Financial statements are often used to judge whether a business is performing well or not, however these numbers alone seldom tell the whole story. Entrepreneurs might be knowledgeable in their chosen field, but may lack the technical skills to fully analyse financial statements. It is therefore crucial to investigate other methods available for analysis of their business with financial formulae.
Seeing the big picture
While financial statements offer a good picture of past performance, they are not entirely suitable for predicting where the company might be in the future. Because they use historical data, they cannot accurately reflect sudden market changes or illustrate where a company is going. They are also not universal across businesses – a R1-million turnover might be exceptional for a one-person show but inadequate for a 30-person business.
More qualitative financial aspects of a business are not effectively accounted for in financial statements. Factors such as labour relations, customer satisfaction and efficient management are never included, but are critical aspects to decision making. One particular failing is that financial statements do not measure conversion rates of sales. This creates a narrow view of the business and its shortcomings.
It’s therefore essential to use other measurement tools alongside financial statements to determine which processes are in need of improvement. Business owners can make use of certain formulae instead of relying on financial statements in isolation. While intimidating due to their surface-level complexities, they can be easily applied.
Firstly, a business owner must ascertain the point at which a business is neither making a profit nor a loss. This is the break-even point. The formula is as follows:
Profit = (Selling Price x Number of Units Sold) – [Total Fixed Costs per annum + (Variable Costs per unit x Number of Units Sold)]
Simply put, this formula is designed to provide an understanding of how many sales are required to cover all associated costs. Anything above this level, or break-even point, is profit for a business.
Budgeting and the setting of realistic business targets are two of the planning processes made easier by this analysis. Equipped with this understanding, as well as targets and ideal profit margins, business leaders can make strategic decisions in order to drive sales. Management can also make better pricing decisions.
Measuring success with financial formulae
In order for businesses to increase their sales, they first have to understand them. All business is effectively driven by five key areas: lead generation, conversion rate, average sale, average number of transactions, and profit margins.
Lead generation refers to the total number of potential buyers that have been in contact with the business. Conversion rates are defined as the number of these inquiries that become sales. Combining these two gives the business’s number of customers.
Average Number of Customers = Lead Generation x Conversion Rate
Once you have the number of customers, you can use it in a formula to determine revenues: This can be done by multiplying it with the average rand sale (or equivalent currency) and number of transactions.
Revenues = Number of Customers x Average Rand Sale x Average Number of Transactions
The final step of this process is to take the resulting revenue number and multiplying it by a company’s profit margin percentage to calculate the bottom-line. If one of the numbers in this process is falling short – poor lead generation, low prices and so on – business owners can work with that specific variable to increase overall profit.
Profit = Revenues x Profit Margins
With these formulae, business owners can enjoy a new perspective on what is happening with their cash flow. Testing and measuring the success of processes is vital to any business and doesn’t have to be as scary as it appears. These tips will have entrepreneurs on the road to profitability in no time.
Pieter Scholtz is co-master franchisor in Southern Africa for ActionCOACH.