FINANCIAL STORY-TELLING: A TALE OF THREE FINANCIAL STATEMENTS
May 28, 2019
The health of a business is typically assessed based on the income statement (P&L), balance sheet, and cash flow. How can you gauge how well your company is doing and understand how others will judge its value and condition if you do not have great financial literacy?
My finance professor (while pursuing my MBA), John J. Scully, PhD, CPA, provided a 3-minute 12-step formula which helps non-financial managers complete a financial analysis (Scully, 2018). He advises starting the assessment with some information found on the cash flow; total cash flows from operations and investments, plant and equipment investments, and financing activities. By analyzing the cash flows you can quickly see whether money is flowing in or out, where cash is coming from, and where cash is going. It also showcases any merger/acquisition activity the company may be involved in. In addition, the cash flow statement incorporates information from both the income statement as well as the balance sheet, giving a good overall story.
After evaluating the cash flow, the next step in a financial assessment is analyzing the balance sheet. First, take a look at the trending of total assets, which tells you the size of the company in terms of what the company owns. Next take a look at the cash and short-term investments, which are the most liquid of assets, meaning they can be used quickly if needed for investments, purchases, payments, etc. The totals will help you understand there are sufficient liquid funds for your particular business needs. Also take a look at the year-over-year trends to see if the totals are increasing or decreasing. The last items are the current and long-term interest-bearing liabilities; current reflecting any payments coming due within 12 months, long-term due thereafter. More information is exposed via the balance sheet through some quick calculations and analysis of relationships between the different line items. Cash burn rate can be determined by comparing the short-term assets and the short-term liabilities. Look also at the debt-to-equity ratio which can give you good insights into the health of the company.
Finally, the income statement, or P&L (profits and losses) lists total revenue, net income, gross profit and operating income. Total revenue is the total value of goods and/or services that have been sold in the given time period. Gross profit is the total revenue minus the cost of goods sold (COGS) or cost of services (COS). COGS or COS are all costs directly involved with providing those good or services (i.e. earnings of the workers and costs of necessary materials). The net income (or net profit) is the total revenue minus the cost of all resources (COGS, expenses, taxes). Finally, the operating income is the total revenue less the total operating expenses. An example of something to look for in the income statement (especially in smaller companies) is the percentage of gross profit to total revenue and the trends. Ideally, as a company scales, the gross profit should be increasing relative to total revenue. If not, you have just identified some operational inefficiencies. This could be corroborated with the balance sheet by analyzing the cash burn rate.
What can you do if you find some holes in your finances?
This is where the pro forma comes into play. A pro forma looks at how you performed financially in the previous fiscal year and makes predictions about how you will likely perform in the following fiscal year based on the top line. Many companies use this as an opportunity just to project predicted growth in revenue, but it can tell a much bigger story. Here are a couple of examples of how to reflect some solutions to discovered short-comings in a pro forma.
Are there ways to increase your company’s operational efficiency? This will drive the bottom-line. Analysis of operational performance cannot be overlooked or taken lightly. Therefore, you should not just project that your company can increase revenue. If revenue increases because of exponentially higher costs in marketing and operational expenses, gross profit may decrease as a result (total or per capita).
Cost per unit
Separate from the financial documents, analysis can be done to determine your companies cost per unit or cost per unit of service. I recommend looking at it in terms of total cost, including operational expenses. Ideally, as a company grows, scaling is appropriately strategized to ensure the cost per unit is decreasing and that there are opportunities to lean processes and decrease costs with the growth. Your trending cost per unit can also provide insights into the potential of achieving economies of scale. To show this in the pro forma, you will be predicting and reporting an updated COGS/COS with a subsequently higher gross profit and net income.
All of the items on the financial statements innervate with one another and create a story. With a little practice and application, even those without deep knowledge or experience in finance can find literacy and actually drive good decision-making within the company when you know what to look for. You can also begin to find red flags before someone else does (like a potential investor).
Scully, J. J. (2018). Three-Minute Financial Analysis for the Non-Financial Manager. Graziadio Business Review, 21(1), https://gbr.pepperdine.edu/2018/07/three-minute-financial-analysis-for-the-non-financial-manager/.
S Kern Consulting is a consulting firm that specializes in developing data-driven strategies to create business solutions.