Kindle Notes & Highlights
by
Chuck Kremer
Read between
December 10, 2019 - January 5, 2020
Companies can be profitable but go belly-up. Companies can be increasing their profits while actually performing worse than before. Companies can be making a profit that looks like a lot of money in dollar terms. But if you stop and analyze the profit, you realize the shareholders would be better off investing in CDs or Treasury bills.
In general, OCF should consistently be larger than net profit. If it is, that’s a sign that a business is doing a good job of managing assets such as receivables and inventory. Financial people say that it is doing a good job of turning its profits into cash.
Just like the experts at the beginning of this chapter, you can “read the tea leaves” and identify your business’s strengths and weaknesses.
From a financial perspective, improvement on the three bottom lines is the goal of a business.
free cash flow, which is operating cash flow minus capital expenditures,
Remember how we noted that financial experts always seem to want more years’ worth of data? And how they’re likely to start building trend charts?
whether its performance on those three bottom lines is improving or declining.
he once wrote, “one myth after another had to be washed from my mind.”
cost of goods sold (COGS), which appears on the income statement, is a measure of “inventory out”—in other words, the number of units sold times the cost of each unit. Second, cash paid to suppliers—inventory paid, on the cash-flow statement—shows how much a company actually spent to increase its inventory. The net of those two numbers explains the difference in year-end inventory. Beginning inventory of $75,000 minus COGS of $350,000 (inventory out—that’s why it’s minus) plus inventory paid of $380,000 equals ending inventory of $105,000. In other words, $30,000 more inventory came in than
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The fact is, you can account for almost every single change that occurs from one balance sheet to the next by taking the appropriate numbers from the income statement and the cash statement and adding or subtracting them.
But accountants in general don’t talk much about how all the numbers fit together. They rarely explain the connections to business owners, and they haven’t learned to present financial statements in such a way that the connections are clear. As we mentioned, many accountants don’t even produce a direct cash-flow statement—
Once Mobley understood the connections, he invented a name for them, the continuity equation. Then he created a simple one-page matrix showing the beginning balance sheet, the income statement, the cash-flow statement, and the ending balance sheet. His students promptly dubbed it the Mobley Matrix. We have rechristened it the Financial Scoreboard.
When you’re adding up the cash-flow statement itself—we call this “doing the vertical math”—collections is obviously a positive number, since it represents cash coming in. When you’re figuring out the ending balance sheet, however—“doing the horizontal math”—you’re adding sales to beginning receivables and subtracting collections to get ending receivables. So here collections is treated as a negative number.
The logic here is that the financial statements show cause-and-effect relationships, and the causes have different effects depending on where they show up on the financials.
TABLE 6.5 Financial Scoreboard,a SOHO Equipment, Year 1 ($000)
TABLE 6.6 Financial Scoreboard Decoder (income statement)—“Vertical Math”
TABLE 6.7 Financial Scoreboard Decoder (cash-flow statement)—“Vertical Math”
But the Financial Scoreboard has several big advantages over the traditional presentation. • It lets you see the big picture of your company’s financials at a glance. It’s like an executive summary. • It shows cause-and-effect relationships. You can understand exactly how and why your balance sheet at the end of a year (or a month) differs from the balance sheet of the preceding period. You can see why receivables went up or down, why inventory has increased or decreased, and where the change on the cash line came from. The Scoreboard thus makes it easy to track progress against goals. • It
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TABLE 6.8 Financial Scoreboard Decoder—“Horizontal Math”
We assume that you want to have a successful, moneymaking business. Beyond that, we don’t have any idea what your goals might be. Maybe you want to be the next Bill Gates. Perhaps you want to run a small family company that you can pass along to your children. Maybe you hope to build up the business over five years, then sell it and play golf.
Most companies must make a profit in the short term, and all companies must make a profit in the long term.
We stuck the qualification in there to remind you that start-up and fast-growth companies often don’t make money right away, and that even well-established companies can afford an occasional year in which they sacrifice profit in pursuit of some other goal (such as expansion).
Mobley’s dictum: you can operate for a long time without profit, but you can’t operate one day without cash.)
If you own a company, you want to know not only what happened but why. You also want to know what you can do about it.
Sales minus COGS or COS equals gross profit. Gross profit divided by sales—a percentage—is usually called gross margin.
The first is to compare your company’s performance with the performance of similar companies in your industry. Business information sources, such as Robert Morris Associates or Dun & Bradstreet’s Key Business Ratios and Industry Norms, can provide you with benchmarking data on key ratios.
TABLE 8.1 Income Statement, SOHO Equipment, Year 1, Dollars and Percents
MOST BUSINESSPEOPLE ARE TAUGHT TO MANAGE PROFIT. Very few are taught to manage cash flow. And yet cash flow is every bit as important as profit. For a small or growing company, cash flow is the very lifeblood of the business. If a small company runs out of cash, it dies.
Offer customers a discount for early payment—and enforce it. Establish relationships with the accounts payable people in your customers’ offices. (Send them flowers—it works!)
The second most common culprit in companies with cash-flow problems is too much inventory. And once again there’s a handy ratio available to tell you if you have a problem in this department. Simply put, inventory days is the average number of days between the purchasing of materials and the sale of the product.
you want to know how many days it takes to turn your inventory once:
on average, the company’s goods sit in the store for nearly three months before they are sold. This might be a fine rate of turnover for a specialized industry such as rare books. For a highly competitive business such as selling office equipment it’s too high. No wonder SOHO Equipment is showing such poor cash-flow results even though it is making a healthy profit!
If you’re a manufacturer, you face a different set of concerns. Manufacturing inventory comes in three forms: raw materials, work in process (WIP), and finished goods.
The moral of the story? Manage your raw materials so that your stocks turn over regularly. Be sure your finished goods find their way to customers as quickly as possible. Above all, minimize WIP. Analyze your manufacturing processes to keep WIP down. Look for bottlenecks that cause the flow of work to back up. Learn concepts such as just-in-time inventory management, which is designed to minimize WIP.
learn an even newer approach to inventory management, called demand flow™ manufacturing, taught by the John Costanza
it’s a bigger mistake to throw out the baby with the bathwater.
Investment in fixed assets should pay off in the form of higher sales or decreased expenses (compared to sales), which is to say it should pay off in the form of higher net profit. To test whether it does, make a graph of net profit over time and a graph of net fixed assets over time. Ideally, both should be rising. But unless net profit is rising faster than net fixed assets—that is, unless the “profit” line is steeper upward than the “fixed asset” line—your fixed assets are not yet paying off financially.
assets = liabilities + equity Despite the financial terminology, it’s a commonsense concept that people use every day. If you buy a house for $250,000 and the bank holds a mortgage for $200,000, you know you have $50,000 worth of equity in the house. Similarly, if a company starts up with a $10,000 stock investment and borrows $5,000 to buy a machine, the company now has $15,000 worth of cash and equipment, or $15,000 worth of assets. But it owes $5,000—the bank has a claim on that—so the equity held by the company’s owners is still only $10,000.
A company, after all, doesn’t want to borrow more money than it can put to work. It doesn’t want to borrow more than it can afford to pay back. Just like individuals, plenty of companies borrow too much and wind up in bankruptcy court for their troubles. Maybe you have heard the term debt-to-equity ratio, which is simply debt divided by equity. This is a useful measure in that it can show when a company is overextended.
—or— ROS × asset turnover = ROA × fin. leverage = ROE This formula, known as the extended Du Pont equation,
Despite what your accountant might tell you, the best route to better ROA is almost never achieved purely by holding down expenses so as to increase profit. And despite what your VP of sales might tell you, it’s almost never achieved by increasing sales while holding assets steady. You need to do both—improve your ROS and improve your asset turnover. The ROA curve offers handy guidelines for figuring out where to put your priorities.
Naturally, you don’t want to borrow too much, or you’ll put your business in jeopardy. Remember interest expense will increase, so all else won’t really be equal. But if your ROA is healthy and your ROE is lackluster, it’s a safe bet you aren’t taking full advantage of the leveraging opportunities that are open to you. Some judicious borrowing can help your assets/equity ratio and thus your ROE.
Other company owners do a kind of half-baked planning. They eyeball the revenue figures for the last year or two, choose some arbitrary growth percentage such as 10 percent or 25 percent, and decide that is their sales target for the year. Or maybe they focus on the “bottom line,” usually meaning net profit, and decide they want to see a 50 percent increase in net profit.
A number plucked out of the air doesn’t mean much. The fact is, neither hope nor faith nor hard work nor all three combined will magically produce a given set of objectives. Rather, some very specific things must happen if your goals are to be realized. If you can’t spell out exactly what those things are, you’re just blowing smoke—and your employees will know it.
A real annual plan has three characteristics: • It spells out realistic business goals and specific strategies designed to accomplish those goals. • It takes into account all the interconnected elements of a business, not just one or two. • It can be translated into hard numbers, as described above. An annual plan isn’t a plan unless you can use it to project an income statement, a cash flow statement, and an ending balance sheet. Ideally, you will be able to show month by month how those numbers will become real. If you have such a plan, you’ll know not only where you are headed but what must
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Once you learn how to plan, you’ll be able to create best-case and worst-case scenarios. You’ll develop contingency plans i...
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you can’t do everything in a year. If you hope to bring out new products two years from now, you have to spend money on R&D today. If you’re aiming at taking your company public someday, you may want to invest now in creating the management and accounting systems you’ll need then.
You should be able to make statements such as these: “We project an increase in sales of 20 percent because we are opening a new location and we know from experience how much revenue a new location generates in its first year.”
“We expect sales to stay flat this year because we are likely to lose Customer X, and the best we can realistically hope for is to replace those sales by winning some business from Prospects Y and Z.”
The initial sales goal needs to be scrutinized and measured against the company’s resources and capabilities in other areas. If, for example, your market is expanding rapidly, your salespeople may be able to realistically project 100 percent growth in a year.
