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Manage by the numbers for growth, value, or performance

Numbers matter. If you have the right numbers—and know how to interpret them—you can managefinancialstatemt your business for growth, value, or performance, says Roger Birong of Birong Associates LLC.

Speaking to participants at the first Jacksonville Advantage Knowledge is Power breakfast workshop, co-sponsored by American Enterprise Bank of Florida, Birong explained that small businesses often fail to manage by numbers because they do not have the proper financial information.

That financial information is captured on several different “scorecards”—the income (profit and loss) statement, the balance sheet, and the cash flow statement. By analyzing information from these three sources, you are able to understand four different types of bottom lines: gross profit, operating profit, net profit, and cash flow. “These scorecards are functions of behaviors and management decisions,” he said. “They are the results of your behavior.” He explained:

• The income statement provides a picture of the various types of income (profit) you have— gross profit (total sales minus total direct cost of sales); operating profit (gross profit minus overhead expenses); and net profit (operating profit plus other income, minus interest expenses). Each of these types of profit is a different type of bottom line, and it is necessary to know what each is for your business.

• The balance sheet is broken down into two parts: assets and liabilities. The top section of the balance sheet is devoted to assets—things your company owns. Generally they are categorized as cash, current assets (which can be converted to cash within 12 months), and fixed assets (less their depreciation), which are the “big ticket” items, such as cars and equipment.

The bottom section of the balance sheet identifies the things you pay for—your liabilities. Current liabilities are those things you have to pay within a short period of time, such as rent, salaries, utilities. Liabilities also include long-term debt.

When you add your equity (that is, your net income plus your retained earnings) to liabilities, you should get a number that is the same as your assets—hence, the term balance sheet.

• The cash flow sheet is derived from data from the other two scorecards. It shows the amount of cash “at the end of the day.” Cash flow indicates your company’s liquidity.

Applying metrics

The scorecards give you the bottom lines, but those bottom lines are still data—not information. To turn the data into useful information, Birong said you need to apply some metrics and then make comparisons—against performance for a given time period (for example, year-to-date 2009 compared to YTD 2008) or against industry standards.

A number of different ratios (metrics) can be used to analyze the success of your business. Some work better than others, depending upon the type and maturity of the business. Three common ratios include profitability, activity, and liquidity.

Profitability ratios are called “common size” ratios, calculated from data from your income and balance sheets. Three profitability ratios to scrutinize are your gross profit margin (gross profits divided by total sales); operating expenses (operating expenses divided by total sales); and net profit margin (net profits divided by total sales).

Activity ratios reflect activities involved in the operation of the business. For example, you can calculate the average collection period in days for accounts receivable: accounts receivable divided by annual credits sales/365. This figure shows how fast customers are paying bills, he said. “If your terms of sale are 20 days and customers are paying on average in 33 days, you have a collections problem.”

Liquidity ratios tell you about your cash situation—if your company is liquid or not. To calculate your liquidity ratio, divide your total current assets (from the balance sheet) by your current liabilities. “Common sense says you should have a liquidity ratio of at least 1:1,” said Birong. “Inventory is the least liquid of your liquid assets,” he continued. “If you were to calculate your liquidity ratio by taking off inventory and still have a positive number, you are in good shape.”

A common financial metric is debt ratio (total debt divided by total assets) “It’s not bad to borrow money, but you want your debt ratio to be low,” said Birong.

Making comparisons

Metrics are of particular value when you use them to make comparisons—to your company’s past performance (such as year-to-date and end-of-year comparisons), as well as to industry standards. A number of services provide performance information by industry, Birong explained. An excellent source, available in large libraries, is Financial Ratio Benchmarks, published by the Risk Management Association (RMA).

The benchmarks are useful, but they are not infallible, he cautioned, since many factors influence the operation of your business. To get a better picture, make comparisons against your own performance, he advised. Then you can see if trends are developing or if deviations occur. If you are performing better than you expect, congratulate yourself. If worse, take action and correct it.

Roger C. Birong is a certified business appraiser and a certified management consultant. He can be reached at 904-641-3373 or through his company’s Web site, www.birongassociates.com.

American Enterprise Bank of Florida, www.aebfl.com, is a community bank located at 10611 Deerwood Park Blvd.

Don’t miss the next Knowledge Is Power breakfast workshop. The topic: How to reduce your company’s healthcare costs. Go to advantagebizmag.com to register.

SIDEBAR 1

Growth, value, or performance?

Financial statements are tools that allow you to manage your company to achieve your goals. The three broad goals are growth, value, and performance.

• Growth. Companies that are in a start-up phase need to grow fast to get market share.

• Value. This is very important, especially if you planning to exit your business. There are ways to manage your company to increase your equity value in it.

• Performance. Managing for performance optimizes your company.

 

SIDEBAR 2

3 steps to manage by numbers

1. Hire the right person. There are five levels of accounting sophistication, said Birong: mom-and-pop, bookkeeper, accountant, controller, and chief financial officer. As your business grows, your need for better financial information also grows. “Most companies are one level behind,” he observed. You need the right level of skill and knowledge to assure you have the proper information and reports to make good decisions.

2. Learn the basics. Learn how to read the income statement, balance sheet, and cash flow sheet and be able to apply the basic metrics (ratios) to that information, so that you can assess where you are and if you are doing what you want to do with your business.

3. Develop management systems. One of these critical systems is an operating budget, which then allows you to determine if you are on track—and if not, how to get back on track.


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