How To Analyse Your Financial Statements in Xero
May 11, 2016
Part 2 of a 3 part series in using Xero to manage your business.
#2 How To Analyse Your Financial Statements in Xero
The Income Statement or Profit and Loss, together with the Statement of Financial Position (or Balance Sheet) and the Statement of Cash Flow, are the three main financial statements that a company produces, at least annually.
What are they?
The Statement of Financial Position shows what you own (assets) and what you owe (liabilities) at a moment in time, it’s a snapshot of the company, while the Income Statement shows what happens over a period of time, what comes in, what goes out and what the balance is as a result.
The Statement of Cash Flow is showing the actual cash movements over a period of time, what money came in, what came out and what is leftover.
In the Income Statement you won’t find any data regarding the money that have come in or gone out during the period, because quite often they happen at two different moments in time.
Therefore it is fundamental to have the Statement of Cash Flow on the side of our Income Statement while analysing it. It is almost more important for a company because it is actually telling us the real money that goes in and out during the period, not just our sales or payments we have made. We can have a profit at the end of the period but, as it says on Inc.com:
The reason you look at both is that you want to see if all that profit being shown is supported by cold hard cash coming into the company. Booming profits on the income statement and weak – or even negative – cash flows means that the quality of the earnings being shown isn’t very strong and deeper analysis will likely be needed.
If our company is a start-up we agree to accept a negative cash flow even with a positive and growing net income but for a more establish company the cash flow should be quite close to the Income Statement result.
If we are using Xero as our accounting software, we have the ability to check both our Income Statement, at any point in time and for any length of time, and the Statement of Cash Flow (which is under the New Report section).
The Income Statement can be compared with our budget while the Statement of Cash Flow will have to be exported in excel and compared with our Cash Flow forecast.
We have mentioned how to prepare this in last week’s article on how to manage your business using Xero. Also, in the add-on section of Xero.com you will find numerous add-ons that will help you with the Cash Flow.
Let’s go in Xero and run our Income Statement report.
Under the Report section select Profit and Loss report.
As a default, Xero will show you the current month with the previous three months, so we can analyse our trend.
Another very interesting view that Xero offers is the ‘current financial year’ that is showing, for each month, the monthly budget we have prepared and it will populate the actual numbers by the end of each month comparing them with its budget. It is telling us where we are going and what should be achieved based on our plans.
If we have the Tracking categories set up we can also see our Income Statement for each category we have set up, clicking on Compare Client and Compare Agent.
We can choose to compare specific periods and within a date range too. All these options allow us to choose what we want to analyse and how.
Personally, I do find the one under the Compare Period section a good view option because we can select the date, the period up to 12 and compare it with previous period as well as with the budget, in order to have key variances to work with.
Whichever one we select, the structure will be the same:
Income – Cost of Sales = Gross Profit
Gross Profit – Operating Expenses = Net Profit before Taxes
Net Profit before Taxes – Taxes = Net Profit (for the financial year)
Every time we will be looking at our P&L, we have to remember that on the NPBT we have to pay taxes. In New Zealand, it is a good practice to calculate at least 25% of it as taxes to pay to have an indicative result of what our Net Profit will be during the year (if we are not paying any provisional tax).
What data we should focus on? What is a way to analyse them?
We should focus on trends. Create trend lines for key items over multiple periods. Typical trends are for Total Income, Gross Profit, Operating Expenses and Net Income. Drill down on the numbers that created that trend over a period to understand what has been happening.
We can also do an analysis exporting our Income Statement in excel and express all the expenses as a percentage of revenue for each period considered. Look for trend and path between revenue and expenses, analysing any discrepancy that could be present.
Then work on the Key Variances with your Budget. Are we going in the right direction? Look at the number and click on them to understand what has create that variances.
Next we should do a proportion analysis with financial ratios available in Xero that will involve analyses between Income Statement results and Balance Sheet ones.
Technically financial ratios are calculated dividing one number by another and enable us to examine the relationship between items, with the possibility of measuring that relation in time. We use financial ratios to highlight areas of the business that need attention before the problem becomes easy visible.
There are quite a few financial ratios that we could calculate and they can be broke down into four main categories:
- Profitability or return on investment ratios.
- Liquidity ratios.
- Leverage ratios.
- Operating or efficiency ratios.
Xero offers us already a set of the most common ones.
Let’s go onto the Report section and click on Business Performance:
And let’s start analysing them. This is only an explanation of what they are, ratios should be analyse with your accountant/bookkeeper.
We have the Gross Profit Margin (Gross Profit/Net Sales it’s a Profitability ratio) which is a real measure of how the company is doing: is it making a profit by selling its product/services? It’s calculated by subtracting the cost of goods sold to the revenue and dividing the result by revenue. If we click on the name of the ratio ‘Gross Profit’ …
… we can see the breakdown of the calculation and if we go with the cursor on the numbers it does tell us what they are made from.
Xero also provide us with a graph and the numbers for each period that creates the graph.
The Gross Profit is a very important ratio, it shows the proportion of the profits generated by the sale of products or services before selling and administrative expenses. It is used to determine the ability of the company to be cost-effective while offering its main activity.
The Net Profit on Net Sale (Net Income/Net Sales it’s a Profitability ratio) gives us the overall profitability of the company, it measures the remaining profit after all costs of production, administration, finance and taxes have been deducted from sales. In general terms, net profitability measure the effectiveness of the management. Best is to look at it in a trend as well as compare it with other firms in the same sector.
The Debt Ratio (Debt/Total Assets it’s a Leverage ratio) is showing the portion of the capital that is provided by borrowing. A Debt ratio greater than 1 means the company has negative net worth so it is technically bankrupt.
The Debt to Equity Ratio (Debt/Owner’s Equity it’s a Leverage ratio) measures the riskiness of a company’s financial structure. The lower is the ratio, the better is, meaning that the company is using a larger proportion of Owner’s money to financing itself rather than borrowing. Best is for Debt to be around 50 to 80 percent of Equity.
The Current Ratio (Current Assets/Current Liabilities it’s a Liquidity ratio) measures the ability of the company to pay its bills in the near term, 12 months. The ratio implies that Current Liabilities can be liquidated to pay Current Assets and the perfect ratio will be 2:1 while a lower proportion indicate less ability to pay in a timely manner.
The Fixed Assets to Net Worth Ratio (Net Fixed Assets/Tangible Net Worth it’s a Leverage Ratio) indicates how much of the owner’s equity has been invested in fixed assets. Only fixed assets are include in the calculation and they are valued less depreciation.
The Current Liabilities to Net Worth Ratio (Current Liabilities/Tangible Net Worth) shows us the ability that we have to pay my debts with my Net Worth – what the owner’s owns directly.
The Working Capital to Total Assets Ratio [(Current Assets-Current Liabilities)/Total Assets] tells us how easily we can repay our debt. It’s a measure of a company’s efficiency and its short term financial health.
These listed above are ratios that Xero offer us. By clicking the star next to the ratio’s name we can have it appearing on our Dashboard and keep an eye on them.
As mentioned above, we should discuss with our Accountant/Bookkeeper which are the ratio that will give us a better view of our business, how to read them and analyse them.
Recommended Monthly Actions:
- Prepare your Budget.
- Run the Income Statement Report with Balance Sheet and Statement of Cash Flow report.
- Look for trends within the main results.
- Control key variances with your Budget.
- Do a proportion analysis, choosing which one is the best ratio for our business and keep an eye on it through our dashboard.
- Revise your management plan based on these findings.
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This week’s post has been a team contribution. Giuliana is our Xero and bookkeeping expert and when not actually doing bookkeeping for our clients she also offers one-on-one coaching sessions. Contact Justine to learn more about what these sessions involve.