‘The Books’ Are Not Bed-time Reading

No one I know would consider sleeping on the job a good thing. Of course, as far as I know, bed-testing isn’t a job, though I’d be happy to put my hand up for it…anyone?

Seriously, though, if a business owner or manager is not paying attention to ‘the books’ they could be said to be sleeping on the job. (To clarify that by ‘the books’ I mean the financial statements.)

Why do I say this? Because they are important! They are an important measure of how the business performed over the period, and of what its financial position was at the end of that period.

While the financial statements are not in any way the only measure a manager or owner should be using, they are a key metric.

In what way? You know how the books you get at the library, or on your Kindle, tell a story? Well, ‘the books’ do too!

Just like the two types of library/Kindle book — fiction and non-fiction — there are two types of ‘book’. Taking a broad-brush definition, fiction books tell of action (unless they’re really boring), and non-fiction books tell how things are.

Similarly, the Profit & Loss (= Statement of Financial Performance or Income Statement) describes the (results of) the actions (a.k.a. transactions) in the period, and the Balance Sheet (= Statement of Financial Position) describe how things are at the end of the period.

The Performance Story

So, how do we read this story? What learnings can we take from the Statement of Financial Performance (Profit & Loss)?

This statement, depending on how it is structured, can tell us such things as:

• How we have traded against our budget, which was hopefully prepared based on actual prior performance and sensible assumptions, and backed by an action plan which we are working to.
• Whether sales (or other items) are up or down compared to last year.
• If we’ve been purchasing too much closing stock going up faster than sales — which is okay if it’s not too much, and we’re expecting sales increases to continue.
• How our gross margins are tracking — have we been:
• Discounting too much, or less than expected?
• Upselling more than we expected, or less than usual?
• Cross-selling more than we planned, or less than normal?
• Writing off excess or obsolescent stock?
• Whether we’ve been postponing some expenditure — not always a good thing (e.g. regular maintenance on machinery).
• If we’ve taken on additional human resources earlier than anticipated sales increases have eventuated.
• How effective advertising has been — to a degree, anyway. After all, an increase in this cost should cause an increase in sales, shouldn’t it?

Before we can take this further, some definitions are necessary, but first, we need to paint a picture. “Yippee”, you say, “a picture book!” Sorry, not quite!

This is what a (simple) Statement of Financial Performance might look like:

Note:

• We’ve left prior year comparisons out for the purpose of this discussion.
• Taxation has also been left off, as this is a function of the above “bottom line”.

Questions / Comments / Potential Issues

Let’s go through the above statement and note areas that would require follow-up (assuming you noticed them because you weren’t using them to put you to sleep):

1. Sales are down for the month and year-to-date.
2. What is being done about this?
3. Is the business plan being followed? (If so, something else must be done.)
4. What are the underlying causes for this?
5. What can be done about them? (E.g. training for team members in upselling & cross-selling, price increases.)
6. If the drop is due to the mix of products sold, what is being done to increase sales of the higher margin items, or increase the margin of other items?
7. Purchases are running close to budget level.
8. Why is this, given Sales are down?
9. In spite of this and lower sales, stock is not up much. Why is this?
10. Have suppliers upped their prices? If so, are we seeking alternative suppliers or products?
11. Gross Margin is down on budget.
12. Why is this?
13. December is a discounting month, but why was it necessary to sell at such lower margins, especially given sales were still down in spite of this?
14. Advertising was up on budget for December.
15. Why is this?
16. Has the advertising been reviewed — it doesn’t seem to have helped sales?
17. Depreciation is down on budget.
18. Have we postponed purchasing new assets?
19. If not, why is it down?
20. If so, why is this, and is it the correct strategic decision?
21. Rent & Rates are over budget.
22. Is this to do with a rent increase?
23. Can anything be done about it?
24. Repairs & Maintenance are below budget.
25. Is this luck, or have we just not carried out some maintenance we’d expected to?
26. Are we sure this won’t result in machine failure/breakdown (which would cost more to fix than the repair or maintenance)?
27. Is the postponed expense something we are obliged to carry out legally? If so, we’d better get on with it.
28. Telephone & Tolls expense is over budget.
29. Have we added another line or phone?
30. Have the prices gone up?
31. Wages & Salaries are above budget.
32. Have we added an extra person?
33. Do we have to keep them, or is it a temporary increase, such as maternity leave cover?
34. Can we cut back on some hours, given sales are down?
35. Interest received is below budget.
36. Is this due to lower interest rates?
37. Are cash holdings lower (likely, given lower sales and higher purchases)?
38. Have debtors been paying at least as quickly as usual?

As you can see, this one financial statement both tells us a lot, and raises a lot of questions — not necessarily all easy to spot when you’re tucked up in bed! Of course, if you were working in the business you would already know a number of the answers. However, these questions or their answers will give rise to a number of actions.

And that’s partly what the statement is for — to tell us the (financial) results of our actions to date and encourage us to perform better with future actions. They prompt us to consider how well we are doing at achieving our business plan and also whether, in fact, we need to amend that plan due to changes in the circumstances.

We must always drill down to the real causes of results — and not just take the stories/excuses (*) we are given as the real picture. As you can see, this statement can give rise to quite a performance.

(*) Ever heard this definition of ‘excuse’ — a lie wrapped in the tissue of respectability?

The Position Story

So, we’ve gone through understanding the Performance story. What does the Position story tell us? How do we read the Statement of Financial Position (Balance Sheet)?

From this statement, we can learn a lot also, including:

• Whether cash holdings have improved.
• If Inventory (a.k.a. Stock) has increased.
• How well Debtors are being managed.
• Whether we owe more to Creditors now than when the period started.
• If we’ve borrowed more money.
• Whether the business is liquid.
• How solvent the business is.

You will note that a lot of the items above link to the Performance story, and you really need a grasp on both to get the full picture. Speaking of pictures, here’s one for this story:

Questions / Comments / Potential Issues

Now that you are awake (hopefully!), let’s see what this statement tells us:

1. Cash is down. Combined with the Bank Overdraft we are in negative funds, despite starting the year in funds.
2. Why is this? (The answers are probably in some of the following items, but may also stem from lower Sales, or higher stock Purchases, or the fact we’ve purchased some Fixed Assets and a Patent.)
3. What is being done about it?
4. Debtors are up.
5. Why is this?
6. Is there some hardcore debt that should be written off (after all possible steps have been taken, of course)?
7. Do we need to tighten up on our debt collection policies and procedures — maybe even our terms of trade?
8. Stock has increased.
9. Why is this?
10. Are Sales down on what was expected, or are we expecting a surge in Sales?
11. Is there some old or obsolescent Stock that needs to be written off or sold off?
12. Can some Stock be returned?
13. Fixed Assets have been added.
14. Did we need these items now, in light of the above?
15. We now have a Bank Overdraft. Refer the comments under point 1 above.
16. Creditors have gone up.
17. As per point 3 (d), can we return some stock items?
18. How soon will Creditors start putting the heat on?
19. Is it necessary to have a sale, in order to get more cash in, so we can service Creditors?
20. Have we talked to the Bank about increasing the overdraft (if we have to)?
21. The Bank Loan has gone down.
22. Have we made all the necessary payments?
23. In light of issues highlighted above, is it possible to put a hold on payments temporarily, or even borrow more (if that’s wise, and if the bank will let us)?
24. Retained Earnings have gone down because we have made a loss, so far, this year.
25. Cash and Debtors between them are not sufficient to cover Creditors. This means the business does not meet the Acid-Test ratio — under which the result of dividing the first two by the latter should ideally be in the range 1.5 to 3.
26. Current Assets is still more than Current Liabilities, but the difference has significantly decreased. In other words, Working Capital has dropped.
27. The Cash ratio (Cash divided by Current Liabilities) has gone negative, reflecting the worsening liquidity of the business.
28. The Debt to Assets ratio (Total Liabilities divided by Total Assets) is 25%. This means that 25% of the business is now financed by debt (up from 20.8% at the start of the year.
29. The Equity ratio reflects the other half of the above — 75% of the business is funded from equity.

So, there you go, there’s a whole lot of thinking (and subsequent action) required when you read ‘the books’. Better not make them bed-time reading then!

If you really do have trouble sleeping, try an accounting textbook.

Originally published at beanstalkknowhow.com on February 28, 2018.