Business Accounting Series - Part III: Common Mistakes
Learn about common mistakes businesses make with financial statements and see examples to help you use financial statements to improve your business.
December 09, 2022
5 Failure to review financial statements regularly
5.1 Review frequency
5.2 What to look for
6 Failure to set budgets
7 Failure to set forecasts/goals
8 Tying it all together - an ice cream shop
8.1 Cyclical revenue pattern
This is a continuation of our Business Accounting Series of articles. Please read Part I - Basic Concepts to understand the basics of business accounting and Part II - Using a Financial Statement to be sure you understand what a financial statement is and how it is read.
With an understanding of what financial statements are and how they work, the biggest failure is not reviewing them regularly. Regular review allows trends to be found that enable the business to take advantage of opportunities and prepare for difficulties. Regular review also enables the business to make course corrections before problems become insurmountable.
While financial statements can be generated and reviewed at any time, a monthly review of financial statements is generally adequate. This is usually fine grained enough to detect useful patterns and also spans enough time for those patterns to emerge. An annual review is also helpful (and most likely mandatory).
A useful financial statement review should compare financial statements from previous fiscal periods and previous fiscal years. This comparison identifies changes over time that signify shifts in revenues and expenses, and indicates if business strategies are working.
Some specific areas of focus include:
- Examine sales for changing trends. What is selling better now than last year? Last month? Three months ago? What is selling worse?
- Is the cost of goods sold changing? How have inventory costs changed? Labor costs?
- Are there any overhead expenses that can be reduced? Any that have suddenly changed?
- Is there reasonable cash in banks to cover short term liabilities? What is the trend of those cash accounts?
- Are liabilities trending up or down? Are short term liabilities fully paid each fiscal period (as necessary)?
A key purpose of a financial statement is to communicate the cost of doing business as well as the profits. Knowing these is critical to setting a budget. Failure to set budgets results in poor allocation of funds to departments, projects, or developments. This poor allocation means that the business cannot grow to its potential. Conversely, setting budgets allows a business to undertake plans to grow as the necessary resources can be allocated in advance.
After performing the financial review as suggested in section 5, the business should be able to identify items that should be budgeted for. Items to budget for may include:
- Real estate acquisitions
- Vehicle maintenance
- Marketing efforts for upcoming products
- Upgrades to production machinery
- Technology related upgrades
- Disaster recovery testing and implementation
- Research and development
- New hires
Clearly the possibilities are endless. The important point is to use financial statement information in order to deeply understand how the business is functioning and plan for likely future expenses. Setting budgets allows the business to take action now with a future event in mind.
Financial reviews and proper budgets allow for informed forecasts and goals. A business cannot make reasonable forecasts or set attainable goals without knowing costs, sales trends, profitability, and budgeted resources. Too often, a business has a nebulous goal of “make money” without putting together concrete plans on how that is to be accomplished. Financial statements can reveal business opportunities and give reliable data on how to take advantage of those opportunities.
To help illustrate how financial statements can help with goal setting, let’s look at an example. For this example we will use a fictitious ice cream shop. The ice cream shop focuses on selling - unsurprisingly - ice cream, but has a few variations. In particular, it also sells brownies with ice cream.
Our example begins by looking at financial statements on a regular basis, in this case every month. Suppose we have twelve financial statements, each for one month of the year. We also compare these to the corresponding monthly financial statements from previous years. In this example, the financial statements show that summer months have high revenues while winter months are low. Such an example is not surprising given our fictitious business of an ice cream shop. How might the financial statements give us further understanding, and what goals can be set for growth?
Suppose that in order to increase revenues during the winter, the ice cream shop decides to expand its offerings. On the financial statements, the business has broken down sales of various items along with related costs. Naturally, ice cream sells quite well during the summer and poorly during the winter. But the business notices that one product - brownies topped with ice cream - has less pronounced sales peaks and valleys. This gives the business the idea to pursue bakery sales during winter months. The financial statements have enabled the business to form an achievable goal with a high likelihood of success based on sales history.
The financial statement is a particularly useful tool to determine how well the new goal will succeed. Because they track sales as well as expenses, financial statements show what profit margins the new bakery goal is likely to produce. Using the financial statements, suppose our hypothetical ice cream shop determines the costs of ingredients, running the ovens, and labor to produce brownies. Now the business can use that knowledge to anticipate how those costs will grow as more emphasis is placed on brownie production. With this information, the business can safely move forward with its new goals of bakery sales and be confident in its profitability.
The financial statements can now help the business achieve the goal by giving information useful in preparing a budget. With a goal established and futures revenues projected on sound historical data, the business can implement a plan to achieve the goal. This starts by allocating resources, first financial resources and then resources of space, equipment, and labor. Financial resources are allocated by using the financial statements as a guide. This will show when money is available and in what amount. With this information a timetable for developing the new revenue stream can be created and a target set for when the new revenues should appear.
As the plan to achieve the goal is implemented and the new product is developed and sold, the financial statements again play a critical role: we use them to determine the success or failure of the new product. The financial statements are used to determine if our forecast of product success was accurate, and if not, gives the information needed to understand why. This allows the business to fine tune the product or make other necessary changes.