I had a client back in the 1970s who had an extremely high IQ. Had it not been for a variable rate SBA loan initiated at 8 percent then rising to 28 percent, we would have been rich. But the interest did go up, so here I am. The man told me of an incident where he failed miserably on a test in grade school. The school figured out that instead of answering the questions, he was trying to figure out the pattern to the answers.
That same proclivity served him well as a business owner because patterns are critical to business. I received a great deal of satisfaction from reviewing financial statements. Financials to me are like a book. You need at least five years of data to really get the most benefit from the documents. The story is not about being in a spot; it is about how did you get to that spot?
Every business has a story; it has a beginning. You need to know who, how and why. Financial statements tell parts of the story. A business has an end. Generally, the cause of the end is woven into the fabric of years of financial reports. A CPA lecturing at a seminar in the mid-1980s predicted the bankruptcy of General Motors. Being a Flint boy, that was blasphemy. Inquiring after his presentation as to his prediction, he simply stated that if the financials are correct, you just follow the numbers to their logical conclusion.
Looking at financials, business owners jump right to the bottom line. That’s fine, but you also have at least two more statements to peruse. The balance sheet shows where you’re at and the cash flow statement presents a picture of your liquidity. From those three statements, you should be looking for patterns. What’s going up? What’s going down and why?
The analysis of patterns raises questions. The first knowledge needed to resolve a problem is to know a problem exists. I cannot imagine a business that does not track sales. That’s good but could be misleading. You can usually raise sales by lowering your price. Break-even analysis is important to project gross profit at different levels of sales. An awareness of the break-even concept should be solidly set in the manager’s mind. An increase in advertising is logical if there is an increase in sales. If there is not an increase in sales, an investigation needs to be done as to the effectiveness of the promotions.
Charts and graphs can be great tools for visualizing trends. It may not make all that much visual impression seeing a shrinking gross profit rate in numbers and percentages. The visuals in a color graph of the relativity of numbers over a period may be more likely to move the reader to action than just seeing numbers.
Patterns can be good, bad and neutral. Some patterns are neutral simply because the amount spent analyzing that account would not yield any significant savings. A bad pattern would obviously be a drop in sales or a significant increase in cost of goods sold. The reason why I need five years of financials because, by definition, patterns refer to changes over a period. A 2 percent increase in cost may not cause alarm. If it becomes a yearly increase, you could find yourself in significant trouble. Few people possess the memory to accurately recall what the situation was 60 months ago.
Taxes play a large role in the need to follow patterns. Recent tax changes, especially at the state level, have improved the situation. Improved is good, but taxes still are a significant outlay of funds. Taxes to a certain extent are controllable. For a small business where tax control is often attained through the use of benefits mainly benefitting owners, be sure to make allowances for a reduction in profit due to increased owners benefits. Profit in a small business is measured by the profit, wages and benefits accruing to the owner.
The point I hope to have made is that you need to be intimately familiar with the ebb and flow of your business. What’s up and what’s down and over how long has a pattern developed? Does a banner year indicate future banner years or is it an anomaly? Was it just a bad year or should you be looking at a job with a competitor? Read your financials as if you were reading a novel, but you write the last chapter.
Paul Hense is the retired president of local accounting firm Hense & Associates and past chairman of the Small Business Association of Michigan.