WHAT YOU NEED TO KNOW

So far we have looked at short-term cash issues; what generates cash in the long term, however, is profit. This chapter therefore attempts to demystify the terms surrounding financial information and, in so doing, to show how you can use financial information to understand and control your business.

The two key areas you should measure and understand are profitability and financial stability. Profitability includes the types of costs you incur; gross profit, contribution and breakeven; profit improvement; and cost drivers. Financial stability considers liquidity and gearing.

The keys to using financial information, therefore, are as follows. You should:

• use profit centres;
• control and analyse cost trends;
• use cost information;
• quantify management decisions;
• use management accounts;
• monitor returns; and
• monitor your working capital cycle.

Having measured your performance, it is important to realise that the absolute results for any company at any particular date tend to be less important than the use of the information to measure trends over time (e.g. growth) and to benchmark performance against others. You should also appreciate that financial figures are produced as a result of what you are doing to run the business. They are the symptoms and evidence of what is happening, not the cause of what is happening.

However, once you are measuring your financial performance you can set financial targets for your business (e.g. reducing your average debtor payment time to 45 days by the end of the first quarter) as part of your plan, and use this financial information to monitor your progress. And the actions you will have to take to make these financial results appear will be real actions in the real world, such as setting tight credit terms for your customers, issuing statements, picking up the telephone to chase in the money when it is due and putting customers on stop if they don’t pay.

PROFITABILITY

Profitability means measuring whether you are making any money, finding out what you are spending money on and understanding how much business you need to have in order to make a profit.

Types of costs

To understand your profitability, you must understand your cost structure. There are various types of costs for any business (see Figure 16). Fixed costs are, of course, not fixed in the long term (you can move factory or hire and fire factory staff) and will eventually reflect levels of production and activity. A profit and loss account, however, will only divide costs into two broad areas:

• 1.Cost of sales (CoS) which will include all variable direct costs.
• 2.Overheads, which will include all fixed indirect costs.

Businesses differ as to how they categorise direct fixed costs as either cost of sales or overheads. If you do not include all your direct fixed costs in calculating your cost of sales, you risk underestimating your costs when it comes to setting prices or tendering for contracts. The result of continuously selling at less than your true cost of manufacture (i.e. at a loss) is, inevitably, failure. It is generally best, therefore, to include your direct costs as fully as possible in establishing your cost of sales.

If your production volumes swing significantly between periods, however, you will need to be careful in using cost of sales to establish a meaningful ‘contribution’ figure for sales, and you may find it best to treat all fixed costs as overheads for the purpose of calculating break-even levels.

Gross profit and break-even

The first important profit figures are your gross profit and gross profit percentage as these are used to calculate break-even.

Example

Company K sells each of its widgets for £150. Its cost of sales per widget are:

• raw materials (£50)
• labour and manufacturing costs (£50)

Its gross profit per widget, therefore, is £50. Based on gross profit/sales, its gross profit percentage is 33.3% or £50/£150.

Company K has overheads of £1,000 per month. As its gross profit per widget (or ‘contribution’ towards covering overheads) is £50 per widget, it has to sell 20 widgets a month (£1,000/£50) before the total contribution is sufficient to cover all the overheads, (or to ‘break even’).

Its break-even turnover is therefore £3,000 per month (£150 x 20).

This break-even has used ‘accounting figures’ based on costs taken from the profit and loss accounts. However it is often useful to redo this exercise to calculate a ‘cash break-even’, stripping out the key costs that do not represent cash (e.g. depreciation) and replacing this with the real cash item (e.g. lease payments).

Example

Company K’s overheads include a £100 depreciation charge and a £50 HP interest charge per month. The HP payment per month is in fact, £250 (£50 interest and £200 ‘capital’ payment). So Company K’s overheads restated on a cash basis are as follows:

	£
Overheads	1,000
Less Depreciation	(100)
Add Capital payment	200
	1,100

As a result, its break-even turnover on a cash basis is 22 widgets or £3,300 per month.

Profit improvement

As you start to consider break-even calculations, something becomes very clear. To improve profits, you can do any or all of three things:

• 1.Increase turnover.
• 2.Increase margins (gross profit percentage).
• 3.Reduce overheads.

And if you can do all three, the effects multiply.

Example

	Company L (10% improvements)
Turnover	£1,000	+ £100	£1,100
Gross profit (%)	50	+ 5	55
Gross profit	500		605
Overheads	(250)	-25	(225)
Profit	250		380	= 52% increase

Cost drivers

The relative level of your costs compared to your competitors’ will be the result of a number of factors, the most common of which are listed below. Look at the opportunities to reduce costs in each of these areas but be alert to the common pitfalls of poorly applied cost reductions – for example, where disruptions and other problems outweigh the planned saving:

• Economies of scale (sometimes bigger is better).
• Capacity utilisation (you are paying for that plant and those people, whether they are earning for you or not).
• Learning curves (the more you do, the better at it you become).
• Location (relative local costs and transportation costs).
• Purchasing (how good at buying are you?).
• Operating efficiency.
• Investment (e.g. in automation or training).
• Waste management.

FINANCIAL STABILITY

Liquidity

Liquidity is an indication of the business’s likely ability to pay its liabilities. Quite simply it is a measure of do you have enough cash? The basic measure is liquidity or the current ratio, which divides current assets by current liabilities:

In simple terms you would expect that a ratio of more than one would indicate financial stability, and a ratio of significantly less than one would indicate problems. Whilst this is generally a safe working hypothesis, you must compare the ratio calculated against that of other businesses in the same industry (’benchmarking’) as, in some sectors, an apparent low liquidity is normal. As for all the ratios covered in this chapter, the following are what you need to know for any figures you calculate:

• Whether, for the industry you are in, the ratio is relatively good or bad.
• What the trend is over time (increasing or decreasing liquidity).

To generate cash at a known value, stock must first be sold. Stock is, therefore, less ‘liquid’ than debtors and cash and is also, therefore, less reliable for meeting existing liabilities than are these assets.

The acid test measure of liquidation, therefore, excludes stock to see how readily the business can pay its immediate liabilities:

Gearing

Gearing measures how financially exposed you are. It looks at the extent to which your business’s long-term finance is based on borrowed money rather than your funds or ‘equity’:

Again, the importance of the figures lies less in the absolute number and more in how your business compares to other businesses in the sector and long-term trends.

As interest charges on long-term loans will need to be paid whatever the profits generated by the business, the higher the gearing (i.e. the greater the proportion of the business’s long-term funding that is borrowed money), the higher will be the business’s ‘financial’ risk.

Example

Company M must pay £20,000 per annum or default on its loan, whilst Company N only has to find £10,000 per annum out of its profits:

	Company M	Company N
	£000	£000
Long-term loans	100	200
Capital	200	100
	300	300
Gearing (%)	33.3	66.7
Interest cost @ 10% p. a.	10.3	20.7

A related measure is interest coverage which shows the sensitivity of available profit in covering interest payments (e.g. to the bank):

USING FINANCIAL INFORMATION

Profit centres

To see what is happening to a business it is often helpful to break its performance down into individual areas – at least at the gross profit and contribution level (even if it is impractical to allocate overheads separately).

Example

Company O is an advertising agency that designs adverts, books space for clients and prints brochures. Its monthly management accounts are as follows:

	£000
Sales
Media	60
Printing	50
Design charges	5
	115
Cost of sales
Press charges	51
Printers	30
Studio wages	4
Studio direct costs	4
	89
Gross profit	26
Gross profit (%)	22.6

By breaking this down into different areas of activity (’profit centres’), however, a clearer picture emerges of where Company O does (and does not) make a profit:

	Media	Print	Studio
Sales	60	50	5
Cost of sales	(51)	(30)	(8)
Gross profit/loss)	9	20	(3)
Gross profit (%)	15	40	60

Controlling and analysing costs and trends

A good management technique to ensure that overheads are tightly controlled is ‘zero-based budgeting’ where, rather than simply taking last year’s costs and adding x% for inflation, you start with a blank sheet of paper and forecast each business cost on a line-by-line basis. Doing this exercise is a good way of ensuring that the requirements for all costs are questioned at least once a year!

Of course, in practice, the requirement to incur most overheads will stay the same year in year out, in which case ‘horizontal’ and ‘vertical’ analysis can be used to spot the trends in expenditure.

Example

		Company P
	Year 1	Year 2	Year 3	Horizontal
	£000	£000	£000	analysis – Year 1 = 100%
Sales	100	110	120	100	110	120
Cost of sales	50	60	70	100	120	140
Gross profit	50	50	50	100	100	100
Selling overheads	20	25	25	100	125	125
General overheads	10	12	15	100	120	150
Admin overheads	5	5	6	100	100	120
Net profit	15	8	4	100	53	27
	Vertical analysis Sales = 100%
Sales	100	100	100
Cost of sales	50	55	58
Gross profit	50	45	42
Selling overheads	20	23	21
General overheads	10	11	13
Admin overheads	5	5	5
Net profit	15	7	3

Horizontal analysis shows how revenues and costs are growing over time (but be careful to adjust for inflation effects over longer periods). Vertical analysis shows how much of sales each category of expenditure is consuming in each year. You would want to know why general expenses have grown by 50% in three years but, as this is only 13% of sales, the more immediate issue is the increase of cost of sales to 58% of sales (from 50%).

Using cost information

By dividing costs by sales (or by staff number or assets), a pyramid of ratios can be produced which allows you to ‘drill down’ to look at a business’s operating efficiencies. It is most effective when there is good benchmarking data against which to compare the ratios.

Example

Company Q reviews its marketing and finds that 10% of its sales are recycled into TV ads.

However, by benchmarking, the company finds its competition is spending 20% of sales on TV ads and growing at three times the rate, so perhaps Company Q needs to rethink its promotion strategy.

Management decisions

Use accounting information to assist in decision-making.

Example

Company R currently spends £10,000 on advertising and attracts 100 new customers a year. It is offered an e-business banner advertising package for £5,000 which will be seen by 25,000 people of whom it estimates 10% will be interested and, of these, 1% will become customers. Company R uses costing information to quantify the relative returns and rejects the offer:

	Spend	New customers	Cost per new customer
Existing	£10,000	100	£100
Package offered	£ 5,000	25	£200

Management accounts

Companies S, T and U all have identical results for the first quarter and identical year end targets of £ 1.8m turnover and a profit of £480,000.

Company S produces no management accounts (the ‘we know how we are doing’ mentality).

Company T produces a normal, accurate and timely set of accounts.

	Company T
	Month 3	Profit and loss
	(£000)	Year to date
Turnover	100	325
Cost of sales	(40)	(130)
Gross profit	60	195
Gross profit (%)	60	60
Overheads	(50)	(150)
Profit	10	45

Company T’s results tell management how they have done so far. But they do not really help Company T’s directors to manage the business going forwards.

Company U produces a fuller pack of monthly information in two reports:

Company U: Report 1 (£000) – Month 3 profit and loss

	Actual	Budget	Variance	Explanation
Turnover	100	150	(50)	Widget sales poor due to competitor V’s promotion
Cost of sales	(40)	(60)	20
Gross profit	60	90	(30)
Gross profit (%)	60	60
Overheads	(50)	(50)	-
Profit	10	40	(30)

Company U: Report 2 (£000) – Month 3 rolling forecast

	Actual to end Month 3	Qtr 2	Qtr 3	Qtr 4	Total	Target
Turnover	325	400	500	700	1,925	1,800
Cost of sales	(130)	(160)	(200)	(280)	(770)	(720)
Gross profit	195	240	300	420	1,155	1,080
Gross profit (%)	60	60	60	60	60	60
Overheads	(150)	(200)	(175)	(150)	675	(600)
Profit	45	40	125	270	480	480

Note: The forecast has been adjusted to show an extra spend in overheads of £50K and £25K on promotion in quarters 2 and 3 to drive up sales so as to get back on target.

Company U’s monthly management information helps the directors to manage their business because:

• the profit and loss report includes a variance analysis which identifies quantified differences between actual and planned performance that require investigation; and
• the monthly revision of a rolling forecast enables the directors to use the information on current performance to look forward and to plan the steps that need to be taken to continue to manage performance towards the target for the year (e.g. increasing promotional spending to drive up turnover).

Which company, in your opinion, is helped most in achieving its profit target for the year as a result of its management accounts?

Monitoring return

Investing the company’s money in different activities will produce different rates of return.

Example

Company V has a manufacturing arm that makes widgets for sale to third parties, a fitting and servicing arm, and also a repair division, each of which makes a net profit of 10%. From the sale of a fourth business, it now has £100K to invest and needs to decide which activity to develop. How should it decide? One clue lies in looking at the relative returns generated by the investment in assets for each of the businesses (£000):

	Manufacturing	Fitting and servicing	Repair
Assets employee
Land & buildings	150	25	50
Plant & machinery	50	10	25
Stock	100	5	100
Debtors	150	30	20
Total assets employed	400	70	195
Sales	900	360	50
Profit	90	36	5
Return on assets employed	22.5%	51.4%	2.5%

On the basis of performance to date, an investment in developing the fitting and servicing business may generate over twice the return of investing in the manufacturing business.

What do you think Company V’s management should do with the repair arm? Depending on how important the repair facility is to the overall recipe, one answer is that it should be sold and the money realised ploughed into the other two areas. However, before shutting down any operation you need to look carefully at the question of overheads.

Example

Company W has the same areas of business as Company V but its repair arm is making a net loss (£000):

	Manufacturing	Fitting and servicing	Repair	Total
Sales	200	100	50	350
Cost of sales	(100)	(50)	(30)	(180)
Gross profit	100	50	20	170
Overheads	(75)	(40)	(35)	(150)
Profit	25	10	(15)	20

The directors decide to shut the repair arm. Unfortunately, it turned out that they were still left with £20K of the overheads as these related to the premises from which manufacturing and fitting also operated, and which now have to bear this cost in full (£000):

	Manufacturing	Fitting and servicing	Total
Sales	200	100	300
Cost of sales	(100)	(50)	(150)
Gross profit	100	50	150
Overheads	(85)	(50)	(135)
Profit	15	–	15

Company W’s profit has actually dropped by £5K as a result of shutting down an apparently loss-making operation! This is because the contribution lost was greater than the overheads saved.

Monitoring the working capital cycle

Your accountant may mention ‘debtor’ or ‘creditor days’. The importance of the concept of the ‘working capital cycle’ to these is set out in Chapter 6. The calculation formulae for these are as follows (in each case take an average value for the asset/liability concerned):

You should always monitor your aged creditor and debtor lists which will reflect these ‘days’, and you should tie your credit control procedures into your working cashflow forecast.

Example

Company X has:

Plotting these on a graph as shown below illustrates that as the payment clock for creditors is ticking towards the average period before payment of 82 days, the purchased goods take on average 86 days to make their way through stock to a sale. It is then a further 62 days before on average the cash is received, leaving a 66 day funding gap that will need to be met through borrowing.

THE MANAGEMENT/FINANCIAL INFORMATION YOU NEED

To be useful, management information should be gathered regularly – prepare it on a regular basis (e.g. weekly/monthly). As far as possible, prepare the information on a consistent basis and present it in a consistent way for ease of comparison and for trend spotting. Monthly management accounts should be ready on a timely basis by at least week two or three of the following month. Any longer and the accounts are simply history lessons, not management tools. For use in making management decisions, the information needs to be accurate (or accurate enough that the difference does not matter).

The information should be understandable – clearly laid out, assumptions clearly stated, key points easily identifiable. Wherever possible keep the key points to one or two pages of summary figures (with the rest available for drilling down as required). Many people are uncomfortable when faced with sheets of numbers so, if practical and helpful, use graphs as an alternative way of displaying information (graphs are particularly good for showing trends).

Make sure the information is circulated – the relevant people need to see the relevant information if it is to be of any use. Finally, the information should be used – it should be actively employed to manage the business.

In a particular month, a financial information pack for a business might comprise:

• the profit and loss (including variance analysis – see above);
• the month-end balance sheet;
• aged debtors and creditors; and
• the rolled forward profit and loss (see above) and cashflow forecasts.

But financial information is only part of the story. Your management information should also tell you the key facts on sales (actions, prospects, sales visits planned; performance, average and value, broken down by product, customer/product values, order pipeline, conversion rate per sales visit) and operations (utilisation and efficiency, stock-outs, and customer satisfaction).

SETTING FINANCIAL TARGETS

Your finances provide a reasonable objective measure of your business’s performance for comparison between one period and another. Setting realistic but challenging financial performance targets to be met by specific dates is therefore a vital part of putting in place meaningful turnaround objectives for the business.

These can relate to both profit and loss and balance sheet items. For example:

• Achieve turnover growth of 30% p.a. (probably the maximum normally sustainable level of growth for most businesses).
• Bank borrowings at a level with which the bank will feel secure (say 45% of debtors less than three months and 50% of property value).

SETTING FINANCIAL TARGETS FOR YOUR BUSINESS

Decide how would you define a ‘stabilised situation’ for your business (e.g. creditor payments might be on normal trade terms for your business of two months’ purchases):

	Stable	Ideal
Profitability
Growth
Stock position
Creditor payments
Bank lending vs security
Liquidity
Gearing

Now quantify what financial targets you would set for your business to hit (£000):

Profit and loss
	Now	3 months	1 year	2 years	5 years
Turnover
Gross profit
Gross profit %
Overheads
Net profit

Balance sheet
	Now	3 months	1 year	2 years	5 years
Fixed assets
Stock
Debtors
Cash
Trade	creditors
PAYE/NI/VAT creditors
Other finance/loans

How quickly can you achieve a stable situation? How quickly can you achieve an ideal situation? What do you need to do to know you are operating your business in such a way so as to achieve these targets?

Now summarise the profit improvement steps you need to take on the following chart.