Financial statements are your scorecard. You must have them to properly price, make sure you are earning a profit, spot minor issues and resolve them before they become major crises and make good business decisions.

Surprise! I will settle for, in the beginning, inaccurate financial statements over no financial statements each month. This shows that the company owners are getting in the habit of receiving monthly financial statements. And, once owners are in the habit of receiving them and asking good questions about them, they get more accurate.

A financial statement prepared by the company’s accountant quarterly is unacceptable. Shoeboxes delivered to the company accountant at the end of the year are unacceptable. Timely, accurate financial statements prepared by the 20th of the following month (preferably by the 15th), gives owners the ability to spot and fix minor problems before they become major crises.

The long-term survival of a business depends on them.

The first thing to do when receiving financial statements is to do a quick review. If something looks wrong, question it and get it right before going any further.

Once the statements are as accurate as possible, calculate the 10 ratios, which answer these operations questions:

1. Can the company pay its bills?
2. Is inventory too high? Is it increasing or decreasing?
3. Is there a collections problem coming up?
4. Is there a personnel productivity problem?
5. Is there too much debt or is the level increasing?

These 10 ratios are divided into liquidity ratios, debt ratios, compensation ratios and usage ratios. In 2014 I dissected each of the ratios in detail. Look in the archives for the detailed description of each ratio or invest in my book, “The Courage to be Profitable” (available on Amazon). I will summarize each next.

The first group of ratios is the liquidity ratios. These ratios answer the question, “Is there enough cash coming in on a consistent basis to pay the bills?” The liquidity ratios are current ratio, acid test or quick ratio, and accounts receivable to accounts payable.

The second group of ratios is the debt ratios. These ratios answer the question, “Is there too much debt or is the company getting deeper and deeper into debt?” The debt ratios are debt to equity and long-term debt to equity.

The third group is the productivity ratio. It answers the question, “For each dollar in revenue how much is the company spending on payroll and payroll taxes?

The fourth group is the usage ratios. These ratios answer the question, “Is the company building too much inventory or headed toward a collection problem?” The usage ratios are inventory turns and days and receivable turns and days.

Plot the ratios on a monthly and trailing basis (looking at a year’s worth of data a month at a time). The monthly data and the trailing data are on two separate graphs. The trends are more important than monthly data. Here are five areas to watch out for:

1. If the company’s current ratio and acid test are decreasing (current ratio and acid test lines are trending downward), most of the time the company is becoming less profitable. Even if the profit and loss statement shows a profit, the company is less profitable overall. Find out why.
2. If the inventory days line is increasing the company is building up too much inventory. Even a five-day increase in inventory days is significant. That’s an extra week’s worth of inventory. Discover what is happening.
3. If the receivable days line is increasing the company is headed towards a collection problem or has one. Like inventory days, a five day increase is significant. It is taking a week longer to get paid. Why? If the overhead line on the P&L trailing graph is trending upwards, then the company is spending more each month, as a rule, on overhead. Discover what is being spent and whether it is a reasonable expense.
4. If the distance between the revenue line and the gross profit line on the trailing P&L data is increasing, the company generating more revenue at lower gross margins. It might be better to have fewer sales at higher gross margins to ensure that the gross profit line is always higher than the overhead line (i.e. the company is profitable on a long term basis).