When’s the last time you cracked open your business books to do a thorough risk analysis? For most business owners, the answer is “far too long ago.”
They know they need accurate financial statements to file their income tax or pay their state sales tax, but that’s where they stop. When they do turn to their financial statements for answers, it’s because they’re already feeling pain.
They might be trying to expand into a new market or looking to hire a new employee. They might be having trouble getting break-even cash flow. So, they turn to their business books – only to realize they’ve been hurtling toward a cliff for months or even years.
Building regular risk analysis into the rhythm of your business can help you head off problems before they become painful. That’s because your financial statements – which are really just a snapshot of your prior period decision-making – contain nuggets of truth that can help you make better decisions about the future.
Here are a few of the things risk analysis can clue you in to:
The true health of your business
Many business owners rely on instinct to run their businesses, when the numbers tell a different story.
One business owner came to my firm because he was about to hire an employee. It felt like his business was doing well. Money was coming in, bills were getting paid, and he was working harder than ever. He assumed business must be growing. But when we analyzed his books – and extricated his business finances from his personal account – we found that his business was actually decreasing year-over-year. He just hadn’t been able to see it.
When you do regular risk analysis, you establish a baseline of metrics that can help you quickly detect when things go sideways. These metrics can include the relationship between your cost and revenue structures, as well as your historical performance.
Making smart investments
Your financial statements can also help you identify metrics around profit margin and return on investment. When you are considering launching a new product or writing a new sales contract, you can go back to your metrics and get a quick, back-of-the-envelope understanding of what that decision will do for your profit margin.
You can break these relationships down as much as you need. For example, say your business provides project-based deliverables. If you understand the relationship of your costs by project, you can easily see how much it costs to deliver a certain type of project. This helps you know which lines of your business are the most profitable and can help you make smarter decisions about taking on new work.
Internal control problems
Sometimes, the risks you might uncover in your books point to issues with internal controls. For example, if the sales reports at your retail location aren’t lining up with the bank deposits, you might realize that somebody at the cash register has sticky fingers.
If you don’t have good internal controls, your financial statements might be the first thing to tip you off to a problem.
Debt covenant violations
Many banks require businesses to enter into debt covenants as part of the loan agreement. Generally, the bank will specify certain financial statement-based ratios they want you to maintain.
If you’re not doing your financial reporting consistently, you may unknowingly end up in violation of one or more of those covenants, which puts you in a position of default with the bank. Or, when you finally realize that you are on the road to being in violation, it’s too late to turn your business around.
The key to doing an effective risk analysis
Regular risk analysis should be part of the rhythm of your business. Whether you learn the basics of accounting on your own or hire an accounting professional to help you get started, you need to spend time working on your business and analyzing your books.
Gather your records, including your profit and loss statement and other reports (such as detailed sales), and spend time comparing them across comparable periods of time. Look for relationships between factors such as revenue and cost of sales, costs and profit per project, and spending in different categories.
To be effective – particularly if you’re not working with an accounting professional – make sure you’re keeping consistent, accurate records, that are easily comparable from one historical period to the next.
Most of all, don’t allow your bookkeeping to be reactionary. Remember, by the time you feel the pain, the issue has probably been lurking for quite some time.
Instead, establish a regular rhythm of risk analysis alongside your accountant. When analyzing your financial statements is built into your business systems, you can rest easy knowing you've got an eye out for hidden risks.
That lets you safely ignore your financials the rest of the time and focus on doing what you love.
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