Part 2 of the Year-End Financial Analysis
So now let’s go to the second portion of the year-end financial analysis. The second portion is your cost of goods sold. See, so for that dentist again – and today I’m just using a random example of a dentist.
An Example of Cost of Goods Sold
I want you to all understand that it doesn’t matter what you do; business is business and financials are financials. So as a dentist, what is your cost of goods? See, your rent is not cost of goods. Electricity is not cost of goods. The x-ray equipment you have is not cost of goods.
So if you went out and you bought a half a million-dollar x-ray machine, it’s not cost of goods – and by the way my friend, it doesn’t even show up on your P&L.
Can you believe that? For those of you who don’t know financials very well, can you believe that if you go purchase a half a million-dollar piece of x-ray equipment, it doesn’t even show up on your P&L.
That’s why you better be looking at your balance sheet, because your P&L won’t show you that you had a half a million-dollar expense, especially if you’re doing your financials correctly.
By the way, if it shows that you spent half a million dollars on an x-ray machine, there’s something wrong with the way you’re doing your financials, right? So we’ll get to that when we talk about the balance sheet. I’ll tell you where your half-million-dollar x-ray machine goes, but it certainly doesn’t go in this section.
The Next Section is Direct Costs
So in this section is direct costs. Your rent, not direct costs – all that stuff is not direct cost. What is direct cost? Well, if you buy supplies for example that you use during the cleaning process, if you’re doing let’s say fillings and you have to buy the stuff that you use for the fillings, if you’re for example doing crowns and you buy the crown for $200 and then you install it and you sell it to the person for $600.
Well, that $200 is part of your cost of goods, so your cost of goods should be all of the things that will proportionately (or sort of proportionately) go up and down as your sales go up and down.
Meaning in a perfect world when the top part of your P&L goes up, that second section should go up as well. And when that top part goes down, that second section should go down as well.
If you’re seeing that, let’s say you double your revenue and your costs don’t change, either you’ve done some really amazing things and done some really great negotiation with your vendors or you’re probably doing your P&L the wrong way and it’s not set up right.
Those are the things by the way that I’m going to teach you. I’m going to share with you how to do that. Again, any of you coming to any of my events, that’s the kind of stuff that we get into and we make sure that you get that stuff fixed. But the bottom line then is that second area is your direct costs.
So now you start to analyze how much money am I spending to make the money at the top, and in an ideal world your P&L is set up as such so that when you’re looking at it, for each of the revenue items at the top, you have some associated expenses in that second section.
Now, this is not an easy thing to accomplish but if you can get there, it’s awesome. In some of my companies, I’ve gotten there. In some of my bigger companies, it’s impossible to get there (or I haven’t figured out how to do it yet). But ideally, you’re seeing where I am spending money to make this money up top, and now you start looking at not just revenue, but you start looking at what’s called gross profit.
Now, what does gross profit mean? Well, gross profit sounds good because it’s profit – but then it’s kind of gross, right? What is gross?
It’s not net; it’s not the money you get to take home at the end of the day. It’s the money that you’ve made before you pay all of your overhead – before you pay rent and all the stuff that goes along with doing business.
So what you’re doing there is saying, “Okay, how much money am I really making when I’m doing these fillings and stuff like that?”
The total number at the bottom of that second section is your gross profit, and it’s a dollar amount where you’re going to see, “Okay, we had $100,000,000 in revenue this year and we had $60,000,000 in direct costs, leaving us $40,000,000 to run the rest of the business and cover all the overhead, rent, and all this stuff that goes along with it.”
So what you do is you look at the total, but then you also start digging into the specifics. This is where you start to identify if I’m overcharging or undercharging for something.
I see that in a lot of businesses people aren’t keeping a close eye on their cost of goods. In some cases, they think that something is expensive but they’re not really analyzing, hey, how much am I really selling of this stuff and how much am I buying of it? That’s important, so all of those types of things go into your direct costs and then you get your gross profit.
Looking at Your Overhead
Then we get to the third section, which is what’s called overhead. Technically speaking, overhead is all the stuff that doesn’t really change much from month to moment. Now, some of it will change, right?
For example, if you’re not in the business where legal work is a part of your revenue and it’s just something that you do to defend yourself and to protect yourself, well your legal fees are going to go in the bottom. Some months you’re going to have more legal fees than other months.
However, typically you’re not going to have your legal fees go up when your sales go up. Your legal fees go up when you have problems that you need to deal with legally, so that goes into the bottom section into your expenses or into your overhead, because it’s not really the direct cost of doing business.
It’s just a cost of being in business, right?
Rent is another one of those. Utilities is another one of those. For many of you, payroll for most of you – permanent employees who are in positions where their job is not directly affected by the volume of sales that you make – they go into your overhead.
Now by the way, what if someone’s expense does actually vary depending on the traffic you have, meaning if you’re having a slow week, you actually don’t have that person come to work. Well if that’s the case, then really their costs should be in your direct costs, because when you have a lot of sales, you’re having to give them more work and when you have less sales, you’re giving them less work, so they would be a direct cost. But most payroll in most of your businesses are going to be in this section and this becomes your overhead.
How Can I Control my Overhead?
Now, can you control overhead? Absolutely! How many times have you heard, “I’ve got to cut my overhead!” Because overhead is what kills a lot of companies, especially as you grow and you hear about this saying, “Grow, grow, gone.” Typically that happens because of overhead because you keep adding these overhead items, not understanding that now you’re cutting into your margins.
You’re making it difficult to make money because before the month even starts, you’ve already spent $5 million or $500,000 or $5,000 – whatever the numbers are of the scale is within your business, it doesn’t matter. Those overhead items will kill you if you’re not careful.
So now what you’re doing then is let’s look at this thing as a whole. You’re looking at the top section and saying, “What areas am I making my money in and what’s starting to trend in what way?”
Then you’re looking at your direct costs. Where am I spending money and what are my margins like on these different things? Which items make me the most bang for my buck? And then you’re looking at your overhead and saying, “How much money am I spending just to keep this business alive and where can I make cuts?”
And as always with those things, you’re looking for the same things in all three sections. What are the biggest ones? What are the ones that are changing from month to month (and why)? What’s trending up and what’s trending down?
If your electricity usage is stable, probably okay. But if your electricity usage is starting to trend up, you should look into why. If your fuel costs are starting to surge, why? Whatever those things are, find out why things are doing the thing they’re doing, and you always put them into four categories.
Like I said, what are the biggest ones? What’s changing randomly on a month to month basis (because it’s not random). There’s a reason and you need to find out what it is.
What’s trending up? What’s trending down? And then at the very bottom you’ve got that fourth section which we’re going to ignore, which is all this other stuff – accountant stuff – ignore it. And then at the very, very bottom you have your total profit. Now that number is valuable because you’ve looked at all these things, so that’s your P&L.
And when we do an annual business review, what we’re doing is we’re going into this document and we’re looking at that bottom line and everything that I just talked about.
What we’re doing is we’re planning for next year. But most of you, if you look at your financials, you’re looking at your bottom line and you’re planning from your bottom line. You’re saying, “Okay, last year I made $200,000. Next year I want to make $300,000.” Or, “Last year I lost money; this year I want to make money.” See, that doesn’t work because you can’t directly influence that.
But what you can influence are those items at the top, the different sources of revenue. You can control those different direct costs that you have.
Some of you for example, I look at your P&Ls and you have no marketing expenses. You have no marketing costs in your direct costs, and then you wonder why your sales are terrible. Well guess what, my friends? Marketing is step one, sales is step two. So if you are not doing marketing, well how can you possibly expect to increase your sales? Marketing is a huge part of doing business and many of the business owners I see completely leave marketing out.
Now others I see, they do a lot of marketing but then when you dig down, where is their marketing going? You look at that second section – that’s where marketing would go, by the way – and you’re looking at the different areas they’re spending money and then you look at where they make money in the first section, and those things don’t jive together. So those are the kinds of things we look at.
Now as you’re looking at your P&L, you can actually create a plan for next year where now you say, “Okay, I want to increase sales in this area.” Going back my dentist example, you could say, “I’m going to increase sales in the area of doing these fillings.” Now, what type of marketing would I have to do to get more fillings?
And so now we plan for that kind of marketing. So you do that kind of marketing to get you that kind of sales, and now you can actually see where your business is going to go and how you’re going to get to making that extra $100,000 as opposed to just randomly saying, “I’m going to make more money because I’m going to work harder.” See, it doesn’t work; that’s not the way to do it.
The Balance Sheet
Then the thing you’re going to do next is now you’ve got to go look at your balance sheet. Your balance sheet is where that big, expensive x-ray machine goes, by the way. Your balance sheet is where you see if your customers are actually paying you.
Your balance sheet is where you go to see who you owe money to. What confuses people is this concept of these two scary words on a balance sheet where you see assets and liabilities, and people are like, “Oh my God, what does this mean?” Some of this stuff just looks weird; it’s all like in the wrong place.
ou know, there’s something that where like you owe people money and it’s under assets. Well, how is that an asset? Don’t worry about that stuff; that’s what you don’t want to get involved in if you’re a young entrepreneur, if you’re a business owner, if you’re a professional if you’re a doctor or lawyer. Let your bookkeeper and accountant worry about that stuff. You just need to look at the numbers.
So when you look at accounts receivable, this is how much money people owe you that they haven’t paid you yet. That number is growing a month to month basis, you have a problem, my friend.
See, that’s what you’re looking at. Is that number growing? So when I look at your balance sheet – if we have a couple of years of your balance sheets, I’d say let’s look at what it was last year and look at it this year.
Have your accounts receivable gone up or down? Or on your balance sheet, you do the same thing that we did on the P&L; you do it on a monthly basis. Now we say, “Did your accounts receivable go up or down as the year went on?” If I see a trend where your accounts receivable is going up, I say, “Wait a minute. People aren’t paying you. Why? Who’s not doing their job in your organization?”
And by the way, you might be a one-person show. It doesn’t matter. As we’ll talk about in one of these upcoming episodes when we talk about human resources, you are your own boss and you are a human resource, so you need to manage yourself and the different aspects of you.
If you have a company with hundreds of people, well then great. There’s someone who wears that hat. Why aren’t they doing their job if that’s going up? If accounts receivable is going down, that’s typically a very, very, very good thing because it means people don’t owe you a lot of money.
Now, it could be bad because let’s say the reason people don’t owe you a lot of money is that you’re not making a lot of sales. That’s why the balance sheet and the P&L need to work together.
So you look at this and now this is where your x-ray machine shows up. If you bought an x-ray machine and you bought it cash, here’s what would happen.
You would now show that you have a half-million-dollar asset in that x-ray machine – simple – and it would show it as having a value of about $500,000. Now as time goes on, you depreciate it, meaning you subtract from it.
A year from now, it’s certainly not going to be worth half a million dollars, right? So they update that value and for tax reasons and stuff like that. Again, let’s not get into it. That’s not the stuff you need to worry about. Let your accountant do that stuff. Let your CPA work on that stuff.
You focus on the things that are important in the business.
Now, you’ve probably all heard of this concept of a balance sheet being in balance, meaning the top and the bottom are the same. The reason is this. Let’s say for example that you buy your x-ray machine with cash.
What that means is you used to have half a million dollars in cash and now you’ve spent that money and bought this machine. Well, the reason the balance sheet stays in balance is that one section is going to lose half a million dollars’ worth of cash.
The cash is going to go from half a million to zero, and then over where you list your equipment, it used to say zero and now it’s going to say half a million dollars in equipment, so the two sections stay in balance.
But what if you take out a loan? Same thing; it doesn’t matter. You now have a half a million dollars’ worth of equipment, but then in a different section you show that you owe people a half a million dollars on the loan, and that’s it. That’s all a balance sheet is.
With this information, go back to your balance sheet, hit the collapse button, and look at it. I guarantee you it’s going to make a ton of sense to you.
Now again with your balance sheet, I want it all on one page. When you collapse your balance sheet, it needs to be on one page. If it’s not, your accountant needs to go in there, fix your accounts so that you have fewer accounts, so that it all gets on one page. Again, for most of you if you don’t have a massive, massive company, you should be able to get it all on one page.
So now that you’ve got the P&L and you’ve got the balance sheet in order – now by the way, when do you go to the balance sheet? Well, every time you run your P&L. But when you really start looking closely is when you have things going on with the big picture of the company, like you’re purchasing equipment, you’re taking on debt, when your accounts receivables or accounts payables are changing. Those types of things are very important to keep a close eye on.
The Final Document is Your Statement of Cash Flows
And then finally your last document is statement of cash flows. That’s the easiest one to read, because it just shows where did money come in and where did money go out.
It’s important to look at that because regardless of how your business feels like it’s doing, regardless of how many patients you see, or how many widgets you sell, you’ve got to look at the end of the month. What was the net effect of all this?
How much money went out, how much money came in, and what was the difference?
Was it a positive number or a negative number, meaning did we keep money, or did we get rid of money that we didn’t have, was it break even? Because your P&L could tell you you’re making all kinds of money, but if the cash flows statement tells you that you’re not keeping any money, well there’s something going on.
Maybe it’s that you’re servicing debt. Maybe you’re paying stuff that you bought last year and you’re now paying for your sins of the past. It could be that, but you need to look at those three documents together.
A Final Review of The Financial Analysis Process
So in your year-end financial review then, let’s take the big picture. What we’re doing is we start with the big, big picture. We look at your gross revenue – total sales.
Then what we do is we look at where is all that revenue coming from. What are the different items – different categories of revenue that you have?
Then what we look at is we look at your gross profit. What is left after your direct costs and where some of those direct costs in comparison to the sales?
Which sales channels are making you the highest margins, meaning the money that you get to keep?
Then we go down to the bottom and we look at your expenses and then the net profit that’s left over and we start asking questions.
What major expenses to we have that we could possibly cut?
What are we spending money on that if we got rid of wouldn’t really affect us that much?
Could we sublease out half of our space?
Could we eliminate some employees?
Could we get rid of some services that we pay for on a monthly basis that we really don’t need? Could we cut back our electricity uses?
All that kind of stuff. We look at that overhead and then at the bottom, we look at the net profit.
Then we look at our balance sheet and we look at what is the trend of these biggest accounts?
Accounts receivables, people owing us money. Accounts payable, people we owe money to. The assets that you have within your business. The bank accounts that you have. Are those balances going up or down?
Credit cards, are those going up or down? You look at it year over year and then month over month.
And if you have a brand-new business, now is the time to get this stuff right. Most of you when you start a business, you don’t get these things set up correctly and then you try to set it up when it’s too late.
When a business has no assets and no liabilities, that’s when you want to make sure that you start looking at balance sheet, because the first day you get an asset or you get a liability, you better be able to see it on there and that’s how you’re going to be able to learn this stuff from the ground up.
That’s how I learned. I can tell you for many years I ran businesses and I didn’t understand my financials until I started some new businesses and I started doing them right from Day One, and suddenly it made a lot more sense because it was only one or two transactions I was looking at.
So then you finally look at is my company value going up or down. I
s the company worth more today than it was worth a year ago? That’s an important number to look at. Then you look at your cash and see where your cash is going.
And then the key is this – we’ve been talking in the last several episodes about what you now do, what you do with this information is you make critical, critical decisions about next year.
Where are you going to do marketing? Where are you going to focus your sales?
Where are you going to hire people?
Where are you going to fire people?
Where are you going to change people’s jobs?
What things are you going to keep?
What things are you going to get rid of?
Should you even stay in business?
All of those questions are answered here.
At my Business Boot Camp when we’re spending those two days, that’s what we’re working on. But see, you can come to my Business Boot Camp and do it or you can listen to these episodes.
You lock yourself up in a room for three, four, five, six days – however long it is – and you go through this stuff, then you can do it on your own.
But if you’re not the type of person who’s going to be able to focus for 10 hours a day locked up in a room by yourself or you don’t have all the knowledge you need to do everything we just talked about, that’s what the Business Boot Camp is for.
You’ve got me, you’ve got other experts and a bunch of other entrepreneurs in the room where we can all do this collectively and together. But you can do it on your own. I want you to know you can do this on your own. So do it with me or do it with other people or do it by yourself, but you must absolutely do it.
The key is to make decisions and plan for the next thing that you’re going to do. What you’re going to do is you’re going to make sure that you know exactly what things you’re going to have happen next year, and then we schedule those things in. That’s what your financial analysis is all about.
So what you’ve just gotten from me is the big, big, big picture. There’s a lot of details here I didn’t go into and as you saw, this was already a pretty long episode. But I needed to make sure I gave you this information because this is your ultimate scorecard, is it not?
Schedule Your Next Financial Analysis Now
As a business owner, what’s more important than making money, losing money, expenses, and things like that? That’s what business is all about, right? So you better know how to analyze this information so you can make good, solid decisions.
Hey, look. I love you guys – entrepreneurs out there. I’m so incredibly proud of you as we’ve been putting these episodes out there, I’m getting amazing, amazing feedback and I always appreciate that. Please keep your feedback coming to me. I love hearing from you guys.
You can message me, email me – whatever – get a hold of me. Put comments on my social media. And if there are questions that you have regarding these things, please make sure you go to my social media and post public questions, because when you post them publicly, I can answer your question and a lot of other people can learn from the answer I give you as well.
Either way, I’m always here for you and I want you to go out there, kick some butt in your business. Make sure you get your financial analysis done and right now when you turn off this episode, I want you to schedule in when you are going to do this year-end financial analysis.
No BS – schedule it right now. Go in your calendar and put it in whether you’re going to do it with me or with other people or by yourself, schedule it right now and go book the tickets. If you’re going to go get a hotel for example and lock yourself up for three days, go book the hotel right now. If you’re coming to my event, book the event now. If you’re going to meet with some friends do to this together, talk to them right now and get that scheduled. Put it on your calendar and go out there every day, lead with your heart.
