Managing By The Numbers: A Commonsense Guide To Understanding And Using Your Company's Financials

by Chuck Kremer

It will show you how to use the information to run a better, more profitable company.

running a company is hard. You need every tool at your disposal,

People who run businesses don’t need to be accountants. They only need to make sure that their accountants (and their accounting software) give them the information they need—and that they know what to do with

• It explains what drives the three bottom lines—and shows you how to manage your business so as to optimize your company’s performance on all three measures.

Here’s how to get in touch with Chuck or Ron: Chuck Kremer 8632 West Warren Drive Lakewood, Colorado 80227 chuck_busliteracy@compuserve.com Ron Rizzuto 5124 South Jamaica Way Englewood, Colorado 80111 rrizzuto@du.edu

Why Your Company’s Checkbook Doesn’t Tell You Everything You Need to Know

They tell you important information such as • how your company has performed financially over time • whether you have a sufficient “cushion” against a business downturn • how you stack up financially against competitors in your industry • whether you have spent too much (or too little) on equipment • how you’re doing at collecting the money your customers owe you • whether you’ll be able to make payments on your outstanding loans • whether you can afford to pay yourself more than you have in the past

The Balance Sheet What a Company Owns and What It Owes EVER NOTICE SOMETHING ABOUT A BALANCE SHEET? IT HAS a date at the top.

What the balance sheet gives you is a snapshot of certain key facts about a business as of that date.

(For this reason the balance sheet is sometimes called the statement of financial position.)

The balance sheet all by itself tells you some interesting and important facts about your company: • Is the business solvent—that is, are its assets at least equal to its liabilities? If the company were liquidated tomorrow, would the owners have anything to show for their effort? The balance sheet doesn’t give you an ironclad answer to this question, for reasons we’ll discuss below. But it gives you a rough indication of where you stand on this score. • Is the business sufficiently liquid—that is, does it have enough cash and other liquid assets to cover its short-term obligations? In other words, are you going to be able to pay your bills during the period of time immediately following the date on the balance sheet? • What do the company’s assets consist of? A balance sheet shows you how much money you have in cash or short-term investments. It shows you how much you have tied up in inventory, and in plant and equipment. It also shows you how much you’re owed by other people. • Who has a claim on those assets? A balance sheet doesn’t name names, of course. But it does show you how much you owe to various categories of creditors—vendors, lenders, the government, etc.—and how much belongs to the owners of the business.

with numbers belonging to a company we’ll call SOHO Equipment, Inc. SOHO Equipment’s name and financial statements are fictitious.

working at home—“soloists,”

The assets side of the balance sheet shows what a business owns. Traditionally, they are listed in order of liquidity—that is, how easy it would be to turn them into cash. So let’s go down the asset categories one by one. First on the list comes cash and cash equivalents. This is real money. It includes what a company has in the bank. It also includes certificates of deposit (CDs) that mature in less than ninety days and shares in a money market fund.

Next on the list of assets comes accounts receivable. This is what people owe the business—that is, what they have promised to pay. Usually, most of the receivables consist of trade receivables, or what the company is owed by customers. Businesses expect to be paid by these customers in thirty days or so, so these receivables are almost like cash.

How to read a balance sheet—

To get the $215,000 in total assets, for example, add the $100,000 in current assets, the $100,000 in net fixed assets, and the $15,000 in goodwill, net. Negative numbers in a balance sheet—numbers that must be subtracted when you’re doing the totaling—are customarily indicated by parentheses.

Then comes inventory. Companies in manufacturing industries have raw materials, work-in-process, and finished-goods inventory.

when you hear accountants argue about LIFO versus FIFO, or last in first out versus first in first out, what they’re discussing is different methods of valuing inventory.) The company hopes to sell this inventory before long, so it too is pretty close to cash.

Next comes notes receivable. Notes receivable refers to interest-bearing loans the company has made, primarily to customers.

The first several lines on the balance sheet—cash plus all the items that are expected to be converted to cash within twelve months—are summed up under the heading current assets. Then the balance sheet lists assets that are relatively illiquid—that is, assets that aren’t expected to be converted into cash in that twelve-month period.

First in this category is an item we label gross fixed assets. (Many balance sheets label it gross property, plant, and equipment. Same thing.) This shows what a company...

When accountants write down the value of a company’s fixed assets, they use what they call historical cost. In other words, they measure the value of an asset by what the business paid for it, not by what it may be worth now.

Next comes an item called accumulated depreciation.

Depreciation is simply a way of spreading the cost of an asset over a certain number of years, with the time span roughly corresponding to the useful life of the asset. Accumulated depreciation is just a way of showing how much of the cost has been allocated to prior years. An example should clarify this idea. Say you run a flower shop, and you bought a delivery truck three years ago for $25,000. The entire $25,000 is included in the gross fixed assets line of your balance sheet because that’s what you paid for the truck (its historical cost). But by now, the truck is three years old, and its value has declined. Each year, your accountant has listed a portion of the truck’s price as an expense on your income statement and is said to have depreciated it (more on this in the next chapter). The accumulated depreciation line on the balance sheet shows the total cumulative depreciation over the three years since you bought the truck. So why is SOHO Equipment’s accumulated depreciation zero? Simple: when business assets are sold to a new owner, their “fair” value is refigured as of the date of the sale. That becomes the new gross fixed assets figure, and the new owner begins depreciation all over again.

a balance sheet will then show net fixed assets or net property, plant, and equipment, which is just the gross number minus accumulated depreciation. The gross shows what the company paid for its fixed assets. The net shows that cost minus accumulated depreciation.

There may be other items on a balance sheet as well. Other operating assets is a catch-all category that can include items such as a prepaid insurance policy or prepaid rent on a building.

Other investments refers to assets such as long-term CDs or equity in another business.

You’re likely to run into this puzzling term goodwill—it’s usually written as one word—any time a business is sold,

someone who buys a company (even in an asset sale) is usually buying much more than just the assets recorded on the seller’s balance sheet. The buyer gets an ongoing business. The company has a customer list, business relationships, a reputation, a place in the community. The price of the business will be determined not just by the value of the seller’s assets but by the company’s market value,

That “extra” that the buyer pays is what accountants call goodwill. It appears on the balance sheet just like any other asset, and it will be amortized over time much like any depreciable asset. It’s the most common form of what are known as intangible assets—something that has value but can’t be touched, collected, or spent.

In this case, Bill and Carolyn paid $215,000 for the assets of Williams Equipment, Inc. Since the cash, inventory, and fixed assets were worth only $200,000, the remaining $15,000 is goodwill.

For most small companies, the key items on the balance sheet are cash, accounts receivable, inventory (if the company has any), and net fixed assets. These items will nearly always show the bulk of what a business owns.

UNDERSTANDING THE BALANCE SHEET: LIABILITIES Liabilities and equity make up the right-hand side (or the lower half) of a balance sheet. The liabilities entries show claims on the company’s assets held by people outside the business. The equity entries show what’s left for the company’s owners after all the other claims have been accounted for.

Liabilities are categorized by how current they are. Those that must be paid in the next twelve months are at the top, so we’ll start there.

The first entry is accounts payable. That doesn’t need much explanation: it’s what a company owes its vendors and suppliers for goods and services purchased.

The next entry is taxes payable. Again, no explanation is necessary. What a company owes the government for income tax is just another kind of payable.

And if the business has other short-term obligations, they’ll be listed under other liabilities. This is another catch-all category: it might include vacation that employees have earned but haven’t yet taken and deposits that the company has received from customers for work to be performed in the future.

Then comes long-term debt. If your company has borrowed money from your uncle, the amount it owes will show up here.

So Williams agreed to hold an interest-bearing note for $10,000, with the entire principal due in twenty-four months.

Then come the entries that show equity. Typically, the equity entries are labeled common stock and/or paid-in capital, which includes all the money that shareholders have invested in the company, and retained earnings, which is all the accumulated profits the company has earned that it has never paid out to shareholders. Bill and Carolyn don’t have any retained earnings yet, so their equity is wholly in the form of stock. The $205,000 represents the cash they themselves invested to buy stock in their new company.

The right side—the liabilities and equity side—is a little different. Sure, it’s still numbers. But those numbers represent people. They represent liabilities the company has incurred to the people who are its creditors. They represent the value held by the people who own the business (equity). Lou Mobley of IBM liked to say that the balance sheet is a snapshot that connects things to people.

They have to add up common stock, paid-in capital and retained earnings, and be sure that the total equals assets minus liabilities. This can sometimes be a daunting task, which is why the world needs accountants after all.

Add the cash and accounts receivable figures on the assets side, and write down the sum. Separately, add accounts payable and any other current obligations listed on the liabilities side, and write down this sum. Then divide the first number by the second. What do you get? As a rule, the ratio should be greater than 1.00. If it isn’t, it means you don’t have enough cash and near cash to cover your short-term obligations (those due in the next twelve months). Accountants call this the quick ratio or acid test. It’s a useful tool for estimating at a glance whether your company is facing immediate liquidity problems. (“Liquidity problems” is accountant-ese for not enough cash.)

a balance sheet is called strong when the company has a nice financial cushion. Its liabilities are small compared to its equity. A weak balance sheet is just the opposite: high liabilities compared to equity.

a company can have more assets—even more cash—than it can profitably put to work. A large cash balance makes those current and quick ratios look good (again, all else being equal), but an astute analyst would want to know why that cash isn’t being better reinvested. By the same token, a company with high liabilities relative to equity may be using borrowed money effectively to generate more profits than it otherwise could.

THE SECOND IMPORTANT FINANCIAL REPORT IS CALLED THE income statement. It’s also known as the statement of earnings, statement of operations, the profit-and-loss statement, or just the P&L. It shows you whether your company was profitable—whether it made money—over a given period or span of time.

To understand this danger, remember that most business transactions consist of two parts. First comes a promise and agreement. You agree to buy something from a vendor and you make a promise to pay. You agree to sell something to a customer and the customer promises to pay.

Strange as it may sound, the income statement tracks only the promise and agreement part of a company’s transactions. It is not about cash. It doesn’t show the dollars coming in and out of your bank account. The number at the bottom of the income statement, net profit (or profit after tax), is not cash you can spend!

The reason is that it answers an important question—a question that runs something like this: Let’s take the value of all the goods or services we delivered during any given time period, whether or not we have been paid for them yet. Then let’s figure out as accurately as we can what it cost us to provide those goods or services, regardless of whether we actually wrote checks for those costs. Now: are we making money from our delivery of those goods or services?