How will my business perform in 2021? As we enter the start of a new year, you may be asking yourself that question. Now is a great time to evaluate your 2020 financial statements, so that you can make changes and improve your results this year. Use these tips to analyse your financial results for a more profitable 2021.
Three Important Goals
To start the process, think about what a successful business would look like in 2021. Many business owners use these three metrics to measure success:
- Higher profits: The best way to measure profit is by using profit margin, which is computed as (net income) / (revenue). This ratio measures the profit generated for each dollar of revenue (sales), and profit margin allows you to compare the profitability of products with different sales prices. It’s a great “apples to apples” comparison tool for profit.
- Increased cash collections: In addition to higher profits, your business must be able to collect enough cash to operate the business. Ideally, cash collections from sales should cover your cash needs each month, which reduces the need to borrow money to finance operations. Business owners should compare the percentage increase in sales to the rate of increase in the accounts receivable balance.
- Business expansion: If you’re planning to add salespeople, start selling a new product, or open a second location in 2021, you have to consider the impact on both your profit margin and your cash collections. When you expand, you may need to spend more dollars in the short term to increase your total profits over time. What will the financial impact be in 2021?
If you start your evaluation with these goals in mind, you’ll stay focused on the data that will drive profits, cash inflows, and profitable business expansion.
Meet Julie
Julie owns Sunset Landscaping, a firm that provides landscaping, lawn care, and tree removal services for the residential market. Here is the 2020 income statement, and the 31/12/2020 balance sheet:
| SUNSET LANDSCAPING | ||
|---|---|---|
| Income Statement ending 31 December, 2020 | ||
| Sales | 502,100 | |
| Cost of Sales | ||
| Materials | 150,000 | |
| (sod, mulch, flowers) | ||
| Labour | 230,000 | |
| Total Cost of Sales | 380,000 | |
| Gross Profit | 122,100 | |
| Operating Expenses | ||
| Office salaries | 30,000 | |
| Depreciation | 15,000 | |
| Insurance | 8,000 | |
| Home office costs | 7,000 | |
| Marketing, advertising | 4,500 | |
| Repair and maintenance | 4,000 | |
| Travel costs | 1,500 | |
| Total Operating Expenses | 70,000 | |
| Net Income | 52,100 | |
| SUNSET LANDSCAPING | ||
|---|---|---|
| Balance Sheet ending 31 December, 2020 | ||
| Assets | ||
| Current assets | ||
| Cash | 40,000 | |
| Accounts receivable | 70,000 | |
| Inventory | 30,000 | |
| Long-term assets | ||
| Machinery | 5,000 | |
| Equipment | 40,000 | |
| Vehicles | 60,000 | |
| Total Assets | 245,000 | |
| Liabilities | ||
| Current liabilities | ||
| Accounts payable | 30,000 | |
| Current portion – long term debt | 20,000 | |
| Long-term liabilities | ||
| Bank loan | 100,000 | |
| Total liabilities | 150,000 | |
| Equity | ||
| Owner’s capital | 40,000 | |
| Retained earnings | 55,000 | |
| Total equity | 95,000 |
Start with trends
Julie generates her 2018 and 2019 year-end balance sheets and compares each line item with her 2020 results. The idea here is to identify trends in the data, and then to understand the reason behind each trend.
As Julie reviews the balance sheet data, she notes that sales (in the income statement) have increased 20% from ’18 to ’20. After reviewing each balance sheet line item for all three years, Julie notes several useful trends:
- Cash and accounts receivable: Sunset’s cash balance increased by 15%, while accounts receivable grew by 25%. This trend tells Julie that, on average, customers are paying at a slower rate than in 2016. If customers were paying faster, the cash balance would increase at a faster rate than the accounts receivable.
- Long-term assets: This category only increased by 5%. Sunset has been able to grow sales without the need to purchase more trucks, stump grinders, and other expensive assets. Because the company is generating more revenue from each asset, the business is more profitable and retains more cash.
- Long-term liabilities: The bank loan balance decreased by 20% during the period, because Julie was able to pay down the loan balance. Sunset increased sales without the need to buy expensive assets with borrowed funds. Cash collections, on average, have slowed, but Julie does not need to borrow funds to operate the business.
Performing trend analysis on the balance sheet is helpful because the business owner can get a sense of where the company is headed financially. Consider doing this type of analysis each year.
Consider Sales Prices and Costs
Julie moves on to review the income statement, and this review should focus on sales prices and costs. The 2020 income statement lists sales of $502,100, and Julie should review the prices she charges, and if those prices can be increased to generate higher profits. Sunset provides a written estimate for each job, and Julie prices work based on her industry experience.
If, for example, Sunset charges $300 to cut down and remove a 10-metre tree, can the price be increased? To answer this question, Julie should consider the prices charged by her competitors, and how her repeat customers would react to a higher sales price.
Next, Julie reviews each expense category and considers whether or not she can lower her costs. The landscaping company, for example, bought $150,000 in sod, mulch, and flowers in 2020. Can Julie negotiate a lower price with her vendors? Alternatively, can she find another vendor who can meet her quality requirements, but at a lower price?
Every business owner should review each cost category, and look for ways to cut expenses. You should also consider sales price increases, which is a step that many owners don’t consider. If you offer a quality product or service, your customer base may readily accept a price increase.
Take action to improve results
The reason you invest time to evaluate your financial statements is to make improvements and get better results. In addition to the income statement action steps, Julie must do the following:
- Collection policy: Julie should have a plan to increase cash collections. She should email all customers, once an invoice is 30 days old, and personally call people who have not paid in 45 days or longer.
- Asset Replacement: No business can operate without assets. Sunset must consider the remaining useful life of each asset, and when the assets need to be replaced. Once she has this information, Julie needs to create a plan to fund each asset purchase. She may set aside company earnings to pay for the purchases or plan on borrowing funds.
- Cash forecast: Finally, Julie should work with an accountant and create a 2021 cash forecast by month. The projection considers sales, how quickly customers pay for sales, and when Sunset must pay cash for materials and for payroll. This tool helps Julie determine whether or not she must borrow cash during 2021 to fund business operations.
As you review your financial statements, you may find other ways to increase company profits. The key point is to perform this analysis each year, and use your review to take action. The time you invest will help you have a more profitable 2021. You got this!