Financial Statement Analysis: What Accountants and Bookkeepers Should Be Looking For
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A business can make a profit and still run out of cash. This is why accountants and bookkeepers need to look beyond the profit figure and understand what the financial statements are telling them.
Financial statements tell us how a business performed during a financial period. They show how much money the business earned, what it spent, what it owns and what it owes. However, preparing financial statements is only part of the accountant's job. The real value comes from understanding the figures and identifying problems before they become serious.
For accountants and bookkeepers working with small and medium businesses, financial statement analysis does not need to be complicated. It means comparing figures, checking movements, identifying risks and explaining the results to the business owner in a way that helps them make better decisions.
Start by Understanding the Business
Before analysing the financial statements, understand how the business operates.
A retail business will have stock, while a consulting business may have very little stock. A construction business may have large amounts owed by customers because payments depend on project milestones. These differences affect how the financial statements should be analysed.
Ask the business owner how the business earns its income, who its main customers are, what its major expenses are and whether anything significant changed during the year.
For example, if turnover increased by 20%, find out why. Did the business gain new customers, increase its prices or introduce a new product? An increase in turnover is positive, but only if the additional sales contribute to profit and eventually result in cash being collected.
Compare the Figures With Previous Years
One of the simplest ways to analyse financial statements is to compare the current year with the previous year.
Looking at one year's figures in isolation does not tell you enough. Comparing figures helps identify changes that require further investigation.
For example, assume a business reported turnover of R2 million last year and R2.4 million this year. Turnover increased by 20%, which looks positive.
However, if operating expenses increased from R1 million to R1.4 million, expenses increased by 40%. This means expenses are growing faster than turnover, which could place pressure on profitability.
The accountant should investigate which expenses increased and whether those increases are reasonable.
It is also useful to compare actual results with the budget and, where possible, with similar businesses in the same industry.
Another useful method is to calculate expenses as a percentage of turnover. If staff costs represented 25% of turnover last year and 35% this year, the increase needs to be explained.
Check Whether the Business Is Making a Profit
Profitability is usually the first area business owners want to discuss.
Start with the gross profit margin. This shows how much money remains from sales after deducting the direct cost of goods or services.
For example, if a business sells goods for R100 and those goods cost R60, the gross profit is R40. The gross profit margin is therefore 40%.
If the gross profit margin was 45% last year and decreased to 40% this year, the accountant needs to understand why.
The business may be paying more for stock, offering larger discounts or selling products at lower prices. There could also be stock losses, incorrect stock valuations or errors in recording purchases.
Next, look at the net profit margin. This shows how much profit remains after deducting all expenses.
A business with turnover of R5 million and net profit of R250,000 has a net profit margin of 5%. This means it earns R5 profit for every R100 of sales.
If turnover increases but net profit decreases, investigate the expenses. Pay particular attention to salaries, rent, vehicle costs, finance charges and other expenses that may have increased faster than sales.
Check Whether the Business Can Pay Its Bills
A profitable business is not necessarily a financially healthy business.
One of the biggest challenges facing small businesses is having enough cash to pay suppliers, employees, SARS and other creditors when payments become due.
The current ratio helps assess whether the business has enough current assets to cover its current liabilities.
It is calculated by dividing current assets by current liabilities.
For example, if current assets are R600,000 and current liabilities are R400,000, the current ratio is 1.5.
This means the business has R1.50 in current assets for every R1 it owes in short-term liabilities.
A current ratio below 1 may indicate liquidity problems. However, the accountant must also consider the type of assets included. Stock and outstanding customer accounts cannot always be converted into cash quickly.
The quick ratio provides another useful measure because it excludes stock and focuses on assets that can generally be converted into cash more quickly.
These ratios should not be considered on their own. The accountant must look at when money is expected to be received and when payments must be made.
Look Closely at Debtors, Creditors and Stock
For many small businesses, this is where financial problems begin.
Debtors' days measure how long customers take to pay their accounts.
For example, if a business offers customers 30-day payment terms but debtors' days have increased to 75 days, the business is waiting much longer than expected to collect its money.
This creates cash flow pressure.
Assume a business makes credit sales of R300,000 per month. If customers start paying 30 days later than before, approximately R300,000 more could be tied up in outstanding accounts.
The accountant should review the debtors' age analysis, identify overdue accounts and discuss collection procedures with the owner.
Creditors' days are equally important. They show how long the business takes to pay suppliers.
If customers take 75 days to pay but suppliers require payment within 30 days, the business must fund the 45-day difference.
Stock must also be reviewed. Stock that remains unsold for long periods ties up cash and may eventually need to be written down.
A business may report R800,000 in stock, but if R200,000 relates to damaged, outdated or slow-moving items, the value reported in the financial statements may not be recoverable.
Accountants and bookkeepers should regularly review stock movement reports, stock counts and the age of inventory.
Understand the Business's Debt
Borrowing money is not necessarily a problem. Many businesses use loans to purchase equipment, vehicles or property.
The important question is whether the business can afford the repayments.
The debt-to-equity ratio helps show how much the business relies on borrowed funds compared with the owner's investment.
Interest cover is another useful measure. It compares profit before interest and tax with interest expenses to show how comfortably the business can cover its interest costs.
However, paying interest is only part of the obligation. The business must also have enough cash to repay the loan capital when payments become due.
Accountants should pay particular attention to loans involving directors, shareholders and related parties.
In smaller businesses, these loan accounts often increase because owners withdraw money or personally fund business expenses.
Check whether the balances are correct, whether loan agreements exist and whether the transactions have any tax or Companies Act implications.
Follow the Cash, Not Just the Profit
The cash flow statement is one of the most important financial statements to analyse.
A business may report a net profit of R500,000 but have very little cash available.
This can happen when customers have not paid, stock purchases have increased or the business has made large loan repayments.
The cash flow statement helps explain where the money went.
Pay particular attention to cash generated from operating activities. This shows whether normal business operations are bringing in cash or using it.
If a business reports profits every year but consistently has negative operating cash flow, further investigation is necessary.
Also check whether the business is borrowing money to pay normal operating expenses such as salaries, rent and suppliers.
Borrowing to purchase equipment that will help generate future income is different from borrowing every month simply to keep the business operating.
Watch for Warning Signs in the Financial Statements
Financial statement analysis is also about identifying figures that do not look reasonable.
If turnover increases significantly but the owner says business has been quiet, investigate the difference.
If debtors continue increasing while sales remain unchanged, check whether customers are paying and whether outstanding balances are recoverable.
If stock increases every year without a similar increase in sales, investigate whether the stock exists and can still be sold.
Accountants should also look for unusual journal entries near year end, unexplained changes in accounting policies, missing expenses and liabilities that have not been recorded.
Outstanding VAT, PAYE and other tax liabilities deserve particular attention. A business may appear profitable while owing SARS substantial amounts.
Personal expenses recorded as business expenses are another common issue in owner-managed businesses. These transactions must be identified and treated correctly for accounting and tax purposes.
Consider Whether the Business Can Continue Operating
Accountants must consider whether the business is a going concern.
This means assessing whether the business can continue operating for the foreseeable future, generally at least 12 months from the reporting date.
Warning signs include repeated losses, negative equity, serious cash shortages, overdue creditors, unpaid taxes and loans that the business cannot repay.
For example, if a business depends on a bank overdraft that expires in three months, the accountant should establish whether the facility is likely to be renewed.
Where there are significant concerns about going concern, management must assess the position and ensure the financial statements are prepared and disclosed appropriately.
For businesses reporting under IFRS for SMEs, the applicable going concern requirements must be considered.
Make Sure the Figures Are Correct Before Analysing Them
Financial analysis is only useful when the underlying accounting records are reliable.
Before calculating ratios, ensure that bank accounts have been reconciled, debtors and creditors agree to their supporting listings, stock balances have been checked and loan balances are supported by appropriate records.
VAT, PAYE and other SARS balances should also be reconciled.
If debtors are overstated or expenses have not been recorded, the financial statements may show a profit that is not accurate.
Accountants must also understand the level of assurance attached to the financial statements. In South Africa, companies may require an audit, an independent review or neither, depending on the applicable Companies Act requirements, including their public interest score and other relevant circumstances.
An audit or independent review provides a different level of assurance from financial statements that have only been compiled. This distinction matters when relying on the figures.
Explain the Results in a Way the Owner Understands
The purpose of financial statement analysis is not to produce pages of ratios that the business owner does not understand.
The purpose is to identify what is happening and what needs attention.
Instead of telling an owner that the debtors' collection period has deteriorated, explain that customers are taking 20 days longer to pay than last year and that this is placing pressure on cash flow.
Instead of simply reporting that the gross profit margin decreased by 5 percentage points, explain how much gross profit the business is losing and what may be causing it.
Where possible, quantify the effect in rands and recommend practical actions.
A small business does not need 30 different ratios. It needs a few relevant measures that are reviewed consistently and discussed with the owner.
Final Thoughts
Financial statement analysis should form part of the regular work accountants and bookkeepers perform for their clients, not something that happens only when annual financial statements are prepared.
Reviewing monthly or quarterly management accounts can help identify problems much earlier.
A sudden increase in debtors, declining gross profit margins, rising expenses or growing tax liabilities can all be addressed more effectively when identified early.
For accountants and bookkeepers, the value lies in understanding the numbers, asking the right questions and helping the business owner take action.
Preparing accurate financial statements is important. Helping a business owner understand what those statements mean is where accountants and bookkeepers can make a real difference.
