Accounting is the way to keep score of a company’s activities, but finance brings a business to life in the form of growth, investments & product development.
One important role of business finance is to identify ways that the company can save on unnecessary expenses and increase profitability. The right Accountants & financial advisors look at what makes financial sense for a business, and what doesn’t, to ensure smart money management.
Smart money management ensures companies & individuals meet their long & short term financial goals by saving, spending & investing correctly.
It is important to always remember that we don’t work for the numbers, the numbers work for us. Money is just a tool to help us make better decisions, and that is what finance is, a tool to drive us to a better, safer tomorrow.
In short, people who understand the importance of finance and appreciate how it’s used within an organization have a leg up on those who just dismiss costs as expenses.
Overview of financial statements
A company’s financial statement is used to show a company’s performance over a certain period of time, usually every fiscal quarter. The financial statement mainly consists of three different statements: balance sheet, cash flow statements and income statements.
By being able to read a financial statement, you can determine where a company has made or lost money, where the money was spent and how the company stands in their current financial position.
An important thing to note is that financial statements give shareholders an overview of how their investment is performing.
Each has its own purpose which we will look at briefly.
* Balance sheet
A balance sheet lists the assets, liabilities and net worth/shareholder equity of the company as of the report date.
– Assets make up all the property the company owns, including different bank accounts, real estate, machinery, investments etc. An asset can also be intangible such as a trademark or patent.
– A liability is a financial obligation a company owes to others, and it is reported on a company’s balance sheet. A common example of a liability is accounts payable. Accounts payable is when a company purchases goods or services on credit from a supplier. liabilities also include loans payable (money borrowed from the bank), bonds payable, interest payable, wages payable, and income taxes payable.
– Shareholder equity lists the company’s net worth in the event that it is liquidated and what each shareholder would receive after paying the creditors of the company.
* Income statement
An income statement shows the financial results of the company’s operations and activities expressed over a period of time (i.e. 1 quarter, year-to-date, etc.). It includes revenues, profits, losses, and expenses.
In short, an income statement is used to assess profitability.
The cash flow statement is similar to the income statement in that it records a company’s financial (cash) performance over a given period of time. The difference between the two is that the income statement also takes into account some non-cash accounting items such as depreciation.
In short, A cash flow statement shows exactly how much money a company has received and how much it has spent, usually over a short period of time like one or two months.
Power tip: If a company plans to issue financial statements to outside parties (such as lenders or investors), the financial statements should be formatted in accordance with one of the major accounting frameworks. Financial statements that are being issued to outside parties may be audited to verify their accuracy & for authentication purposes.
How do we calculate a company’s valuation?
A business owner might want to know their company’s valuation for many reasons, but the most common reasons being the valuation for the purpose of a sale, valuation for the purpose of bringing in partners or sharing equity or valuation for the purpose of seeking investors or capital.
There are many ways to value a business, but there’s no “right” way. Ultimately, the business is worth whatever you think it’s worth.
Let’s say you are looking to buy an existing coffee shop. The owner said to make him an offer, but you’re not sure of the best way to determine the worth of the business. You could ask to see his books or to value the business based on a profit multiplier (You never want to value a business based on revenues, because even with high revenues, there might be no profit or even losses) there are many instances where companies sold for 2 x profit & even as high as 60 x profit.
Generally, you always want to look at the value of the business’s assets. If you were to buy the coffee shop, you would at least have to buy all the same stuff if you were starting a coffee shop from scratch, so the business is worth at least the replacement costs already.
The balance sheet can also give you a good indication of the company’s assets.
Keep in mind: If the company doesn’t have a good set of books, I would stay clear of wanting to buy it.
A break-even analysis is important because it helps an entrepreneur, team or company determine the sales quantity needed or the number of products to be sold without incurring a financial loss. It is important to do this, as the viability of your business is reliant on staying above this number.
Many entrepreneurs decide to completely discontinue an idea, product or service after conducting this kind of analysis. They immediately realize that it would be better for them to invest their time and money in producing and selling something else.
Let’s look at a tangible break-even example:
Siya is a self-employed chef, making and selling quality burgers for R25 each.
Siya determines his break-even cost by starting with his fixed costs of R12,000 per month. These costs include rent, electricity & cost of ingredients.
He divides R12 000 by the gross profit of R15 that he makes on the sale of each burger. So, his break-even in terms of unit sales is R12,000 divided by R15, which gives 800 burgers a month, around 26 needed to sell each day.
Break-Even Formula in units
Fixed Cost / Gross Profit per Unit = Break-Even in Units
R12 000 / R15 = 800 Units (Burgers)
(Ingredients would be a variable cost: variable costs can also be known as unit level costs. These costs change depending on how busy you are, the more you sell, the more you need to spend to meet the relevant costs associated with the sale. For this example, variable costs were not used.)
Siya could also think of his break-even in terms of total sales: 800 burgers multiplied by 15, which would equal R12 000.
If Siya’s sales are fewer than 800 burgers (or R12,000) per month, he is losing money. But, if his sales are greater than R12,000 per month, he is making a profit—R15 for every 800+ burgers that he sells each month which he can keep because his costs have been covered.
A break-even analysis helps you determine whether your overhead is realistic or needs to be reduced, adjusted, or not pursue the business any longer. Maybe for Siya’s burger store, it might have been impossible to sell more than 600 burgers in a month. If that is the case, then the fixed cost of R12 000 per month is too high for his business model. He needs to make some changes, either negotiate a lower rent, add an additional food product line, move to a better location, or determine if he should still continue with the business.
In short: A Break-Even Analysis Is A Reality Check for Your Business
This article is for information purposes only and you are advised to seek professional advice from your own accountant as your individual situation will vary.