READING AND UNDERSTANDING FINANC

In my practice as a Management and Marketing consultant, time with clients is often devoted to helping them to understand how to read the information provided to them from their accountant or accounting department in the form of Profit and Loss Statements and Balance Sheets. The counseling process is not in the form of accounting advice or legal advice, but rather as an education process. Reason being, of course, is that if a manager does not understand the numbers, how will he/she know how to take the necessary steps to strengthen the balance sheet, cash flow, gross margins and net profits, just to name a few vital areas?

It is not unusual to hear clients say, “I am doing more business than I have ever done, yet I cannot pay my bills! What am I doing wrong?”

When I hear this common question my first mental response is they are either not controlling expenses or they are not familiar with how to determine the selling price. I ask, “How do you figure your gross margins on an item?” Most often they will ask, “What do you mean, how do I figure my gross margins?”

By that question I mean, “If the Cost of Goods sold is $1,000.00 (cost of materials is 84% of the total cost of goods sold; freight is 1%; and labor is 15%) how do you determine how much to invoice your customer? Their response is most often, “Well, I have to make a profit, so if the total cost of materials, freight and labor is $1,000.00 and I want to make a 25% gross profit, I add $250.00 to the total costs. So, I figure my gross profit is 25%.

What they don’t always realize is when doing so they are figuring their gross profit using the “Mark-on” method (an amount added to cost) and not “Mark-up” method (gross margin as a percentage of total sales). In the above “Mark-on” example the client thinks he is going to earn a 25% gross profit, when in reality the gross profit is only 20% (gross profit ÷ Sales), leaving 5% out their in la, la land. He believes he is going to earn a 5% net profit, assuming his operating expenses don’t exceed 20% of his total sales, but instead, he just breaks even. Of course you can see what would happen if expenses exceeded the planned 20% ratio. This is a common mistake easily rectified by purchasing a “Mark-up” wheel from you local Office supply.

Ratios are shown as percentages of total sales on the P & L Statement and as percentages of total assets on the Balance Sheet. See examples below.

ITEM- P & L	AMOUNT	% - Actual
TOTAL SALE - (cost + 25%)	1,250.00	100.00%
Cost of Goods sold-	1,000.00	(C.O.G. ÷ TOTAL SALE)= 80.00%
GROSS PROFIT (25% add on or mark-on)	250.00	(GROSS PROFIT ÷ TOTAL SALES= 20.00%

TOTAL EXPENSES	250.00	(TOTAL EXPENSES ÷ TOTAL SALES)=20.00%

NET PROFIT (before taxes & debt service) (Net profit and cash flow are not the same thing)	0.00	(TOTAL NET PROFIT ÷ TOTAL SALES)= 0.00

ITEM – P & L	AMOUNT	% - Actual
TOTAL SALE - (C.O.G. ÷ .75)=	1,333.33	100.00%
Cost of Goods sold –	1,000.00	(C.O.G. ÷ TOTAL SALE)= 75.00%
GROSS PROFIT =	333.33	(G.P. ÷ TOTAL SALES= 25.00%

TOTAL EXPENSES (Assuming Exp. At 20% of Sales)	266.66	(TOTAL EXPENSES ÷ TOTAL SALES)= 20.00%

NET PROFIT (before taxes & debt service) (Net profit and cash flow are not the same thing)	66.67	(TOTAL NET PROFIT ÷ TOTAL SALES)= 5.00%

Financial statements represent a photograph of what a business looks like at any one point in time. Ratios are indicators of a managers performance and are helpful (although historical) in guiding managements future actions.

RATIO	DATA NEEDED	SOURCE	FORMULA
Return on Sales	Net Income Sales	P & L P & L	Net Income ÷ Sales
Average Total Assets	Total assets (begin) Total assets (end)	BS BS	TA (begin) + TA (end) ÷ 2
Earnings Available	Net Income Interest	P & L P & L	Net income + Interest
Return on Total Assets	Interest expense	P & L	(Net income + Interest ÷ Average total assets
Average Owner’s Equity	Owner’s equity (begin)	BS	OE (begin) + OE (end) ÷ 2
Return on Owner’s Equity	Owner’s equity (end)	BS	Net income ÷ Average owner’s equity
Current Ratio	Current assets Current liabilities	BS	Current assets ÷ Current liabilities
Working Capital	Current assets Current liabilities	BS	Current assets - Current liabilities
Quick Ratio or Acid Test	Cash	BS	(cash + Marketable securities + A/R) ÷ CL
Times Interest Earned	Accounts receivable	BS	(Net income + interest expense) ÷ Interest expense
Fixed Charge Coverage	Depreciation	BS	(Net income + depreciation + interest expense) ÷ Principal payments CF (interest expense + principal payments)
Debt/Equity	Total liabilities	BS	Total liabilities ÷ Owner’s equity
Average Accounts Receivable	Accounts receivable (Begin)	BS	AR (begin) + AR (end) ÷ 2
Accounts Receivable Turnover	Accounts receivable (end)	BS	Credit sales ÷ Average accounts receivable
Average Days to Collect	Credit Sales	P & L	365 days ÷ AR turnover
Average Inventory	Inventory (begin)	BS	Inventory (begin) + Inventory (end) ÷ 2
Inventory Turnover	Inventory (end)	BS	Cost of sales ÷ Average Inventory
Average Days to Sell Inventory	Cost of sales	P & L	365 ÷ Inventory turnover
Operating Cycle		BS	Average days to sell inventory + Average days to collect
Average Working Capital	WC (begin) WC (end)	BS	WC (begin) + WC (end) ÷ 2
Working Capital Turnover	Working capital (begin)	BS	Sales ÷ Average working capital
Total Asset Turnover	Sales Average WC	P & L BS	Sales ÷ Average working capital

The information contained in financial statements can and should be used to provide insight into the financial strength and earnings capacity of the business. This extends beyond such single statement captions as “net income,” and necessitates that relationships between accounts be examined. While an almost unlimited number of such ratios and comparisons are possible, a relatively small group of these are traditionally the object of most attention.

The nature of the analysis depends on the perspective of the reader. For example, the short-term note holder would be primarily concerned with the company’s ability to pay its current obligations. The holder of long-term debt might look to both historical and projected earnings and cash flows. The stockholders, current and future, would share a viewpoint similar to that of the long-term debtholder, with perhaps more concern for earnings (vis-à-vis cash flows) than the creditors might exhibit.

The management of a company is concerned with all of the above factors and, in addition, needs financial information that is useful on a daily basis.

As you might surmise, financial statements change each time a transaction occurs. The financial statements you generate tomorrow will be different from the ones you generate today. Financial statements do not care how good you are at managing your business; they just report what you show as fact. Therefore, accuracy of the information posted in the accounting system that generates the financial statements is vital. Posting all long-term debt in current liabilities or current liabilities in long-term debt, for instance, can affect the current ratio and acid test and will give your banker a distorted view of you and your financial statements.

It would be wise to study the ratio formulas and learn how to apply them to your financial statements. How do you look today?