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

by Chuck Kremer

Accountants add up all these sales for a given time period and list them as sales (or revenue) on the top line of the income statement. Next, they do their best to add up all the costs that are connected to those sales.

For example, say you run a clothing store. If your store buys several gross of golf shirts in March and sells them during April, May, and June, accountants don’t count all the costs in March and all the revenue in April, May, and June. They count the cost of each shirt against the revenue from that shirt in the month that the shirt is sold.

And if you deliver your goods in a truck, they figure out how much you originally spent for the truck and how long it can be reasonably expected to last. Then they allocate a part of the total cost to the period of time covered by a particular incom...

“the accrual method of ac...

An accrual-based income statement shows sales over a given period of time (April, say) and the costs associated with April’s sales,

It shows the revenues and costs that you have accrued in that time span.

A cash-based income statement looks just like an accrual-based income statement, but it is compiled differently. Sales are recorded only when the cash is received. Costs are recorded when the checks are written. We don’t recommend managing with a cash-based income statement

Yes, it does let you postpone paying taxes on profits from sales you haven’t yet collected. But it doesn’t show you whether your company’s sales are really profitable.

if a balance sheet is like a snapshot, an income statement is more like a movie: it tells what happened during a given a time span.

The first line on any income statement—the “top line”—is always sales or revenue.

you can’t ordinarily record a sale the instant that the customer places an order; you actually have to provide the goods or service. (For very long-running projects such as construction, revenue is sometimes recorded as the job reaches certain percentages of completion, instead of being recorded all at the end of the job.

The next line for many companies is cost of goods sold, or COGS.

COGS is the single most important number on the income statement because it is the biggest factor affecting profit.

COGS generally includes only the price of goods acquired for resale (plus, usually, “freight in”—that is, any shipping cost associated with getting the goods in stock).

Companies that don’t deal in goods, of course, don’t have a COGS line. Some service companies do have a line labeled COS, for cost of sales or cost of services, which represents the specific cost of providing services. For example, a seminar company might take all the costs associated with a particular seminar—the presenter’s time and travel expenses, the cost of the room, instructional materials,

Next on the income statement comes gross profit, which is just sales minus COGS or COS. Now and then you’ll hear someone refer to this figure as “gross margin,” but we think it’s clearer if you call the dollar figure gross profit. Gross margin is better defined as a ratio: gross profit divided by sales. By this terminology, SOHO has a gross profit of $150,000 and a gross margin of 30 percent.

The next line on SOHO Equipment’s income statement is operating income, also called operating profit. You compute it by subtracting MSG&A expenses and depreciation and amortization from gross profit.

Interest and other expense covers all the expenses that don’t come from daily operations. If you have loans, as SOHO Equipment does, the interest you owe will show up here.

Profit before taxes is just operating income minus interest and other expense. An example of “other expense” that would show up here is a loss (or gain) on the sale of a fixed asset such as a piece of machinery. Since that is a presumably a one-time transaction (accountants call it a nonrecurring item), it is handled separately on the income statement.

Income taxes is your accountant’s estimate of what you owe the government on the profit you have made in the period covered by the income statement. Since SOHO Equipment made no profit in its first year, it doesn’t have to set anything aside for taxes.

Net profit (or profit after tax) is the famous “bottom line.”

some track a measure known as EBITDA, which is an unwieldy acronym for “earnings before interest, taxes, depreciation, and amortization.” EBITDA is typically figured by taking operating income and “adding back” depreciation and amortization.

the depreciation expense will be determined by accounting rules for depreciating trucks, which are based on reasonable estimates of a truck’s useful life, not by the amount of cash actually being laid out.

if your company is growing fast, you may be building up inventory, buying new machinery, opening up new branches, and in general spending a whole lot more cash than you are generating. Your income statement may show that your company is highly profitable—and all the while you might be running out of cash!

There’s another downside to accrual-based income statements. They provide a huge opportunity for what you might call creative accounting. Accountants are required to use a code of rules known as Generally Accepted Accounting Principles, or GAAP. The logic behind GAAP is reasonableness; the rules must make sense.

They can select one or another method of valuing inventory. They can insert reserves for warranty costs, bad debt, and other eventualities—or not.

All such moves can be perfectly legal and perfectly consistent with accounting standards, but they will make the bottom line of the income statement look very different depending on which tactics the accountant chooses. (This is known as “the gap in GAAP.”) Unless you’re financially sophisticated, you can be fooled by clever accounting. And if you run your own business, what you really want to know isn’t just the bottom line on an income statement, which is subject to all these accounting manipulations, but also how much cash is actually flowing into (and out of) your bank account. This brings us to the next subject: cash flow.

Every year, tens of thousands of businesses fail. Some were showing a profit at their demise. What happened? Simple: they didn’t have enough cash to stay in business.

“You can operate a long time without profit,” said Lou Mobley, “but you can’t survive one day without cash.”

It tells you how much you deposited in your bank account, how much you wrote checks for, and what the difference was during a specific time span. Cash information helps lenders know whether you can pay them back. Cash information tells you whether you can buy a truck today and still make payroll next week.

It tells you how good a job you’re doing at turning your profits into cash.

in 1987, when the Financial Accounting Standards Board (FASB, pronounced faz-bee) ruled that all financial statements involving CPAs must henceforth include a statement of cash flow.

Your accountant might still tell you that you should rely on your income statement rather than your cash-flow statement to see how your company is doing—even though the whole point is to use both, not one or the other, along with the balance sheet. Your accountant might also tell you that the indirect cash-flow statement he or she prepares is just fine. Trust us, it isn’t. A direct cash-flow statement is analogous to a checkbook.

OCF + ICF + FCF = change in cash

ending cash = beginning cash + change in cash

Operating Cash Flow

OCF is the lifeblood of a company. After all, a company generates cash in only three ways—from operations, from selling assets, and from lenders and investors (borrowing money or selling stock). But cash from operations is the most important of the three.

You should be thinking about your OCF every day and checking it every month.

You can be GE or Microsoft, but if you don’t have a healthy ongoing OCF you’re on the way down.

Investing Cash Flow

When you analyze ICF, the most important line to look at is the amount spent on fixed assets. This is a good measure of your company’s investment in its future.

Some capital-intensive, high-growth companies will maintain an ICF greater than OCF for a period of years. Over the long term, however, most companies want OCF to be greater than ICF—that is, they want to fund investment internally so as to reduce their dependence on outside sources of financing.

Financing Cash Flow FCF, finally, shows your relationship to (and dependence on) investors and lenders. Are you repaying your outstanding loans or is your indebtedness growing? Are you having to sell more stock in your company to finance your cash needs? Are you paying your shareholders dividends?

Jack Welch took over GE as CEO around 1980 and proceeded to transform it. He reduced the payroll substantially. He sold off dozens of businesses and acquired dozens of others. Not everybody likes to give “Neutron Jack” credit, but there’s no denying that his moves paid off handsomely in terms of profitability.

In late 1991, Welch decided to refocus his managers’ attention on cash flow as well as on profitability.

In some cases, incentive compensation was changed to reward improvements in asset management.

they began taking action. They found new ways to warehouse inventory to get products to customers faster. They began using electronic data interchange (EDI) to bill customers and collect from them. They began negotiating more favorable payment terms with both customers and suppliers.

HAVE YOU EVER WATCHED PEOPLE WHO REALLY KNOW WHAT they’re doing pore over a set of financial statements? We’re thinking of savvy investors, smart lenders, sophisticated business owners, and financial executives. They spread the papers out in front of them. They go back and forth from the income statement to the balance sheet to the cash-flow statement. (If there isn’t a cash-flow statement, you can be sure they’ll request one.) They ask for more information—last year’s data, the year before that, even the year before that—and they start making trend charts. Pretty soon they begin asking all kinds of questions. And if you know anything about the company they’re examining, you realize the truth: these people learn a phenomenal amount about a business just by studying the numbers. They can spot its strengths. They understand some of its vulnerabilities and challenges. They often know enough to decide whether it’s worth investing in or lending money to. Think how valuable it would be if you could do this for your own business.

a complete set of financials is like a set of powerful lenses. Some of the lenses are wide-angle, showing you what your company’s overall results are. Others give you close-up views; they help you understand nitty-gritty details such as the reason your receivables have been on the rise.

Without the information, you’re flying blind.