Ask entrepreneurs what ingredients form the lifeblood of their businesses and most will say that enthusiasm, commitment and dedicated service are key. While all of these are very important, entrepreneurs who know where their businesses stand financially are the most successful. They also know that financial statements are the glue that holds any business together.
“Understanding financial statements is a major part of helping build a business’ success,” says Ravi Govender, Head of Small Enterprises at Standard Bank.
Because of their importance, the topic of financial statements was selected as one of the topics for the series of BizVideos on Standard Bank’s BizConnect website. In Standard Bank’s continued drive to provide solutions aimed at creating a sustainable SME sector, the BizVideos were designed to provide practical advice to small business owners on how to manage a business effectively. The videos can be accessed by logging on to www.standardbank.co.za/bizconnect from March to May 2014. (Please see Editor’s Note for schedule.)
“Financial statements enable business owners and other professionals such as accountants, bankers, and potential investors in a business, to see how a business is performing,” says Mr Govender.
The main elements within financial statements are balance sheets, income statements and cash flow statements. The functions of these are:
- A balance sheet provides a full picture of a business, gives detailed information about a company’s assets, what it owes (its liabilities), the number of shareholders in the business and the percentages they own (shareholders’ equity). A company’s assets have to equal, or ‘balance’, the sum of its liabilities and shareholders’ equity. The assets are things bought or created so that products and services can be sold. ‘Current’ assets include stock, bank accounts, investments and money due to the company. ‘Non-current’ assets are fixed assets and include buildings, IT equipment, vehicles, furniture and shop fittings. Liabilities give details on what money is owed to suppliers or other third parties. They include ‘current liabilities’ such as payroll commitments, overdraft payments, rent and tax payments, and ‘long-term’ liabilities such as shareholders’ loans and outstanding third party payments. Shareholders’ equity is the money that shareholders have invested in a company. Also called capital or net worth, it is also the money left for shareholders if a company sold its assets and paid off what it owed.
- An income statement shows the revenue earned during a defined period and the costs and expenses involved with earning the revenue. It shows whether the company was profitable or not. An income statement tells the owner what the gross profit of the company is. This is derived by taking total sales (total monthly turnover) and deducting the cost of sales (any costs undertaken in providing a service or making a product). Expenses, including depreciation costs and tax are then deducted from the gross profit to reveal the ‘net’ (or final) profit. Expenses include ‘fixed costs’ such as salaries and rent and ‘variable costs’, like stationery, telephone costs, marketing and other expenses.
- A cash flow statement reports on cash inflows and shows what has been paid by customers. It also shows cash outflows such as money paid to suppliers and stock purchased. It also adjusts for provisions like depreciation where no actual cash has changed hands. A cash flow statement also helps the owner focus on reducing debtors, controlling stock and other aspects of the business.
“With the financial statements providing everything you need to know about your business, all that remains is to use the numbers so that you can assess how well the business is performing,” says Mr Govender. The most important things to consider are:
- Gross profit margin, which is the percentage profit the business makes for every rand sold before expenses are deducted. If the gross profit margin is 50%, it means that for every R1 worth of stock you sell, you make 50 cents towards covering your operating expenses.
- Net profit margin, which is the percentage profit your business makes for every Rand sold after all costs have been deducted off the revenue.
- The current ratio, compares current assets, such as unpaid invoices, against current liabilities (unpaid bills).The ideal is a current ratio that is two or more, as the company’s assets are then double its existing liabilities.
- Return on owner’s equity. This ratio compares net income to the equity you have invested in the business. It reveals how much you are making from your investment. For example, if you have invested R200, 000 and the business is generating a net income of R100, 000 a year, your return on owner’s equity is 50%.
“Initially, the thought of getting to grips with financial statements may be daunting. However, once they are mastered, business owners are quick to realise just how valuable they are as tools for effective management. Invest the time required, become ‘financial statement literate’ and reap the benefits,” says Mr Govender.