revenue, you’ll want to investigate if you have a problem with collections.
Other analyses require a bit more math. For example, determining if you can meet your short-term obligations (liquidity) and sustain your activities over a longer period of time (solvency) require financial ratio calculations.
One key ratio, called “current ratio,” is your current assets divided by your current liabilities. Current assets include cash, accounts receivable, inventory, and any other assets that can be converted into cash or used up within the current period. Current liabilities are what you need to pay off in the current period.
According to Dr. Tom Robinson, managing director of the education division of the CFA Institute, a good current ratio for a small business is 2 to 1. That is, if you have twice as many current assets as liabilities, you are considered to have good short-term financial strength.
For example, if SpeedShop Racing’s current assets are $2,000,000, and its current liabilities are $1,150,000, then its current ratio is 1.74 ($2,000,000 divided by $1,150,000). This means SpeedShop Racing is in a relatively good short-term financial position.
As a current ratio number dips closer to 1, it can signal that the business will have trouble meeting its short-term obligations. As a current ratio increases to 3 or 4, it can be a sign that the business has so much cash on hand, it’s doing a poor job of using/managing it.
Other calculations, such as determining how many times your inventory is sold and replaced over a period time, can give you specific information about your efficiency. To determine your inventory turnover ratio, you can divide the cost of goods sold by the average inventory, or simply divide sales by inventory.
But remember that in analyzing the resulting ratio, it’s your call what the number means. For example, a very low ratio can mean you have too much inventory because of poor sales, or that you’ve just beefed up your inventory getting ready for the season to start. An unusually high ratio could mean sales have been strong, or that your buying has been ineffective.
You can also get useful information from one or more common-size analyses. In a vertical common-size analysis, you express assets, liabilities and equity as a percentage of total assets.
Comparing these percentages across years lets you spot changes, and changes can give you information. For example, if inventory was 10 percent of your total assets last year and 12 percent this year, you would want to investigate why your inventory grew faster than your total assets.
In a horizontal common-size analysis, you calculate the year-to-year change for each line item in the P&L and balance sheet, looking for how an item has changed relative to total assets and revenue changes.
If, for example, revenue grew by 8 percent, assets increased by 5 percent, and inventory jumped 12 percent, you would investigate why you’re building up inventory when revenue is increasing at a strong pace. Is there any chance you are building up too much stock?
Using the Numbers
A budget isn’t like a credit limit; it’s not a ceiling for how much you can spend. It’s a planning tool to take some of the stressful guesswork out of running a retail business.
But without building your budget from real data, you run the risk of spending more money than you’re taking in. Or, conversely, not spending enough money to grow your business and stay competitive.
One solid approach to budgeting is to use your previous P&Ls and balance sheets as your basis, factoring in industry performance trends and your good sense of what you expect to happen in the coming year.
As planning expert Tim Berry says, “This is where you plan your expenses. You are estimating expenditures across the business, from rent and overhead to marketing expenses such as advertising, sales commissions, and public relations. Decisions you make here are as important as the mathematics are simple: Your sum of expenses ultimately determines your company’s profitability.”
Analyzing your P&Ls and balance sheets with your accountant and other financial professionals can give you the information you need to grow your business successfully.