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Should I be able to read financial statements?

With over half a million NZ businesses (557,680 as of Feb 2020) largely being private, financial statements are likely the best information you’ll get about a business that you’re interested in. 

3 Popular P&L Indicators for Investors & Business Owners

Using apples as an example 🍎🍎🍎

(1) Gross Profit 

This year JH Apples Limited made $1M from apple sales. Although, it cost the company $200k to grow those apples (i.e. seedlings, water supply, fertiliser a.k.a COGS - costs directly associated with growing the apples). With this cost, she's left with a gross profit of $800k (80%). 

You ask, is that a good or bad gross profit? Well, it depends and this is when you want to start asking focused questions such as:

  • How does a 80% gross profit compare to the company's last time period?
  • What is driving the costs to grow the apples? For instance, do I need a different plant variant?
  • Do I need to improve the process to grow? 
  • Who do I need to call or involve to improve the efficiency of my business operations?
  • What do my competitors appear to be doing?


(2) Operating Profit 

What about the cost to hire someone to pick and sell the apples? 

Right, we're talking salaries, software management tools, professional advisors (i.e. lawyers πŸ˜„) or in other words administrative expenses (a.k.a costs not directly linked to the growing of apples, or costs that would exist regardless of production, like the lease of orchard land). 

Let's say in the same year, these administrative expenses costs JH Apples Limited $300,000.

Using the above gross profit example of $800,000, we then take off this $300,000. With this cost, she's left with an operating profit margin of $500,000 (50%).

Again, we ask is that a good or bad operating margin? You guessed right, it depends. We have a new set of questions to ask such as:

  • Am I paying my staff too much or too little? 
  • How do I boost marketing without spending too much?
  • If my lease is up for renewal soon, should I renew or negotiate better rental terms?
  • Do I need to consider changing or getting more professional advisors?


(3) Net Profit 

Ah, here we have the "bottom-line". 

So far, we can see how JH Apples Limited's original $1M of sales gradually got smaller once various costs got accounted for to make the gross profit and operating profit margins. 

To calculate net profit, we account for costs like tax and interest (where this margin is arguably the most powerful indicator because it covers all business costs). 

Using the above operating profit margin of $500,000, let's say that tax and interest (and other non-operating costs) cost another $200,000. With these costs, she's left with a net profit of $300,000 (30%).

Is this a good or bad net margin (where your investors / shareholders will likely be the first ones to tell you 😏):

  • Competitive Advantage: Does my net profit margin stand out from my competitors and attract investors?


Further Comments


Treat Each Indicator Separately: It may be tempting to jump straight to the Net Profit figure, but you risk losing oversight into how that number is made up. 

Each of the above indicators represent a separate but significant aspect of any business model. Plus, a different set of questions for investors and business owners to be asking. 


Other Financial Statements:

  • Balance Sheet: This shows the assets, liabilities and shareholder equity of the company. The shareholder equity figure can be used against your net profit to form a Return on Equity (ROE) ratio. Investors can use this ratio as a helpful indicator when comparing businesses in the same industry. 
  • Cash Flow Statement: Ever heard of cashflow is king? This complementary statement shows investors your spending behaviours. How quickly are you getting money in and paying off any debt? How much money can the business expect in order to budget for future plans?


Financial Reporting Obligations

  • Investor Updates: Investment agreements can record a promise to provide investors quarterly reporting and/or financial statements upon written demand.
  • Tax: Financial reporting to the IRD is mandatory for all companies (except small ones), where the level of detail depends on the business's income and assets (See IRD for more details). 


Lawyers: A financially literate lawyer can be helpful to structure your business or proposed commercial transaction. They can also have well-informed and efficient conversations with you, your team, accountants and financial advisors. 


NB: JH Apples Limited is not a real company. Well, unlikely anytime soon 😊

Please reach out to Janey at janey@jhlaw.nz if you have any questions regarding the above. The above is purely for informational purposes, where JH LAW will need to determine if the above information is applicable or appropriate to your particular situation. 



 

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