Performance Analysis

Introduction

Performance analysis through financial statements, particularly the income statement (or statement of profit or loss), is like conducting a thorough health check-up for a business. It measures how well the business is doing in making money from its operations. Let's dive into understanding profit, its importance, and the nuts and bolts of an income statement, especially in the context of small businesses and food trucks.

What Profit Is and Why It Is Important

Profit is the money a business makes after paying for all its costs, expenses, and taxes. It's crucial because:

Reward for Risk-Taking: Starting and running a business is risky. Profit is the reward owners get for taking those risks.
Source of Finance: Profit can be reinvested into the business to buy new assets, develop new products, or expand operations, driving growth without needing to borrow money.
Indicator of Health: Regular profits suggest the business is doing well, attracting investors and lenders.

How a Profit Is Made

Profit is made by selling goods or services for more than it costs to produce or buy them. For a food truck, this means selling dishes at prices that cover the cost of ingredients, labor, and overheads like fuel and maintenance, with money left over as profit.

The Statement of Profit or Loss

This statement provides a detailed breakdown of how profit (or loss) was achieved over a specific period. It starts with revenue (sales) and subtracts cost of sales (direct costs of producing what's sold) to arrive at gross profit. Then, it subtracts operating expenses (like rent, utilities, marketing) to determine net profit before taxes, and finally net profit after taxes.

Importance of Profit to Private Sector Businesses

For businesses in the private sector, profit is essential because it serves as:

A Reward for Entrepreneurship: Encouraging individuals to start businesses.
A Source of Finance: Supporting expansion, innovation, and sustainability.
A Measure of Success: Helping attract further investment and loans.

Difference Between Profit and Cash

It's crucial to distinguish between profit and cash:

Profit represents the financial gain after all costs are covered, as shown in the income statement.
Cash refers to the actual money available, which can be affected by non-operational factors like loans received or repayments made.

A business can be profitable but still struggle with cash flow if profits are tied up in inventory or customers haven't paid their bills yet.

Main Features of an Income Statement

Key components include:

Revenue: Money earned from sales.
Cost of Sales: Direct costs related to what's sold.
Gross Profit: Revenue minus cost of sales.
Operating Expenses: Costs not directly tied to producing goods or services.
Net Profit: What remains after all expenses are subtracted from revenue.

Using Income Statements in Decision Making

Simple income statements can guide crucial business decisions by:

Highlighting profitable and unprofitable activities.
Identifying areas where costs can be reduced.
Informing pricing strategies to improve margins.

Amendment of a Statement of Profit or Loss

Changes, like discovering unrecorded expenses or revenue, require amendments to ensure accuracy. This might involve adjusting entries in the accounting records to reflect the true profit.

Impact of Given Changes on the Statement of Profit or Loss

Any change in revenue, costs, or expenses directly affects the bottom line. For example, if a food truck finds a cheaper supplier, reducing the cost of sales, its gross profit will increase, improving net profit.

Statement of Financial Position

The Statement of Financial Position, commonly known as the Balance Sheet, is essentially a snapshot of a company's financial health at a specific point in time. It's like a detailed inventory of what a business owns and owes, showing the balance between assets (value owned) and liabilities (value owed) plus equity (the owner's stake). Let's explore this concept further, focusing on small businesses and food trucks.

Purpose of the Statement of Financial Position

This statement serves multiple purposes:

Financial Health: It provides a clear picture of a business's financial stability and liquidity.
Financing Activities: Shows how the business is funded and how resources are allocated.
Asset Management: Reveals what assets the business owns, which is crucial for planning and investment decisions.

Main Elements of a Statement of Financial Position

The statement is structured around three main categories: assets, liabilities, and equity.

Non-Current Assets: Long-term assets expected to provide value for more than one year, like the food truck itself, kitchen equipment, and any long-term investments.
Current Assets: Short-term assets that can be converted into cash within a year, including inventory (food supplies), accounts receivable (money owed by customers), and cash in hand or in the bank.
Current Liabilities: Short-term obligations due within a year, such as accounts payable (money owed to suppliers) and short-term loans.
Net Current Assets (Working Capital): The difference between current assets and current liabilities, indicating short-term financial health.
Non-Current Liabilities: Long-term debts due after one year, like a loan taken to purchase the food truck.
Reserves and Equity: Equity includes the owner's initial investment plus any retained earnings (profits kept in the business after dividends are paid). Reserves are portions of profits set aside for specific purposes.

Classifications of Assets and Liabilities

Assets are usually classified into:

Tangible Assets: Physical items like equipment and vehicles.
Intangible Assets: Non-physical assets, such as patents or trademarks.
Financial Assets: Investments in other companies or securities.

Liabilities are often categorized into:

Short-term Liabilities: Obligations due within a year.
Long-term Liabilities: Debts payable over a longer period.

What A Statement of Financial Position Shows

By examining a balance sheet, you can deduce:

How a Business is Financed: A high proportion of equity suggests financing through investment and profits, while significant liabilities might indicate reliance on loans.
Asset Ownership and Management: The types and values of assets can show what the business prioritizes and its operational focus.
Liquidity: Comparing current assets to current liabilities gives insight into the business's ability to cover short-term debts.

Amendment of a Statement of Financial Position

Amendments may be needed if errors are discovered or if asset valuations change due to revaluation or depreciation adjustments. This ensures the statement accurately reflects the business's financial status.

Relationships Between Financial Statements

The Statement of Profit and Loss and the Statement of Financial Position are interconnected:

Profit or Loss Affects Equity: Net profit increases retained earnings within equity, while a loss decreases it.
Asset Purchases or Sales: Buying or selling assets affects both the profit and loss statement (through depreciation or gains/losses on sales) and the balance sheet (asset and cash or loan accounts).

Structuring Financial Statements

Financial statements are typically structured with major headings like Assets, Liabilities, and Equity, with subheadings detailing specific accounts within these categories. This organized approach helps stakeholders quickly find the information they need.

Financial Statement Analysis

Financial Statement Analysis is a critical tool for businesses, including small ones like food trucks, providing insights into their financial health, operational efficiency, and future viability. It involves examining the financial statements to understand the business's performance and make informed decisions. Let's explore its significance, tools, and some key accounting ratios in detail.

Significance of Financial Statement Analysis

Financial statement analysis helps stakeholders—owners, investors, creditors—evaluate a company's performance and financial position. It identifies trends over time, benchmarks against competitors, and assesses risk and profitability. This analysis is crucial for making strategic decisions, securing financing, and attracting investors.

Tools for Financial Statement Analysis

Comparative Statements: Compare financial statements from different periods side by side to identify trends and changes.
Common Size Statements: Express all items as a percentage of a base figure (e.g., total sales or assets), facilitating comparison across periods or companies.
Ratio Analysis: Uses specific ratios to evaluate liquidity, solvency, efficiency, and profitability.
Cash Flow Analysis: Examines the inflows and outflows of cash to assess the company's liquidity and long-term solvency.

Accounting Ratios: Liquidity Ratios

Liquidity ratios measure a company's ability to meet short-term obligations.

Current Ratio = Current Assets / Current Liabilities. It indicates whether the business has enough resources to cover short-term debts. A ratio above 1 suggests good liquidity.
Quick Ratio = (Current Assets - Inventory) / Current Liabilities. It assesses a company's ability to meet short-term obligations without selling inventory, offering a more stringent measure than the current ratio.

Improving Liquidity Ratios

Increase Current Assets: Improve collections on accounts receivable, sell unused assets, or increase sales through marketing and promotions.
Reduce Current Liabilities: Negotiate longer payment terms with suppliers, pay off short-term debts, or refinance short-term debt into long-term debt.

Solvency Ratios

Solvency ratios evaluate a company's ability to meet long-term obligations, indicating financial stability.

Debt to Equity Ratio measures the proportion of company financing that comes from creditors and investors. A lower ratio suggests a healthier balance between debt and equity.
Interest Coverage Ratio = Operating Income / Interest Expense. It shows how easily a company can pay interest on outstanding debt, with higher values indicating greater ease.

Enhancing Solvency Ratios

Reduce Debt: Pay down existing debt or avoid taking on new debt. Consider equity financing instead of debt financing for new projects.
Increase Equity: Issue more shares (if applicable) or retain more earnings instead of distributing them as dividends.
Boost Operating Income: Improve profitability through cost reduction strategies, price adjustments, or exploring new revenue streams.

Activity Ratios/Financial Efficiency Ratios

These ratios assess how effectively a company uses its assets.

Inventory Turnover Ratio = COGS / Average Inventory. It measures how quickly inventory is sold and replaced over a period.
Trade Receivables Turnover Ratio = Net Credit Sales / Average Accounts Receivable. It shows how efficiently a company collects payment from customers.

Boosting Activity Ratios/Financial Efficiency Ratios

Inventory Turnover Ratio: Reduce excess inventory through discounts or promotions, improve demand forecasting, or enhance inventory management practices.
Trade Receivables Turnover Ratio: Implement stricter credit policies, offer early payment discounts, or pursue overdue accounts more aggressively to speed up collections.

Profitability Ratios

Profitability ratios measure how effectively a company generates profit.

Gross Profit Ratio = (Gross Profit / Net Sales) * 100. It indicates the percentage of revenue that exceeds the cost of goods sold.
Net Profit Ratio = (Net Profit / Net Sales) * 100. It shows the percentage of revenue that remains as profit after all expenses.

Increasing Profitability Ratios

Improving profitability ratios involves strategies to increase revenue or reduce costs.

Gross Profit Ratio: Negotiate better terms with suppliers to reduce the cost of goods sold or increase prices carefully without reducing demand.
Net Profit Ratio: Reduce operating expenses through efficiency improvements, renegotiate fixed expenses, or outsource non-core activities.

Gearing Ratio

Gearing ratios measure the degree to which a company's operations are funded by debt versus shareholder equity.

Gearing Ratio = Total Debt / Equity. A higher ratio indicates more debt relative to equity, suggesting higher financial risk.

Lowering Gearing Ratio

A lower gearing ratio indicates a healthier balance between debt and equity.

Reduce Debt: Focus on paying off existing debt or converting short-term debt into long-term debt to improve financial stability.
Increase Equity: Reinvest profits into the business or issue new shares to increase equity.

Investment Ratios

Investment ratios help investors assess the value of investing in a company.

Dividend Yield = Dividend per Share / Market Price per Share. It shows the return on investment for a shareholder.
Price/Earnings Ratio = Market Price per Share / Earnings per Share. It indicates how much investors are willing to pay per dollar of earnings, reflecting the market's expectations of future growth.

Improving Investment Ratios

Dividend Yield: If feasible, increase the dividend payout to make the investment more attractive relative to the share price.
Price/Earnings Ratio: Improve the company's earnings through operational efficiencies and growth strategies, which can also lead to an increase in the company's stock price.

Interpreting Accounting Ratios

When you compare financial results over different years, it's like looking at a series of pictures that show how a business has grown and changed over time. This comparison can highlight trends, such as increasing sales or rising costs, which might not be obvious from a single year's data. For example, if "Gourmet on Wheels" sees its gross profit margin increasing year over year, it suggests they're becoming more efficient in managing the costs of goods sold or are successfully increasing prices without losing customers.

Improving Profitability and Working Capital

Improving profitability and working capital is crucial for any business to sustain operations and fund growth. Here are some recommendations:

Increase Revenue: Consider introducing new menu items, expanding to new locations, or increasing catering services.
Reduce Costs: Negotiate better terms with suppliers, minimize waste, or find more cost-effective ways to market the food truck.
Manage Inventory More Effectively: Aim for a higher inventory turnover rate by adjusting inventory levels to match demand, reducing the risk of spoilage or obsolescence.
Improve Receivables Collection: Offer incentives for early payment and follow up promptly on overdue accounts to ensure faster cash inflow.

Gross Margin vs. Profit Margin

The difference between gross margin and profit margin is a critical indicator of a business's efficiency.

Gross Margin shows the percentage of revenue remaining after subtracting the cost of goods sold. A higher gross margin suggests the business is efficiently managing its production or procurement costs.
Profit Margin, on the other hand, takes into account all expenses, not just the cost of goods sold. It indicates how much of each dollar in sales remains as profit after all expenses.

A significant gap between the gross margin and the profit margin means the business has high operating expenses that might need to be reduced to improve overall profitability.

Relationship of Gross Profit and Net Profit to Other Financial Aspects

Valuation of Inventory: Overvalued inventory can inflate gross profit, while undervalued inventory does the opposite. An accurate inventory valuation is crucial for reliable profit figures.
Rate of Inventory Turnover: A high turnover rate generally indicates efficient inventory management and contributes to higher gross profit by reducing holding costs.
Revenue: Increasing revenue should ideally lead to higher gross and net profits, provided costs are managed effectively.
Expenses: Rising expenses can erode net profit, even if gross profit remains strong. Keeping expenses in check is essential for maintaining healthy net profit margins.
Equity: Over time, sustained net profits increase equity, enhancing the financial stability and potential growth of the business.

Limitations of Accounting Information

While accounting ratios and financial statements provide valuable insights, they have limitations:

Historical Nature: Financial statements reflect past transactions and may not indicate future performance.
Non-Financial Factors: They don't capture non-financial factors like market competition, customer satisfaction, or employee morale, which can significantly impact future profitability.
Accounting Policies: Different accounting methods can affect how financial results are presented, making comparisons between businesses challenging.

Cash Flow Statement

The cash flow statement is crucial for understanding a business’s liquidity - its ability to pay bills and invest in new opportunities. Let’s explore this concept using "Bella’s Boutique," a small retail clothing shop, as our example.

Meaning and Objectives of the Cash Flow Statement

The Cash Flow Statement shows how changes in the Balance Sheet and income affect cash and cash equivalents. It splits cash flows into three main categories:

Operating Activities: Cash received or spent as part of regular business operations, like selling clothes or paying rent.
Investing Activities: Purchases or sales of long-term assets, such as buying new shelving or selling an old cash register.
Financing Activities: Cash exchanges related to the company’s equity and debt, like taking out a loan or repaying it.

The main goal is to provide a clear picture of what’s happening with the business’s cash, helping owners and investors understand if the business is generating enough cash to sustain and grow.

Benefits of the Cash Flow Statement

Liquidity Insight: Shows how well the business can meet short-term obligations and opportunities.
Investment Decisions: Helps investors assess the health and potential of the business.
Budgeting: Aids in creating more accurate budgets and financial forecasts.

Cash and Cash Equivalents

This term refers to not just physical cash but also assets easily convertible into cash within three months, like marketable securities or short-term government bonds.

Classification of Activities

Operating Activities: Includes adjustments for non-cash transactions like depreciation (which reduces the value of assets like furniture and fixtures over time) and changes in working capital (like inventory or accounts receivable).
Investing Activities: Might involve cash paid for new equipment or cash received from selling an old delivery vehicle.
Financing Activities: Could include receiving a new loan (increasing cash) or making loan repayments (decreasing cash).

Preparation of the Cash Flow Statement

Preparation involves adjusting the income statement and changes in the balance sheet accounts to reflect only cash transactions.

Adjustments Include:

Depreciation and Amortization: These are added back to net income because they are non-cash expenses.
Profit or Loss on Sale of Assets: If Bella’s Boutique sells an old display for more than its book value, the profit is deducted from net income because it’s considered an investing activity, not an operating one.
Dividends and Taxes: These are financing activities (for dividends paid) or operating activities (for taxes paid) and are adjusted accordingly.

Other Considerations:

Bank Overdrafts and Cash Credits: Treated as short-term borrowings, they’re part of financing activities.
Current Investments: Considered as marketable securities unless specified otherwise, affecting investing activities.

Case Study

Imagine Bella’s Boutique had a year with several financial moves:

They bought new store fixtures for $5,000 and sold old ones for $500, which had a book value of $300, leading to a $200 gain.
They received a bank loan of $10,000 and repaid $2,000 of another loan.
Depreciation for the year was $1,000.

In the Cash Flow Statement:

Operating Activities: They adjust net income for the $1,000 depreciation (adding it back since it's a non-cash expense) and subtract the $200 gain on the sale of assets (since it's an investing activity).
Investing Activities: The purchase of new fixtures is shown as a $5,000 outflow, and the sale of old fixtures is a $500 inflow.
Financing Activities: The new loan is a $10,000 inflow, and loan repayments are a $2,000 outflow.

By analyzing the Cash Flow Statement, Bella can see if her boutique generated enough cash from selling clothes and accessories to cover all her expenses and investments.