Accounting has been called the language of business. If you’re like most business owners though, you’ve probably wanted to learn as little as possible about this language. In my experience however, I’ve seen a high correlation between an owner having a basic knowledge of financial statements and operating a successful business. Remember, one doesn’t have to be fluent in a language in order to communicate. A few years ago a friend traveled to France and Italy and didn’t think it was necessary to learn a few phrases in these languages. After the trip though, he said that knowing how to say a few simple words such as “where’s the bathroom?” or “I want a beer” would have avoided a couple of minor emergencies and scored points with the locals. Likewise, learning a few key financial terms and ratios allows management to review past results and take corrective action as necessary. As one of my supervisors always used to say: ”you can’t manage what you can’t measure”.
First of all, it’s important to lay a good foundation. Everyone needs help in order to succeed. This includes assembling a strong financial team such as a good bookkeeper or accountant, a CPA and a banker. If you hire a financial professional make sure they are well trained and keep accurate records. If you’re company is looking to reach the next level consider bringing in a senior financial person and think of it an investment in your future.
Now, let’s briefly consider how your Balance Sheet and Profit & Loss Statement can help you to quickly analyze results and set future goals:
Balance Sheet: if a medical professional wants to make a quick assessment of your health they measure your blood pressure, temperature etc. Likewise, a Balance Sheet can provide an owner with the vital signs of a company with a minimal amount of effort. For example, your current ratio (current assets divided by current liabilities) can give you a quick snapshot of your liquidity. The current ratio should normally be at least 1:1 with a ratio over 1.5:1 being excellent. A ratio less than 1:1 is a cause for concern – especially if you do not have access to a bank line of credit for cash flow emergencies. The better your current ratio – the less strain on your financial resources.
Days Sales Outstanding (DSO) is another very useful financial ratio. It measures the amount of time it takes your company to collect account receivables from credit sales. The formula is: (total receivables/total credit sales X number of days in the period). If your standard credit terms are 30 days and your DSO is 40 days then you’re collecting your receivables 10 days late on average. If your credit terms vary by products or customers, you can calculate Best Possible DSO using only current receivables in the formula and then compare this number to your total DSO. Setting DSO goals and tracking this ratio allows you to follow-up on collection issues and maximize your cash flow.
Profit & Loss (P&L) Statement: the P&L provides the owner with much more data than the “bottom line”. For example, the gross margin (revenues minus cost of goods sold) tells the owner whether the company is generating sufficient profit to cover overhead expenses and leaving enough for “take home”. Tracking gross margin percentages and making needed adjustments is time well spent. For example, a decrease of only 3% in your gross margin on $1,000,000 of revenues results in a decrease of $30,000 in net income all other things being equal. Also, annually, budget and closely monitor your overhead expenses. Consider asking your employees for suggestions on reducing overhead expenses which can often result in quick improvements to net income. Also, your CPA or banker may be able to help you with standard ratios for your industry and size of business. You can also purchase data on financial ratios from credit rating agencies.
In summary, learning a few phrases in the language of business can help you succeed and avoid a “management by crisis” environment. Each month, or at least quarterly, management should review Key Performance Indicators (KPI’s) such as profitability, current ratio, DSO etc. in order to measure results versus goals and objectives. Keeping the process simple and holding yourself and your team accountable will create the right culture to drive high-performance.
In my next article we’ll discuss the importance of why your company’s cash flow should be budgeted and monitored.