Business Literacy

Everyone in the company must know how the company makes money and what their role is in it.  As logical as this sounds, I am amazed at how few people see financials of their organization, let alone truly understand them.  With the exception of payroll, I believe a company should share financial results to increases stakeholder awareness and interest in the success of the company.  Any payroll information other than in general terms or accumulated data only hurts relationships.  Granted, a production operator doesn’t have the same information needs as a department supervisor, and a Warehouse Manager doesn’t need to know much about the way the company is financed, but giving them basic financial information on the company and how their efforts help the bottom line empowers employees to look for ways to improve the company.  For many companies, this will require some basic training (which can be tied into the budgetary process) on financials.  If you do have access to your company’s financials, do your best to understand them.  Accounting is the language of business and should be studied, at least the basics.

Financial reports can be confusing at best.  Many small companies jealously guard their financials, for fear people won’t understand the need for reinvestment and clamor for raises rather than building the business.  Most large companies “roll up” their results to the point the numbers are unrecognizable.  At the division level, one of the goals may be to maximize inventory turns (and thus return on assets); while at the corporate level the same company would report large inventories as a good thing, explaining how high inventories are maintained in order to help “quickly meet customer demand”.  Don’t laugh, I’ve seen it.

Key process indicators (KPI’s) are those numbers which tell the quick pulse of the company, such as daily sales and invoicing, inventory turns, or average day’s accounts receivable.  These help top managers make sure the flow of the business is good, and should be checked weekly, if not daily.  Some managers want to wait until month end to see the numbers, but I maintain that the longer you wait, the more difficult it is to make timely corrections as the business traverses choppy waters.  On the other hand, most variances smooth out over time.  Having a strong reaction to daily fluctuations can really be dysfunctional.  Just as the company may have 5-6 KPI’s Top Managers watch, each department should have its own set of KPI’s.  They should be charted over time, and include corrective actions for those areas that are falling short.

The Power of Sharing Numbers

Imagine that a company manufactures plastic extrusions at 96”.  Normal operating procedure is to cut the extrusion at 97” and then re-cuts the piece “exactly” at 96”.  Waste is just over 1%.  If material costs 50% and profits are 10%, then trim waste is .5% of sales, and 5% of profits.  In a $10MM (sales) company with $1MM profits, waste is $50K/year.  The operator has no sense of this.  She is following her standard procedures and has no clue she is throwing away more than her salary every year – how could she?

Now let’s take it further.  Share these numbers with the operator and she will be horrified.   Share this number with a middle manager and she will look at her shoes and talk about “fixing it” – all the while feeling defensive and that she is following the procedure she was given.  Share this number with an owner and she will be angry and look for someone to blame.  What is the appropriate response?  Sharing the numbers gets employees at all levels thinking about the waste and how they might reduce it – with the winner being the entire company.

Accounting Primer

There are two main financial reports:  the Balance Sheet and the Income Statement.  The Balance sheet is a snapshot of the company’s health on a certain date.  Key components are assets (things of value, such as plant and equipment, inventories, cash, and receivables), liabilities (money owed others, including banks and vendors) and shareholder’s equity (net value of the company).  Assets = Liabilities + Shareholder Equity.

Working Capital is the key to liquidity.  Working Capital is calculated as Current Assets (cash, short term accounts receivable, and inventory) minus Current Liabilities (short term accounts payable, accruals, taxes payable, and bank debt).  Working capital grows as more money is invested in the company or earnings are retained.  So long as a company has enough working capital it is in good shape to pay its bills.  Hence the saying Cash is King.

As its name suggests, the Income Statement compares revenues and costs, ultimately showing net gain (or loss) for a given period of time.  First item listed is revenues, followed by variable costs (cost of goods sold or COGS) and fixed (overhead) costs.  Here is a cost structure for typical Manufacturing, Retail, and Airlines businesses (in terms of % sales):

Typical Costs
Mfg Retail (WalMart) Airline (Southwest)
Variable costs
Direct Labor 10%
Materials 53% 76% 39%
Fixed and Overhead
Indirect Labor 10% 10% 26%
R&D, Rent, Utilities 20% 9% 31%
Profit 7% 5% 4%
total 100% 100% 100%

Gross margin is calculated by the formula (revenues – variable costs)/revenues. Gross margins for the above manufacturing example are calculated as (100-(53+10))/100 = 37%.   That means 37% of each dollar sold goes to covering fixed costs.  Once fixed costs are covered, 37% of each dollar sold goes to profit.  Breakeven sales quantity is the $ sales value where all fixed costs are covered, given by the formula $sales x gross margin = fixed costs. Gross margins vary widely – typically higher for specialty manufacturers and service providers and low for high volume industries.

The overall health of the company is measured by the relationship between the income statement and the balance sheet, typically by what is known as ROA.  ROA is the relationship between Return and Investment given by the equation ROA = profitability/ (working capital + net fixed assets).  ROA is tempered by risk- an uncertain future discounts any investment’s potential.   If return on assets, adjusted for risk, is lower than other investments, the company will have trouble raising equity.  Depending on the investment climate, ROA of 4-8% or better may be considered a good investment.

No company has ever gone bankrupt for losing money.  Bankruptcy only happens when a company cannot pay its bills.  So long as someone will loan the company money (Liability) or invest in the company (for a piece of Shareholder Equity).  Start-up companies such as Amazon.com and biotech startup companies can operate for years without making a profit because of their ability to raise equity on the capital markets to pay their bills.  On the other hand a profitable company (income > costs) that cannot collect cash enough may not be able to pay its bills and literally grow itself into bankruptcy if creditors demand payment.

How to view the financials

All expenses should be viewed as both the actual $ amount and as %Sales – this smoothes out much of the seasonality and other variations as production and consumption vary.  The best way to look at financials is with a reference – preferably the previous year’s results.  Comparing year to year helps put the numbers in perspective.  As with most indicators, the most important thing when viewing financial information is to truly understand what is driving changes in the numbers.  If materials expense has risen from 52% of sales to 54% of sales – that is a clear indicator of problems in the supply chain and must be addressed. If KPI’s are changing, such as # days reason outstanding increasing from 30 to 40, there must be a reason.  Understanding that the rise is due to an increase in export orders, which have a longer line of credit than domestic orders, for instance, tempers the response.  Rather than focus on someone not doing a good job in collectibles, the task becomes one of how to change terms for exports or get bank help carrying the note.

The sales volume (express as units sold) at which the company breaks even is called the break-even point.  Profits are $0 at the breakeven point.  The breakeven point is calculated by the following formula: Break Even Point = Fixed Costs / (selling price-variable costs).  I understand “Black Friday” – the day after Thanksgiving known for huge early Christmas deals – got its name from being around the breakeven point for most retailers.  Until Thanksgiving, all sales merely covered costs.  Profits for those retailers were a function of sales after Thanksgiving.

Financial Analysis

Financial analysis needs to happen company-wide.  Sophisticated financial analysis should be the province of a few, but everyone in the appropriate department should be plugged in to the key issues:

  • How many salespeople know which accounts are most profitable for the company? Least profitable?  A careful analysis will show a number of “good” accounts are barely profitable – in part due to “special handling”, discounts, and freebies over the years that may or may not be merited.  We often go overboard to satisfy the squeaky wheel – at what cost?  Most commissions are structured around gross sales, not net profit.  Perhaps it is time to fire a few customers.
  • Which product lines are growing? Shrinking?  Why?
  • Which product line is most profitable? Why?  New products, often the life blood of companies, often start with higher overhead and launching costs.   At what point does it make sense to keep investing in some of the older, standard products?
  • Which territories are growing? Shrinking?  Why?  What are we doing to change the trend?
  • Which products are the easiest/cheapest to make? Why? How can we leverage these?
  • Where do we have the most scrap and how can we reduce it? Same for defects.

Now that you are familiar with the basics we can turn to Targeted Cost Reductions (see separate blog).

Copyright 2013 by Paul Yandell.  All Rights Reserved.

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