Understanding your profit

Survey results from participants that attended our recent cloud accounting seminars series, reported that the main item they would like assistance with is “understanding financial statements”.

Financial statements

Given financial statements are produced at least annually (if not more frequently), business owners should in theory understand and be able to interpret their meaning. Piecing together the meaning of the different reports accountants generate is sometimes difficult to grasp. Profit doesn’t always mean cash in the bank, and people often ask, “if I made $120,000 for the year, where did all the cash go?” Generally, you want to approach the answer to the question from the result and work back to the beginning i.e. find out how much of a profit you need to make to satisfy the demands of a business.

Where does all the cash go?

For example, take a typical “mum and dad company.” They spend $60,000 to run their house, put food on the table, and take care of themselves personally. Within the business, they need to allow for a new vehicle every four years, at let’s say $40,000, so this equates to $10,000 per annum on average. Their business also has a loan that needs to be repaid at $25,000 per annum. Overall the cash demands that exit their business each year will be $95,000.

Don’t get too excited just yet. The $95,000 annual cash demand is net of tax. This $95,000 equates to $132,000 of gross annual income, meaning tax payable demand of $37,000 exits each year to satisfy the Inland Revenue.

When you consider this level of earnings, it is quite high in context of the $60,000 or $5,000 per month the family needs to live on each year. Another thing that can trip people up is that the loan repayments, living costs (drawings) and asset purchases do not feature within the profit and loss statement. The profit and loss statement is only helpful to us in determining what the business is making. It doesn’t tell the story of cash demands upon the business by the owners, government and the business infrastructure itself.

Other factors

The above example is a simple view of the world as far as relating cash demands to profit generated. Other factors can affect cash availability such as customers not paying their bills, or stock levels building up. A common complaint amongst the building industry currently seems to be customers not paying their accounts. This is where the balance sheet can come into play, when you compare balance sheets at different points in time.

By completing comparisons, you can tell where your stock levels, accounts receivable and accounts payable levels are all heading. If your inventory or accounts receivables are going up, then this often causes cash to be squeezed. At the end of the day, cash is king, so it pays to look after those accounts that don’t pay on time, settle disputes so tidy up payments can be made and not stall or quit slow moving / obsolete stocks that should be turned into cash instead of taking up valuable shelf space.

Statement of Cashflows

One report that is helpful and able to be run on most software programs is a ‘Statement of Cashflows’. Try running one of these reports next time you are looking at your financial reports – it is highly possible it will reveal something enlightening for you. It is a relatively simple exercise to work out how your income fits with your outgoing commitments.

If you would like more assistance in this area, contact your Findex adviser.