Before we start part two of this two part series (read Part 1 of the year-end financial analysis process first) on conducting a year-end financial analysis for your business, let’s recap part one.
In part one we covered:
- The three documents of a year-end financial analysis
- An introduction to the three sections of a profit and loss statement
- How to make sense of the total revenue section of the profit and loss statement
First we’re going to cover the cost of goods sold and expenses sections of the profit and loss statement. Then we’re going to cover the final two documents of your year-end financial review, which are the balance sheet and statement of cash flows.
P&L: Cost of Goods Sold
The costs of goods sold section of the profit and loss statement shows the direct costs of generating the revenue displayed in the total revenue section. Let’s go back to the Dentist example we used in part one. One of the Dentist’s line items is installing crowns. The cost of each crown is $200, and the Dentist charges patients $600 for installation. The $200 price-per-crown goes in the cost of goods sold section.
Remember, only the direct costs of offering the line items in your total revenue section go under cost of goods sold. Say our Dentist purchases a new x-ray machine for $500,000. That would not go under cost of goods sold. It wouldn’t even show up on the profit and loss statement. This purchase would go on the balance sheet, which we’ll be discussing a little later.
Your cost of goods sold will typically fluctuate up and down in direct correlation with your business volume. It shows you your profit and margins for each of your line items. Once you have these two sections in harmony, you can then analyze your gross profit.
Your gross profit is the money you make before paying out your overhead. Figuring out this number for each line item is simple.
Say our Dentist installed 10 crowns this year at $600 a pop. That is $6,000 of total revenue. At $200 per crown, the total cost of goods sold is $2,000. That gives our Dentist a gross profit of $4,000 for installing crowns. Looking at your gross profit allows you to see if you are overcharging or undercharging for any of your line items.
The final section of your profit and loss statement shows all of your costs of being in business. Three main components of this section are rent, utilities, and payroll. These are your costs that don’t rise and fall in relation to business volume. What most business owners fail to realize is excessive overhead can kill a business.
Have you ever heard the saying “grow, grow gone”? So many companies get too big, too fast and end up with unsustainable overhead. You want a “trim the fat” mindset when you look at your expenses section. Are all of your overhead costs absolutely necessary?
If you remember from part one, we covered the four key questions to ask yourself throughout your year-end financial analysis.
- What is trending upwards?
- What is trending downwards?
- What is trending randomly?
- What is making / costing the most money?
Together, the three sections of the profit and loss statement provide clear answers to these four questions. You’ll also ask these questions when you analyze your balance sheet and statement of cash flows.
Your Balance Sheet and Statement of Cash Flows
The second document of your year-end financial analysis is the balance sheet. Remember the x-ray machine our Dentist purchased? The balance sheet is where that purchase would show up. The balance sheet shows tangible results. It shows you who owes you money (accounts receivable), who you owe money to (accounts payable), your expenses, your assets, and your total cash amount.
Most people get scared by the “assets and liabilities” section of a balance sheet. Let your bookkeeper or accountant handle this section. You want to focus on the areas we just covered.
Balancing a balance sheet involves making sure all fluctuations to your total cash amount are reflected as either assets or expenses. The balancing processing is why the third document, the statement of cash flows, is so important.
The statement of cash flows answers two important questions: “Where did my money come in?” and “Where did my money go out?”. It is the simplest, but most important, document of your year-end financial analysis.
When you use the profit and loss statement, balance sheet, and statement of cash flows together, you are able to see both the big-picture and small details of your business’s financial health.
The final step of the year-end financial analysis is using your analysis to make your business goals for next year. Most people incorrectly make their plans based on their bottom line. It is nice to want to increase your revenue by $100,000, but how are you going to increase your revenue? These three documents can show you exactly how you can generate this extra revenue.
Take the Year-End Financial Analysis Challenge
I want to end this article with a challenge. Set a date right now for your year-end financial analysis. The sooner we get this done, the sooner we can get to work on next year.