See where you are going by knowing where you came form
I hear you. Accounting data is merely historical information, so how can old data help with future decisions?
For one, it tells a story of where you came from. What your business have been through and what the financial impact of that history have been. By learning from your history, you can better your future by implementing what you have learnt.
For some, this is obviously easier said than done. I am a chartered accountant so I know what to look out for in accounting data, but for someone with little or no financial background, they may be overwhelmed as soon as they see numbers. However, those numbers can tell you more than you may imagine. For instance, by making use of financial analysis, we can identify trends and possible problem areas, compare the stats to the industry and see if you are on the right track.
Forecast your cash flow more accurately
Use historical accounting data to update your budgets and cash flow forecasts to make them a bit more accurate. Compare actuals with budgets to identify how well you can thumb suck, if you should try a different thumb suck technique to get more accurate estimates or to identify areas that need to be investigated.
No more frozen cash
Accounting data can also identify problem areas in operations and controls, or poor policies resulting in unfavourable financial situations. A good example of this would be when too much money is tied up in stock. This happens quite a lot when companies purchase more stock than is required, or keep high levels of slow moving stock items. The upside of this is that you have immediately available stock to service customers, but the downside of this is that the cash could have been working for you elsewhere in the business, instead of sitting in your store room in stock boxes.
Get paid faster by your customers
Another great ratio that analysis of the accounting data can show us, is debtor days. This ratio tells us on average how long it takes for your debtors to settle their accounts. Obviously the sooner your customers pay, the sooner cash is injected into your business. And we all know: “cash is king”. So if you see that your debtor days are too high, then perhaps it is time to review your debt policies, or implement some sort of incentive to get your customers to pay early.
I have an outstanding account? You don’t say…
On the other hand, we have creditor days which tells us on average how long it takes you to pay your creditors. I know, you are a good customer to your suppliers and you want to maintain a good business relationship. However, remember this basic rule of thumb: You want your customers to pay you as soon as possible, and you want to pay your creditors as late as possible. This is cash flow 101. Now don’t go and let your supplier accounts run into 120+ days in arrears because of this article!
Always keep within the credit terms of your supplier, which is generally 30 days. If you can negotiate a longer term, then excellent. The general desired buying and selling model looks like this: Buy goods on credit, sell to customer, collect cash from customer before supplier credit term ends, then pay supplier and keep the change (which hopefully is substantial). So it is obvious that if the credit days are maxed at say 30 days, then your debtor days needs to be way under this.
Gross profit is not gross, it’s cool!
Ever heard of gross profit? If you are in business, then you most likely did. This is a very important calculation that tells us how profitable is your products or services. Gross profit = Sales – Cost of sales. All businesses have expenses, of which most of them are fixed. Fixed costs merely refers to the costs that remain about the same regardless of how many products you produce or sell. In order to make a profit out of your business operations, your income needs to exceed the expenses. Or from another angle, your gross profit needs to exceed your fixed costs. The faster your gross profit can cover the fixed costs, the more profitable your products are deemed to be. You should compare this ratio with prior periods as well as with industry averages to identify any possible cause for investigation. If you see a drop in gross profit margin, then your direct costs of your goods increased with a higher margin than your sales.
There are a whole lot of other ratios and calculations that a good financial analysis can produce, and all of them have a story to tell. Have your accountant perform an annual analysis on your financial statements and have them interpret the results in plain english. Any decent accountant will be able to produce such a report, and not take 6 or 7 years to complete. This can be an annual thing, or more frequent, depending on your preference.
So yes, accounting data is historical information, but it can be of great use to determine the future. Just make sure that the accounting information is up to date as far possible. Outdated information is useless and potentially dangerous if you or anyone rely on it to make big decisions.