UK: Beyond Financial Statements

Last Updated: 10 December 2012

The profit and loss sheet only lists income and expenses. It doesn't give you a clue regarding the relationships between the numbers. Some entrepreneurs are top-line junkies and look only at gross sales while others pay attention only to the bottom line (net income), but that doesn't tell you the whole story of the business, either. Cash flow planning – where you lay out your cash flow needs, requirements and projections for a specified period of time – provides a much better picture of what is really happening in the business.

Cash flow planning: Look at the difference

Comparing your actual cash flow to your plan tells you where you are versus where you want to be. It allows you to see where the differences are and why you're not doing what you want to be doing. Then you can make some proactive (rather than reactive) changes to improve operations.

When developing a cash management plan, you need to know three things:

  1. How much cash you will need to run the business.
  2. When you will need it.
  3. Where you will get it.

Net income and cash flow are very different. You can show a profit on paper and still run out of cash. Cash flow doesn't necessarily equate to profit and loss.

Balance sheet projections

A forecast balance sheet is a reality check. Projections should focus on the following items:

  • cash
  • receivables
  • accounts payable
  • inventory/work in process
  • debt and equity.

Your goal should be to produce financial statements – the P&L and balance sheet – no later than the 20th of each month. Very large companies may take longer. Some small companies can do it in ten days or less. You should be able to answer three very important questions:

  1. When will our cash balance drop to its lowest level?
  2. When will we run out of cash?
  3. How long will our present cash resources last?


Marketing budget

In addition to a cash flow plan, it's a good idea to do a marketing plan that includes a budget for the following 12 months. Marketing can be a fiscal black hole; managing and measuring the return for dollars invested can give vital information about how well the marketing budget is being spent.

Consider using zero-based budgeting. First, ask: "Do we really need this?" for every line item. If the answer is "yes", start from zero and build up from there. Don't start with last year's total and try to cut down. Keep in mind that every dollar you take out of the expense section falls straight to the bottom line.

Budgeted expenditures need to meet the following criteria:

  • Does the expenditure increase sales?
  • Does the expenditure increase ROI?
  • Does the expenditure increase cash flow?

If the answers to those questions are negative, then inclusion of the line item or position in the budget needs to be questioned.

Increasing revenues

There are four ways to increase the revenue stream:

  1. Increase the number of customers you serve (of the type you want).
  2. Increase the number of times your customers come back (or refer others).
  3. Increase the average value of each sale.
  4. Increase the effectiveness of the business.

It costs about eight times more to acquire a new customer than to retain a current customer. Getting even 5% of your customers to come back more often during the year can dramatically increase revenues. Product bundling, additional referral sources, scripted sales calls, changes in the product or service and special promotions are just some of the ways you can entice customers to come back more often.

An often-quoted statistic is that 20% of your customers yield 80% of your business. It's a statistic you should investigate. Go through your customer list and identify the top 20% and look for ways to increase their business with you. Next, go through the remaining 80% and decide whether or not to keep them. If you can, track the gross profit on each customer. Get rid of those who aren't profitable.

Of course, you can only streamline a small business so much on the cost side. Focusing on the revenue drivers gives you a much better chance of increasing the value of the business. Adopt the mindset that one day you will sell your business for the maximum value. You'll manage the business differently than if you're just trying to get an income from it.

Price sensitivity

Setting prices is one of the trickiest parts of running a business. You can increase profits by increasing price as long as any decline in volume is offset by the price increase. Conversely, you can increase profit by decreasing price as long as the increase in volume offsets the decrease at the gross margin level. Before you lower prices, however, make sure you understand how much harder you will have to work to maintain current margins.

For example, to decrease price by 16% on a product with a 30% margin, you need to increase volume by 114% in order to maintain the same level of profitability. The numbers don't always tell the full story. Increased sales means increased activity below the gross margin line. For every additional sale, you incur other costs, such as more commissions, or more invoicing and order processing activity, that fall below the gross margin line.

Managing business processes

Traditional accounting statements measure results, not activities. It is impossible to directly manage a result, but you can manage the activities that give rise to the result. Fortunately, there are processes that can give you information much more quickly than the backward-looking financial statements. These processes allow you to manage the business proactively rather than reactively.

Measures such as the average number of sales per day, the average amount of each sale, responses to advertising, close rates on such responses, are just a few. The US Inc. magazine once ran an article on a steel rebar manufacturer that tracked one measurement: number of pounds shipped per day. The business owner knew his prices and margins and knew what he had to ship per day to meet his plan. If shipments lagged, he could react quickly and not wait for the financial statements to see how he did.

Collections

You can never make it too easy for your customers to give you money. If you don't currently take credit cards, take them. Find ways to speed up your accounts receivable process. We also recommend having strict credit control and collections policies, and running credit checks on new customers, especially large ones. Don't hesitate to ask for a credit application and check it out.

Focus on gross margin

Too often, companies focus only on gross sales, when other leading indicators are far more important. Gross margins (sales price minus cost of sales) are critical. Don't take on customers unless you can achieve your desired gross margin. An unprofitable customer is worse than no customer at all.

Customer advisory board

We advise developing a customer advisory board to find out what is important to your customers and what they don't like about doing business with your industry. If you can overcome the negatives of your industry, you can gain a lot of customer loyalty.

Invite a good cross-section of customers to a meeting, thank them for coming and then leave. Use an outside facilitator to ask the questions and facilitate the meeting. Customers will be a lot more open and honest when you aren't in the room. This kind of focus group yields a lot more information than just sending out a survey.

Critical success factors

What do you absolutely need to get right in order to succeed? The answers are different for every business. Success always comes back to the quality of the product and quality of the service. But it's the customer's perception of quality that matters, not ours. So focus on the things that form the customer's perception of quality.

For a physical product, quality can mean a number of things, including:

  • performance
  • features
  • reliability/dependability
  • durability
  • conformity (to customer, industry, etc., standards)
  • serviceability
  • aesthetics.

For a service business, quality might mean:

  • intangibles
  • reliability
  • timely response
  • assurance of service delivery
  • empathy
  • communication
  • confidentiality.

Key performance indicators

Key performance indicators measuring time, size, dollars, numbers, percentages and other factors are financial or non-financial measures of an activity. These, too, vary for each business and industry. Some common ones include:

  • sales per employee
  • sales per dollar of salary
  • inbound calls and conversion rate on inbound calls
  • sales per foot traffic
  • number of sales per day
  • average sale
  • number of pounds shipped
  • order backlog
  • work in progress
  • number of bids submitted versus number of bids converted.

Identify the five or six critical success factors you absolutely must get right in order to make your business a success. In particular, look for things that frustrate your clients, such as lack of timely delivery or accessibility.

Once you have decided what key performance indicators you need to measure, identify the data you need to capture. When you have the baseline numbers, we recommend setting target performance indicators and tracking them using some kind of performance analysis sheet. Input the information for each period covered – daily, weekly or monthly, depending on your business cycles – and compare actual results with projections.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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