IN THIS CHAPTER

Getting a grip on profit analytics and cash flow

Taking charge of your business’s accounting policies

Using sensible budgeting techniques

Getting the accounting information you need

Being a pro as you talk about your financial statements

Financially speaking, business managers have four essential jobs:

• Scoring adequate capital from debt and equity sources
• Earning adequate profit on that capital
• Expediting cash flow from that profit
• Controlling the solvency of the business

How can accounting help make you a better business manager? That’s the bottom-line question, and the bottom line is the best place to start. Accounting provides the financial information you need for making good profit decisions — and it stops you from plunging ahead with gut-level decisions that feel right but don’t hold water after due-diligence analysis. Accounting also provides the cash flow and financial condition information you need. But in order for accounting information to do all these things, you have to understand and know how to interpret it.

Reach Breakeven and Then Rake in Profit

Virtually every business has fixed expenses. These are operating costs that are locked in for the year and remain the same whether annual sales are at 100 percent or below half your capacity. Fixed expenses are a dead weight on a business. To make profit, you first have to get over your fixed-costs hurdle. How do you do this? Obviously, you have to make sales. Each sale brings in a certain amount of margin, which equals the revenue minus the variable expenses of the sale. (If your sales don’t generate margin, you’re in deep trouble.)

Say you sell a product for $100. Your purchase (or manufacturing) cost per unit is $60, which accountants call cost of goods sold expense. Your variable costs of selling the item add up to $15, including sales commission and delivery cost. Thus, your margin on the sale is $25: $100 sales price – $60 product cost – $15 variable costs = $25 margin. Margin is before interest and income tax expenses and before fixed expenses for the period are considered.

The next step is to determine your annual breakeven point. Breakeven refers to the sales revenue you need just to recoup your fixed operating costs. These costs provide the space, facilities, and people necessary to make sales and earn profit. Say your annual total fixed operating expenses are $2.5 million. If you earn 25 percent average margin on sales, then in order to break even, you need $10 million in annual sales: $10 million × 25 percent margin = $2.5 million margin. At this sales level, margin equals fixed costs, and your profit is zero (you break even). Not very exciting so far, is it? But from here on, it gets much more interesting.

Until sales reach $10 million, you’re in the loss zone. After you cross over the breakeven point, you enter the profit zone. Each additional $1 million of sales over breakeven yields $250,000 profit. Suppose your annual sales revenue is $4 million in excess of your breakeven point. Your profit (earnings before interest and income tax) is $1.0 million: $4 million sales over breakeven × 25 percent margin ratio = $1 million profit). The main lesson is that after you cross over the breakeven threshold, your margin goes entirely toward profit.

Your regular profit and loss (P&L) reports might not separate fixed and variable operating expenses — in fact, I would bet that this is your situation. What to do? I suggest sorting operating expenses into fixed and variable groups based on the titles of the expense accounts in your P&L. You’ll probably have to make some estimates, but, hey, this isn’t rocket science. In any case, you should understand the leverage effect on operating profit caused when you exceed your breakeven sales level.

Set Sales Prices Right

In real estate, the three most important profit factors are location, location, and location. In the business of selling products and services, the three most important factors are margin, margin, and margin. Of course, a business manager should control expenses — that goes without saying. But the secret to making profit is both making sales and earning an adequate margin on the sales revenue. (Remember, margin equals sales price less all variable costs of the sale.) Chapter 12 explains that internal P&L reports to managers should separate variable and fixed costs so the manager can focus on margin (although they generally don’t, unfortunately).

In the example in the preceding section, your sales prices earn 25 percent margin on sales. In other words, $100 of sales revenue generates $25 margin (after deducting the cost of product sold and variable costs of making the sale). Therefore, $16 million in sales revenue, for example, generates $4 million margin. The $4 million margin covers your $2.5 million in fixed costs and provides $1.5 million profit (before interest and income tax).

An alternative scenario illustrates the importance of setting sales prices high enough to earn an adequate margin. Suppose you had set sales prices 5 percent lower. Your margin would therefore be $5 lower per $100 of sales. Instead of 25 percent margin on sales, you would earn only 20 percent margin on sales. How badly would the lower margin ratio hurt profit?

On $16 million annual sales, your margin would be $3.2 million ($16 million sales × 20 percent margin ratio = $3.2 million margin). Deducting $2.5 million fixed costs for the year leaves only $700,000 profit. Compared with your $1.5 million profit at the 25 percent margin ratio, the $700,000 profit at the lower sales prices is less than half. The point of this story is that here, a 5 percent lower sales price causes 53 percent lower profit!

Don’t Confuse Profit and Cash Flow

To find out whether you made a profit or had a loss for the year, you look at the bottom line in your P&L report. But you must understand that the bottom line does not tell you cash flow. Don’t ever assume that making profit increases cash the same amount. Making such an assumption reveals that you’re a rank amateur.

Cash flow can be considerably higher than bottom-line profit or considerably lower. Cash flow can be negative even when you earn a profit, and cash flow can be positive even when you have a loss. There’s no natural correlation between profit and cash flow. If I know the profit number, I don’t have a clue about the cash flow number because cash flow depends on additional factors.

Frankly, accountants do a lousy job of explaining and reporting cash flow from profit. They don’t even call it cash flow from profit; rather, they refer to it as cash flow from operating activities. So how do you get from the profit bottom line in the income statement (P&L report) to the cash flow from profit? You could try reading the first section of the statement of cash flows (see Chapter 7). Good luck with that. The first part of the cash flow statement is written by accountants for accountants. Accountants should be ashamed of how poorly this section helps explain why cash flow differs from bottom-line profit.

If you’re a busy manager, my advice is to boil down your cash flow analysis to three main factors that cause cash flow to be higher or lower than net income for the period:

• Depreciation (plus amortization) expense is not a cash outlay in the period it is recorded, so add this amount to bottom-line net income.
• Group the three current assets: accounts receivable, inventory, and prepaid expenses. If the total change in these three assets is an increase, deduct the amount from bottom-line net income. If it’s a decrease, add the amount.
• Group the current operating liabilities: accounts payable, accrued expenses payable, and income tax payable. If the total change in these three assets is an increase, add the amount to bottom-line net income. If it’s a decrease, deduct the amount.

After doing this jig a few times, the process will become more or less automatic. Furthermore, you should become more aware of and pay closer attention to the drivers of cash flow from bottom-line profit (net income). You’ll be better able to explain cash flow to your banker and investors in the business.

Call the Shots on Accounting Policies

You may have heard the adage that war is too important to be left to the generals. Well, accounting is too important to be left to the accountants alone — especially when choosing which fundamental accounting methods to use. I’m oversimplifying, but measuring profit and putting values on assets and liabilities boils down to choosing between conservative accounting methods and more optimistic methods. Conservative methods record profit later rather than sooner; optimistic methods record profit sooner rather than later. It’s a “pay me now or pay me later” choice. (Chapter 8 gives you the details on alternative accounting methods.)

I encourage you to get involved in setting your company’s accounting policies. Business managers should take charge of accounting decisions just like they take charge of marketing and other key activities of the business. Don’t defer to your accountant in choosing accounting methods for measuring sales revenue and expenses. The best accounting methods are the ones that best fit with your operating methods and strategies of your business. As the manager, you know the business’s operations and strategies better than your accountant. Finally, keep in mind that there are no “default” accounting methods; someone has to choose every method.

Many businesses choose conservative accounting methods to delay paying their income tax. Keep in mind that higher expense deductions in early years cause lower deductions in later years. Also, conservative, income tax–driven accounting methods make the inventory and fixed assets in your balance sheet look anemic. Recording higher cost of goods sold expense takes more out of inventory, and recording higher depreciation expense causes the book value of your fixed assets to be lower. Nevertheless, you may decide that postponing the payment of income taxes is worth it, in order to keep your hands on the cash as long as possible.

Budget Well and Wisely

When you hear the word budgeting, you may immediately imagine a budgeting system involving many persons, detailed forecasting, negotiations over goals and objectives, and page after page of detailed accounting statements that commit everyone to certain performance goals and use benchmarks for the coming period. In reality, all kinds of budgeting methods and approaches exist. You don’t have to budget like IBM or a large business organization. You can do one-person limited-purpose budgeting. Even small-scale budgeting can pay handsome dividends.

I explain in Chapter 14 the reasons for budgeting — first, for understanding the profit dynamics and financial structure of your business and, second, for planning for changes in the coming period. Budgeting forces you to focus on the factors for improving profit and cash flow. It’s always a good idea to look ahead to the coming year; if nothing else, at least plug the numbers in your profit report for sales volume, sales prices, product costs, and other expenses, and see how your projected profit looks for the coming year. It may not look too good, in which case you need to plan how you’ll do better.

The P&L budget, in turn, lays the foundation for changes in your assets and liabilities that are driven by sales revenue and expenses. Your profit budget should dovetail with your assets and liabilities budget and with your cash flow budget. This information is very helpful in planning for the coming year — focusing in particular on how much cash flow from profit will be realized and how much capital expenditures will be required, which in turn lead to how much additional capital you have to raise and how much cash distribution from profit you’ll be able to make.

Demand the Accounting Information You Want

Experienced business managers can tell you that they spend a good deal of time dealing with problems because things don’t always go according to plan. Murphy’s Law (if something can go wrong, it will, and usually at the worst possible time) is all too true. To solve a problem, you first have to know that you have one. Managers need to get on top of problems as soon as possible. A well-designed accounting system should set off alarms about any developing problems so you can nip them in the bud.

You should identify the handful of critical factors that you need to keep a close eye on. Insist that your internal accounting reports highlight these factors. Only you, the business manager, can identify the most important numbers that you must closely watch to know how things are going. Your accountant can’t read your mind. If your regular accounting reports don’t include the exact types of information you need, sit down with your accountant and spell out in detail what you want to know. Don’t take no for an answer. Don’t let your accountant argue that the computer doesn’t keep track of this information. Computers can be programmed to spit out any type of information you want.

Here are some types of accounting information that should always be on your radar:

• Sales volumes
• Margins
• Fixed expenses
• Overdue accounts receivable
• Slow-moving inventory items

Experience is the best teacher. Over time, you discover which financial factors are the most important to highlight in your internal accounting reports. The trick is to make sure that your accountant provides this information.

Tap into Your CPA’s Expertise

As you know, a CPA will perform an audit of your financial report; this is the CPA’s traditional claim to fame. And the CPA will assist in preparing your income tax returns. In doing the audit, your CPA may find serious problems with your accounting methods and call these to your attention. Also, the CPA auditor will point out any serious deficiencies in your internal controls (see the next section). And it goes without saying that your CPA can give you valuable income tax advice and guide you through the labyrinth of federal and state income tax laws and regulations.

You should also consider taking advantage of other services a CPA has to offer. A CPA can help you select, implement, and update a computer-based accounting system best suited for your business and can give expert advice on many accounting issues, such as cost allocation methods. A CPA can do a critical analysis of the internal accounting reports to managers in your business and suggest improvements in these reports. A CPA has experience with a wide range of businesses and can recommend best practices for your business. If necessary, the CPA can serve as an expert witness on your behalf in lawsuits. A CPA may also be accredited in business valuation, financial advising, and forensic methods, which are specializations sponsored by the American Institute of Certified Public Accountants (AICPA).

You have to be careful that the consulting services provided by your CPA do not conflict with the CPA’s independence required for auditing your financial report. If there’s a conflict, you should use one CPA for auditing your financial report and another CPA for consulting services. And don’t forget to ask the obvious question: Does the CPA have experience in providing the expert services? You might ask for names of clients that the CPA has provided these services to and check out whether these businesses were satisfied.

Critically Review Your Controls over Employee Dishonesty and Fraud

Every business faces threats from dishonesty and fraud — from within and from without. Your knee-jerk reaction may be that this sort of stuff couldn’t possibly be going on under your nose in your own business. While waiting in the Omaha airport, I once discussed fraud with a man who admitted that he had served hard time in the Nebraska State Penitentiary for embezzling $300,000 from his employer. He said that such a cocky attitude by a business manager presents the perfect opportunity for getting away with fraud (although he tripped up, obviously).

Without your knowing about it, your purchasing manager may be accepting kickbacks or other “gratuities.” Your long-time bookkeeper may be embezzling. One of your suppliers may be short-counting you on deliveries. I’m not suggesting that you should invest as much time and money in preventing fraud and cheating against your business as Las Vegas casinos do, but every now and then, you should take a hard look at whether your fraud controls are adequate.

Preventing fraud starts with establishing and enforcing good internal controls, which I discuss in Chapter 3. In the course of auditing your financial report, the CPA evaluates your internal controls. The CPA will report to you any serious deficiencies. Even with good internal controls and having regular audits, you should consider calling in an expert to assess your vulnerability to fraud and to determine whether there is evidence of any fraud going on.

A CPA may not be the best person to test for fraud — even if the CPA has fraud training and forensic credentials. A private detective may be better for this sort of investigation because he has more experience dealing with crooks and digging out sources of information that are beyond what a CPA customarily uses. For example, a private detective may install secret monitoring equipment or even spy on your employees’ private lives. I understand if you think that you’d never be willing to go so far to defend yourself against fraud, but consider this: Someone committing fraud against your business has no such compunctions.

Lend a Hand in Preparing Your Financial Reports

Many business managers look at preparing the annual financial report of the business like they look at its annual income tax return — it’s a task best left to the accountant. This is a mistake. You should take an active part in preparing the annual financial report. (I discuss preparing the financial report in Chapter 9.) You should carefully think of what to say in the letter to stockholders that accompanies the financial statements. You should also help craft the footnotes to the financial statements. The annual report is a good opportunity to tell a compelling story about the business.

The owner/manager, president, or chief executive of the business has the ultimate responsibility for the financial report. Of course your financial report should not be fraudulent and deliberately misleading; if it is, you can and probably will be sued. But beyond that, lenders and investors appreciate a frank and honest discussion of how the business did, including its problems as well as its successes.

In my view, Warren Buffett, the CEO of Berkshire Hathaway, continues to set the gold standard for financial reporting. He lays it on the line; if he has a bad year, he makes no excuses. Buffett is appropriately modest if he has a good year. Every annual report of Berkshire Hathaway summarizes the nature of the business and how it makes profit. If you knew nothing about this business, you could learn what you needed to know from its annual report. (Go to www.berkshirehathaway.com to get the company’s latest annual report.)

Speak about Your Financial Statements as a Pro

On many occasions, a business manager has to discuss his her financial statements with others. You should come across as very knowledgeable and be very persuasive in what you say. Not understanding your own financial statements does not inspire confidence. On many occasions, including the following, your financial statements are the center of attention and you’re expected to talk about them convincingly:

• Applying for a loan: The loan officer may ask specific questions about your accounting methods and items in your financial statements.
• Talking with individuals or other businesses that may be interested in buying your business: They may have questions about the recorded values of your assets and liabilities.
• Dealing with the press: Large corporations are used to talking with the media, and smaller businesses are profiled in local news stories.
• Dealing with unions or other employee groups in setting wages and benefit packages: They may think that your profits are very high and that you can therefore afford to increase wages and benefits.
• Explaining the profit-sharing plan to your employees: They may take a close interest in how profit is determined.
• Putting a value on an ownership interest for divorce or estate tax purposes: These values are based on the financial statements of the business (and other factors).
• Reporting financial statement data to national trade associations: Trade associations collect financial information from their members. You should make sure that you’re reporting the financial information consistently with the definitions used in the industry.
• Presenting the annual financial report before the annual meeting of owners: The shareowners may ask penetrating questions and expect you to be very familiar with the financial statements.