Doing a Year-End Financial Analysis is Crucial for Success
My fellow business owners and entrepreneurs out there, did you do a year-end financial analysis of your business last year? Regardless of how small or how big your business is, my question to you is this: last year when the year ended, did you do a full financial analysis?
Again, you could have a business that’s based out of your garage where you make necklaces and you have total sales of $50 a month and you could have this as a side business. You could have an eBay business. You could sell stuff on Craigslist. I don’t care. Or, you could have a massive corporation. My question to you is always the same: did you do a full year-end financial analysis last year?
Because if you didn’t, I can tell you that you are setting your business up for failure. Or if you are fortunate enough to be so good at what you do that you’re still making money, I guarantee you you’re leaving at least 50% of your profits on the table if you’re not doing a full year-end financial analysis.
And I’m not exaggerating when I say that because see, most entrepreneurs who I meet, most people who own businesses – in fact, over 80% of them are not doing year-end financial analysis. Now when you think about that, what you realize is these people are essentially playing a game where they’re not keeping score. Can you possibly win at the game of maximizing your profits if you’re not looking at the score?
A Financial Analysis is Like Keeping Score for Your Business
See, most people think they’re looking at the score. What they’re doing is they’re just looking at the money in their bank account and they’re saying, “Can I pay my bills? How much money am I saving? How much money am I putting away? How much debt am I incurring?”
Stuff like that – if that, by the way. But that’s how they’re judging their business is by how much money is in the bank. But how often are you going back and really looking at your financials? That’s the critical thing I’m going to teach you today. I’m going to teach you how to do a year-end financial analysis.
When do I do a Year-End Financial Analysis?
Now interestingly enough, the way I suggest doing a year-end financial analysis is actually before the year is over. See, once the year is over, you’re going to do another analysis, but that’s the one that you do with your tax guy so you can file your taxes. But for most of you, your year-end financial analysis is going to need to happen sometime between Thanksgiving and Christmas.
Why? Well because if you do your financial analysis between Thanksgiving and Christmas as I’ve told you before, now you can plan for next year, because that’s the most valuable thing.
Who cares about studying history? Why would you go back and study a bunch of history? Well, the reason you study history is because you want to learn lessons from history that you can apply in the future, and that’s the key with doing a year-end financial analysis.
For me, doing my year-end financial analysis is part of my annual review of my businesses that I do every single year. And as I told you, I lock myself up in a hotel room somewhere for an entire weekend or more depending on how big my businesses are and what I’ve got going on.
I lock myself up in this room and I do nothing but analyze this stuff and I go through it all and then I create a plan for next year. That’s how again, when you look at my businesses, each year my businesses will show massive improvements in the first few months of the year because I’m always doing new things.
I’m trying new things, I’m implementing new things, and it makes a massive difference, and the biggest area of that is your finances.
What is a Good Financial Analysis Tool?
So let’s get started with a couple of basics that you need to know when it comes to your finances. First of all, I highly recommend that you use QuickBooks as your financial analysis tool. If you are not already using QuickBooks, I highly, highly recommend you go look into it and see if it’s something you want to use.
If you’re using something else, it might be okay but, in my opinion, today, QuickBooks is the best thing to use for most businesses out there. I can tell you the biggest company I’m running on QuickBooks has over 150 employees, and QuickBooks does just fine.
Now there’s a point where QuickBooks isn’t going to cut it anymore. Maybe if you’ve got a company with thousands of employees or complicated things that go beyond what any of my six businesses do, but I can tell you today QuickBooks can do everything any of my businesses need.
In fact, I want to make sure you’re using QuickBooks online. If you’re still using the old version of QuickBooks that’s a desktop version, you’re going to have to change that right away. The online version of QuickBooks is so incredibly powerful it blows you away. It has an online version, which means you can access it from a desktop anywhere; you just go to the web and you can access your financials.
Second of all, they now have a desktop application that goes along with it so you can actually install a program on your computer so on your desktop it actually runs faster and it’s more smooth and it looks exactly like the online version.
And then the third one which just blows me away how far they’ve come with this in the last year or two is their application – their mobile application, their iPhone/Android app.
This thing is incredibly powerful. I mean you could run your reports, all that stuff, right on this that you can record transactions, you can charge people, you can pay bills, you can do all sorts of stuff directly on it.
And because it’s an online tool, it links up with all of your bank accounts and your credit cards and all that stuff, so it syncs everything for you. You can invoice people online and they can pay it online.
I mean, it’s just so incredibly powerful – such a powerful tool – I think you’d be crazy not to use it. So if you’re not already on QuickBooks online, I highly, highly recommend that you use QuickBooks online.
Mint is a Good Tool for Personal Finances
For those of you who don’t know, I’m a big proponent of Mint.com for your personal financials. For those of you who don’t know, Mint.com was purchased by Intuit, the same company that owns QuickBooks. So what Intuit did is they purchased Mint and then took a lot of the amazing things that they have created for Mint and they’ve now implemented a lot of that stuff into QuickBooks.
So it’s a no-brainer. You’ve got to do it and the cost is minimal. It’s a monthly fee that you pay depending on what version you need. Now, the version of it you need is going to depend on your business, the size of your business, and stuff like that, but get that done.
So today I’m going to talk as if you already have QuickBooks, so a few times I’m going to make references to certain features that are QuickBooks feature.
Now, any financial tool that you use out there – I don’t care what you’re using – is going to do all these things, no matter how simple or how complicated it is, it’s going to have all these features that I talk about.
Now, it might call them slightly different things but for the most part, today’s talk is generic although a couple of times here and there I’ll throw out specific QuickBooks things.
The 3 Key Documents of the Year-End Financial Analysis
Now look, if you’re analyzing your financials there are three key documents that you need to be looking at. Most business owners never look at their financials and when they do, they only look at the first of the three documents.
Why? Because they can’t make any sense out of the second two, and many people don’t even know the second and the third one exist.
1 – The Profit and Loss Statement
The first one that I know all of you have seen is a P&L – a profit and loss statement. Now why do people look at their P&L? Well, they look at the P&L and what do they do? They go straight to the bottom, right? Have you ever done that before? If you have a one-page P&L, you look right at the bottom of the page.
If it’s a multiple-page P&L, what do you do? You just flip to the last page and you go all the way to the bottom, all the way to the right-hand side, and you look at that number. You see how much money you’ve made.
That’s how most of you are reading a P&L. I know, because I coach you guys and I know what you do in your businesses. Well, while that number may seem like a really important number, believe it or not, it’s probably one of the less important numbers that you can get on these documents.
First of all, a P&L is simply theoretical – and this is the key word, theoretical – look at how much money you may or may not have made or lost – purely theoretical. That’s why you’ve got to look at your P&L, but you’ve got to take all the information from your P&L with a grain of salt, especially if you’re running your business on an accrual basis. B
ut this theoretical thing also applies if you run your business on a cash basis. Now, for those of you who are saying, “Arman, I don’t know what accrual is. I don’t know what cash is,” it’s super, super simple.
Everything I talk about is for you, the entrepreneur, whether you’re an established business owner or you just started a business yesterday selling baseball cards as I did when I was 10 or 11 years old. It doesn’t matter. All this stuff is simple, simple things that you can learn.
What is the Difference Between a Cash and Accrual Business?
What’s the difference between cash and accrual? Cash and accrual are simply this. On an accrual basis, you put things on your books when you either earn the revenue or you spend the money – theoretically. Meaning, let’s say you have an electrical bill and it’s for $1,000 for this month.
Well, if you’re on an accrual basis, you put that in and you put that you spent $1,000 on electricity, even though you haven’t paid the bill yet.
Now if it’s on a cash basis, you don’t put in that you had $1,000 worth of electricity this month. You just put in the day you write the check. Now the difference between that is this. Let’s say you fall two months behind on your electricity – don’t do this, because they’ll shut you off.
But if you do, on an accrual basis you still show that you used electricity in the month of October and that you used electricity in the month of November. Whereas on a cash basis, it’ll show that you had no electrical expenses in October and in November, it’ll show the total expenditure. So if it was $1,000 each, it’ll show $2,000. That’s the difference between accrual and cash.
Most businesses are simpler to run on a cash basis than an accrual basis. However, running your business on a cash basis is not really, really, really telling you the best story. S
o ideally, you run your business on an accrual basis but there are some complications that come along with running a business on an accrual basis. For a lot of the small, small, small businesses out there – if you’re doing for example less than $1 Million a year in revenue – I would suggest you run your business on a cash basis, unless there’s some reason you want to go accrual.
As your business begins to grow, you’re going to want to do accrual. For big companies, you cannot do them on a cash basis. To give you an idea, public companies and big corporations, of course they’re all on an accrual basis. It wouldn’t make sense to run those businesses on a cash basis.
It doesn’t mean you can’t look at the cash; you still can, but you run your financials on an accrual basis. Let’s say you’re a doctor. When you see a patient on an accrual basis and the patient is supposedly being charged $100 for the treatment that you’re giving them.
Cash vs Accrual Examples
Let’s say you’re a dentist and you do a filling and it’s going to be $100, let’s say. You book that $100, even though this person might not pay you for another two months, even though you’re going to bill the insurance. It doesn’t matter; you put it on the books for that month.
Why accrual is valuable is because when you’re running your business on an accrual basis, you can actually see the activities in this month.
How much revenue you earned this month, how much payroll you had this month, how much expenses you had this month. All of it is truly for this month, regardless of how much of it you paid, how much of it got paid to you, and all that.
When you run things on a cash basis, you’re sort of seeing the world a little later than it actually happens, and you’re seeing a slightly skewed version of it. Let’s say you’re a dentist and your billing is falling behind; it looks like you’re having bad months.
In reality, you’re having a great month as a doctor; it’s your billing department that’s having a terrible month. One month you get your billing department to get on top of it and they bill everybody, and they get all of the money in, and suddenly on a cash basis it looks like you had a great month. But in reality, all you did was you did really good billing.
So it’s a give and take, right? You’ve got to decide which way you want to run your business. But just keep in mind, when you run your business on a cash basis, it’s a lot easier to do accounting.
When you go on an accrual basis, now it’s a little more complex but not a big deal. And if any of you know, one of the things that I’m a huge proponent of is completely outsourcing your accounting. For most of you out there, you can outsource your accounting. I have personally outsourced accounting for every one of my companies and I highly recommend you do the same.
At my Business Boot Camp, I get into this and I actually bring in the company that I use to outsource my stuff and I teach you how to work with them to outsource all of your financials. So if you have not outsourced your stuff and you’re coming to my Business Boot Camp event anytime in the next six months or a year, then it’s okay.
You can come to that event and you’re going to learn from me how to outsource all of your accounting and bookkeeping.
Now, let’s get into the nitty-gritty of it. When you’re looking at your P&L, you’re now seeing a theoretical picture of how your company is doing.
2 – The Balance Sheet
Next, let’s talk about the balance sheet before we get into the details of the P&L. What is a balance sheet? A balance sheet shows you all of the things that you have – simple. It shows you what you have. It shows you the tangible things. A balance sheet will show you, for example, the end result of all this stuff.
If the P&L shows you sort of what’s going on, what the activity is, the balance sheet shows you the end result of all this. The balance sheet will show you hey, you owe people a total of $50,000 and people owe you a total of $200,000, and you own $50,000 worth of furniture.
It’s all of that stuff. It shows you what your balance is in all of your credit cards. What’s the balance in all of your bank accounts? It’s the end, end, end result.
And guess what? Many people are annoyed by the balance sheet because it seems that it’s so hard to read. But I’ll tell you, it’s actually not that complicated once you understand how it works, and we’re going to talk about the basics of it today.
And if any of you again are coming to my Business Boot Camp, that’s where we really get into it.
3 – Statement of Cash Flows
But then you have the third document, which is your statement of cash flows. Now, a statement of cash flows, especially for a business run on an accrual basis, is extremely important because it shows you where your cash is going. It shows you cash in and cash out.
And by the way with a business, anytime we talk about cash, we don’t really mean just physical cash. Cash, checks, credit card transactions, wires – any money that’s changing hands electronically, physically, or otherwise – is considered cash.
So what you’re looking at on the statement of cash flows is where did my money go and how did money come in. At the end of the month you can look at it and you can literally see very, very quickly and easily on a statement of cash flows is how much money total did you bring in for the month and how much money total did you spend for the month. Would be a valuable number for you to know, yes or no?
If you spent $100,000 and you brought in $95,000, is that something you can continue to do regardless of what your P&L and your balance sheet tells you? Of course not.
So what you’re looking at is you’re constantly looking at those three documents together because the three of them together give you a story about how your business is doing. If you look at any one of them independently, they’ll lie to you.
It’s about bringing those three together to see how your company is really doing on a monthly basis, on a quarterly basis, and absolutely without a doubt on an annual financial review at the end of the year between Thanksgiving and Christmas where you sit there, and you really figure out how to do this stuff for your own business. You dig into it on an annual basis and you analyze these things.
What Sections of my P&L Statement are Most Important?
So now, the P&L then shows you where you are making money and where you’re spending money. Let’s get into this in a little bit more detail.
Remember, I said it’s theoretical, especially if you’re doing things on an accrual basis. If you’re a doctor, a lawyer, or a professional out there, you know that much of what you bill you never get paid because you end up having to go to collections, insurance doesn’t pay, people don’t pay, and God knows what else.
Credit cards get denied. The thing is that sometimes this theory is truly a theory, but it’s a very, very important theory to understand so you still have to dig into it.
The Top Section Shows Your Revenue
When you look at your profit and loss statement (your P&L), you look at the very, very top of it that’s section one of three. So when I talk about a financial statement, I talk about three different sections. Now there’s also this fourth section at the bottom that you can look at, but I’m going to keep it very simple. The top of your financial statement on your P&L is going to show you all of your revenue
. It’s going to show you where money is coming in from. It’s going to show you the sales that you’re making. And if you have multiple channels – again, as a dentist – if you do fillings, if you do crowns, if you do cleanings, if you do all that sort of stuff, if you sell product in your office, it’s going to show you all of those things.
The Second Section is Your Cost of Goods Sold
Then the next section is your cost of goods sold. The next section shows you hey, where are we spending money in order to be able to do the things that we do in section one? This is very important. These are direct costs that are going to affect your sales, meaning the things that go in that second section, these are the direct costs.
This is not your rent, for example, because if you double your business in most cases, you’re not going to double your rent. Your building is your building. Now at some point if you grow enough, you’re going to have to move to a bigger office.
The Third Section is Your Expenses
But for most businesses, when you increase your sales, you do not increase what’s called overhead. Overhead, things like rent, things like utilities, they go into that third section. Those are your expenses.
And then the fourth section which I talk very little about is all this other stuff, all this fancy stuff that your accountant needs to know. You really don’t need to look at that section, but it’s all this other random stuff like taxes and stuff like that, but you really don’t need to do much with that because that’s the part that you have very little control over.
Now there are some things in there by the way that you have control over that have to do with interest rates and stuff like that, but let’s ignore that fourth part. Let’s focus on the first three.
The Revenue Section Explained
Going back to the top, when you look at your P&L and you’re looking at the top section, what you’re looking for is your different streams of income. Now, the first thing I can tell you is this.
For most of you out there, you should be able to get your entire P&L collapsed onto one page, and this is my homework for you if it’s not already collapsed into one page.
Now in QuickBooks there’s a little button that says “collapse.” When you hit the collapse button in QuickBooks, I want to see that your P&L is no longer than one page.
If it’s longer than one page, for most of you out there unless you have a huge business, I suggest you get with your accountant or wait until you go through my Business Boot Camp and get with the people that I’m going to set you up with so we can get it so that your collapsed P&L is on one single page.
If it wraps to a second page, even if it’s just one line, I don’t like that. I want you to be able to see it all on one page. Now when you expand it – again, another one of those QuickBooks terms – when you expand it and it goes to two, three, or four pages, I don’t care. But the collapsed version, I don’t want it to be more than a page.
When you’re looking at this thing, here are some of the most common mistakes I see. When you look at the top portion that shows you your revenue and sales, what many you are going to have is either too many line items or too few line items.
If you look at the top and all of your revenue is one line item, you’re doing something wrong. It’s not telling you the specifics of where that money is coming from. The other extreme that I see is entrepreneurs who have this P&L and you look at the top and there’s like 11 different line items.
See, that’s too many. What you’re looking for is something between three to five, six, seven, maybe something like that, but certainly less than 10 lines and there certainly should be at least three lines up there.
How to Choose Line Items to Monitor
What you’re doing is you’re categorizing your income or your revenue or the money that you’re making. You’re categorizing into big categories. A dentist might have for example all of their basic stuff into one category and they just call it “basic dentistry.” I don’t know what it would be called.
A second one could be sort of the fancy stuff that they do, like the crowns that they do or any kind of additional work that people come in for above and beyond the regular stuff.
And then the third one maybe is the products that they sell. A fourth one could be any referral revenue that they have. Maybe they work with an orthodontist or something.
I’m just making stuff up here, guys. The bottom line is that at the very top you need to see what are the different ways that your company is making money and you need to have those separated out into different channels.
Now, you don’t want to list every single product either, and that’s what I see sometimes is people will have all these lines – like 15 lines. What they’ve done is they’ve taken their items – again, that’s a word that QuickBooks uses. They’ve taken their items and they’ve given each of them a unique account. You don’t want that, either.
What you want is you want to have it where everything at the top is telling you a big-picture quick story. Let’s say you have five items – perfect. Now what you’re doing at your annual review is you’re looking at those five items and you’re saying, “What are my biggest sources of revenue?”
And one of the things that I highly recommend you do in your annual review is you’ve got to look at those line items and you’ve got to decide where am I really making most of my money? Not where did I think I was making most of my money.
Why Analyzing Your Streams of Income is Important
Now this is not profit; this is just sales. This is revenue. This is total gross money that comes in. But what we’re looking at is where the money is really coming in from.
If you’re that dentist, are you really making most of your money on crowns, or are really making most of your money on tooth cleaning?
So if you make most of your money on tooth cleaning but you’re putting all of your focus on doing crowns because they sound like a great idea, what you need to start realizing is hey, maybe I just need to focus more on these cleanings because they’re making me more money.
Now as you’ll learn in the next step though, you then need to look at the profit that you’re getting from each of these. Maybe you’re getting a lot of revenue, but it’s not turning into money in your pocket because the margins are not good. But what you’re looking for is what are those biggest things?
Then the next thing that you’re going to do is this. In QuickBooks – and again in all these financial software, but definitely in QuickBooks – there’s a way that you can click so that instead of showing you the totals, there’s a drop-down that says “Totals only” when you first run this report.
Use Your Financial Analysis Software to get a Month-by-Month Breakdown
What you’re going to do is click that drop-down and then you’re going to do “by month.” When you do by month, it now breaks your entire P&L into showing you every single month.
So if you’re doing it for the last 12 months (which is what I recommend) or doing it for year-to-date – so if you’re doing this between Thanksgiving and Christmas, what you’ll get is 10 months of data or 11 months of data. You’ll have 11 different line items and then you’ll have your total. If you’re doing it for the last 12 months, you get 12 months and then a total.
What you’re looking for is what things are fluctuating a lot on a monthly basis.
What things are up and down? You’ll see some of your revenues pretty steady. Some things are just going up and then they’re falling, and what you’re doing is you’re going to look into those and say why.
- Why did these things fluctuate?
- Was it seasonal?
- Was it a promotion I ran?
- What was going on that caused this to happen?
And then, most importantly, you look at things that have some sort of a trend developing, either an up trend or a down trend.
By an uptrend, what I mean is let’s say some aspect of your business in June had $10,000 and then in July it was $12,000. Then in August it was $15,000 and in September it was $20,000. In October it was $30,000. We need to look at that and see what’s going on that’s making that thing go up, and it is something we want to have go up?
Maybe you’re starting to get into an area of the business that you don’t want to have go up. Or, some things are going down. Is some aspect of your business going down and you’re just not thinking about it?
An Example of Why Analyzing Streams of Income is Important
Imagine AOL back in the day when they had this service. At some point, I guarantee you that their revenue from their basic service of people doing dialup started to go down.
See, that was a really, really important day for them to notice because if their revenue in that area is going down, even though their advertisement revenue and all this stuff is going up, the company as a whole may be doing extremely well.
But see, AOL needed to see that oh my goodness, something is going on. We are not making as much money off of the basic part of our business, which is dialup. That’s what I want you to be watch.
So what are the things that are moving up and down at random almost? Then, what are the things that have either an up slope or a down slop? And then the fourth question (which is the first one I said), what are the biggest items? So when you look at the top of your P&L, those are the three big questions. I’ll go over them with you again:
1. What are my biggest revenue items? Where am I really doing most of my business?
2. What are the parts that seem to be up and down and don’t have any sort of a trend or any sort of an average that makes sense, that are up one day and down the next? What’s going on there?
3. What has an up slope and what has a consistent down slope? You’re looking for those things.
If you get that information, now you’re going to use that information to plan for next year, and that’s why you see my companies and they typically have so many massive changes and improvements towards the end of the year and starting the new year, is because I’m always looking at where my company is and I’m analyzing it.
Some of you might say, “Well Arman, why don’t you do that every month?” You could, but the thing is – and in fact we do a small version of this every month and every quarter – but really, it’s annually. But you can rethink the big things within your business.
All right, so let’s stop right there. That’s a lot of information for you to digest. What I’m going to do is in next week’s episode, we’re going to dig deeper into this same topic and we’re going to finish this off and make sure you know exactly how to analyze all the different areas of your financials. Part two of this series covers the remaining two sections of the profit and loss statement, as well as the balance sheet and statement of cash flows. Be sure to read it in order to complete your year-end business financial analysis.