Financial Tools for Managing Your Business

Profitability and success comes to those who utilize the power of financial and accounting information to manage their business!

Often overlooked; more often than not, misunderstood, the use of financial and accounting information—along with key planning, control, and analytical techniques--can significantly help small businesses achieve their highest expectations for profitability, growth, and operational success. However, success comes to those businesses with leaders who can effectively utilize financial information to guide the overall direction of their firm and make critical business decisions and “informed judgments.”

 In fact, running a business without utilizing financial and accounting information to monitor its “financial health,” is like flying an airplane without an instrument panel. Many small businesses crash and burn, with their owners never looking seriously at the financial statements for the business and what “the numbers” were trying to tell them. Furthermore, there are a significant number of small businesses that operate with limited financial information available to them, often utilizing only a checkbook where cash deposits and payments for expenses are recorded.

To find success in today’s complex global business environment and gain an advantage over competitors, small business leaders must integrate into their “managerial tool set” the use of financial information and analytical techniques. I like to call it learning to “lead with the numbers!”

Five Basic Financial Tools Every Business Can Use

There are numerous ratios, indicators, benchmarks, and thousands of pages of  official accounting standards outlining how to construct financial reports, analyze results, and manage the financial health of an organization. Notwithstanding the fact that it is perhaps impossible for anyone to understand this vast array of guidance, the following five “financial tools,” when used properly, provide small business leaders with the basic financial and accounting information needed to successfully drive profitability and growth for their businesses.

I.              Financial Statements. Quite often financial  statements  are  viewed   as

documents generated primarily to satisfy requests from bankers, creditors, governmental agencies, vendors, and customers. However, there is a world of critical financial information found in these documents, waiting to be used by business leaders. A “set” of financial statements includes the following:

(1)     Statement of Operations – commonly called an Income Statement.

This statement shows customer sales, costs (materials and/or labor) incurred to produce these sales, and general/administrative expenses   (rent, utilities, marketing, interest, depreciation, and other fixed expenses) required to operate the business and keep the doors open. Then we come to a very important part of the Income Statement called “operating income”—the difference between sales, cost of sales, and general/administrative expenses. Logically, when sales have exceeded costs and expenses, a profit for the period exists.  Otherwise, the business has a loss. Finally, income taxes are deducted and “net income” or “loss” is shown. “Net income” or “net loss” is commonly referred to as the “bottom line,” meaning it’s what has been earned or lost after all costs and expenses are taken into account. This is one of the single most important items to monitor and understand, at least on a monthly basis, if a business is to be effectively managed.

(2)     Statement of Position – commonly called a Balance Sheet. This statement presents what a business owns (Assets), what it owes (Liabilities), and the net of the two--Owners’ Equity (Net Worth). When liabilities exceed assets, the firm will have a negative owners’ equity, or net worth, which is a red flag that the firm is not financially fit, or in a start up mode pending future growth and profitability.

(3)     Statement of Cash Flows – commonly called a Cash Flow Statement. This statement shows the sources and uses of cash in a business, broken down by “Cash Flows from Operating Activities,” “Cash Flows from Investing Activities,” and “Cash Flows from Financing Activities.” The sum of the cash flows from these three activities is perhaps the key indicator of a firm’s liquidity (ability to pay its debts). Note that “cash flow” is not the same as “income” on the “Statement of Operations.” In fact, due to unpaid accrued expenses and customer billings on account, a business may very well show a profit but, at the same time, run out of cash to pay its bills. In the final analysis, the lack of “cash flow” is the number one cause of bankruptcy by small businesses.

(4)     Statement of Owners’ Equity – commonly called Net Worth or Equity. This statement is actually summarized on the “Balance Sheet” as the difference between “Assets” and “Liabilities.” However, businesses prepare this statement to present and understand the activities that increased or decreased the Owners’ “Equity Position” in the firm. Profits from the “Income Statement” increase “Owners’ Equity” and losses decrease equity. “Owners’ Equity” can also be increased by the issuance of stock and the infusion of additional capital into the firm. The payment of dividends to shareholders decreases “Equity.” This statement is important, not only from a tracking standpoint, but it can reveal the need for additional capital.

Viewed together, these four financial statements depict the financial status   and operations of a business. They represent the basic financial reporting backbone of a business. Therefore, business owners/leaders must have an understanding of these statements, and a general working knowledge of what each tells about the business. An understanding of what the numbers mean, and the timely use of this knowledge, enhances the competitive position and success of any business.

II.             Cost Benefit Analysis.  The overriding question to ask and answer with regard to spending decisions is: What benefit will be achieved in return for an outlay of funds (cash)? This basic model can be used in any spending situation. Business leaders who constantly ask and require an answer to this question, prior to making spending decisions, insure effective cost controls and profitability in their organizations. And, by setting an acceptable baseline return on an investment, spending can be directed to its best use. When spending on longer term projects, the time value of money and discounted cash flows must be considered. This takes into effect the time-honored fact that “a dollar today is worth more than if received in the future.”

III.         Ratio Analysis.  The simple technique of calculating several financial ratios from each of the following categories will provide a basic understanding of the financial status of a business and how it is performing. Use of these ratios will allow anyone to make an informed judgment regarding the financial health of a business, and compare it to overall industry standards and competitors.

·      Liquidity Ratios–indicate a firm’s ability to pay its bills and overall cash availability.

a)     Working Capital Ratio = Current Assets divided by

Current Liabilities.

b)    Quick Ratio = Cash plus Accounts Receivable divided by Current Liabilities.

c)     Cash Ratio = Cash divided Current Liabilities.

·      Profitability Ratios—indicate the level of profitability and return on investment in a business.

a)     Net Profit Margin = Net Income (after taxes) divided by Sales.

b)    Return on Assets = Net Income plus Interest divided by Average Total Assets.

c)     Return on Equity = Net income divided by Average Equity.

·      Leverage Ratios—indicate the debt structure of a business.

a)     Long-Term Debt Ratio = Long-Term Debt divided by Long-Term Debt plus Equity.

b)    Debt to Equity Ratio = Long-Term Debt divided by Equity.

c)     Total Debt Ratio = Total Liabilities divided by Total Assets.

·      Efficiency & Turnover Ratios—indicate a  firm’s productivity and effective use of its assets.

a)     Asset Turnover = Average Sales divided by Average Total Assets.

b)    Average Collection Period = Average Receivables divided by Average Daily Sales.

c)     Inventory Turnover = Cost of Goods Sold divided by Average inventory.

IV.          Breakeven Analysis. The “breakeven” point for a business is the point at which the profit margin on a specific sales volume equals fixed costs.  It is the point at which neither a profit, nor a loss, occurs. Every business must know their “breakeven point” on a monthly and yearly basis in order to effectively manage cash flow and operations in the current period and the future. The sales volume required for a business to “breakeven” is calculated by dividing its “total fixed costs” by the “average contribution margin percentage” received on its products and services. More importantly, a “what if” analysis can be performed by varying fixed costs and/or contribution profit margin to determine the impact on the firm’s “breakeven point.” For example, if fixed costs increase and the contribution margin remains constant, then the sales volume required to “breakeven” will increase. Businesses that consider moving to a more expensive facility, adding administrative staff, or expecting an increase in any of their fixed expenses, should perform this analysis to determine the additional sales volume required to cover the increased costs. The results are often surprising and may result in a firm forgoing such expenditures, or finding a way to mitigate cost increases. Likewise, a “breakeven” calculation is needed when costs decrease and the “breakeven point” for the firm is lowered.  

V.            Leverage Analysis. Leverage analysis calculations are performed to determine the degree a business is utilizing debt and fixed costs in its operations. A business may be “leveraged” in two ways—“financially,” when debt is used to expand and operate the business, or “operationally,” when fixed costs (facilities and equipment, for example) are added to achieve higher sales volumes.

a)     Financial Leverage = Operating Margin (before interest) divided by Profit Margin Before Income Taxes. The higher the ratio, the more financially leveraged a business is said to be. Note that the difference between “operating margin” and “profit margin before income taxes” is “interest expense.” Therefore, when interest expense increases, without an increase in “operating margin,” then the business becomes more financially leveraged.

b)    Operating Leverage = Contribution Margin divided by Operating Margin. Note that the difference between a firm’s “contribution margin” and its “operating margin” is fixed costs. And, when fixed costs increase without an increase in “contribution margin,” then “operating leverage” also increases. Increasing “operating leverage” is risky since fixed costs are difficult to reduce should sales decrease. However, for businesses with a long-term forecasted sales growth plan, it might just be the correct action to take.

Leading with the numbers

An understanding of the five basic “financial tools” discussed above needs to be a part of every small business leader’s skill set. In today’s increasingly competitive global environment, understanding and leveraging these “tools” is a prerequisite to continuous improvement in a firm’s sales, profitability, and sustainable competitive advantage. If you have struggled to understand and effectively manage the financial side of your business, I hope you are now prepared to integrate “financial tools” into a winning “managerial tool set” and “lead with the numbers!” 

• Phil Watlington teaches finance, managerial accounting and strategic planning through the University of Phoenix and is a senior manager at the General Electric Company. He is the author of “The World Is At Your Door.” You can reach him at (913) 485-2577 or pwatlington@earthlink.net.

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