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• How much has your total payroll increased this year? In dollars?
As a percentage? How will this affect other expenses?

• Is your compensation competitive for your industry?

• Do you check at least annually for internal equity in your com-
pensation system?

• Do some months require significantly more dollars to meet pay-
roll than others?

• Is it possible to stagger pay increases throughout the year?

• Are salary dollars predominantly spent for employees making
and selling the products, or is a lot more spent on administrative
overhead?

• Is your projected head count higher or lower than last year? How
will that influence other expenses?
65
Creating a Budget Everyone Can Use and Understand



INCOME STATEMENT PROJECTIONS

This exercise pulls together on one page (see Worksheet 2.7) all the items
gathered in the budget notebook and looks overall at your profit picture.
Categorizing your expenses this way is important to begin to look at
your overall profit picture as a number you can control.



Making It Happen

From the information gathered in the budget notebook, you can begin to
analyze your profit picture by putting your numbers in four major cate-
gories as follows:


1. Cost of goods sold includes the direct costs that go into producing
your product. The percentage in the box next to this category is
the complement of your gross profit margin. In other words, if
cost of goods sold percentage is 69 percent, gross profit margin
is 31 percent.

2. Sales and marketing expenses include what it costs to market and
sell your product. In some cases, it costs more than the price of
the product to sell it, and only in repeat business is there a rea-
sonable profit margin. It is important to know so that you can
price accordingly.

3. Overhead expenses include all other items such as personnel not
in other categories, facilities costs, and administrative items
such as office supplies.

4. The net income at the bottom of Worksheet 2.7 should be a budget
item, just like the rest of your expenses. I™m not satisfied unless
this number is at least 15 percent, but this varies by your indus-
try and economic times.

To obtain the current year projection (the shaded column), enter the total
number from each budget notebook page you filled out for each category.
For sales, enter the projection for this year and the actual for last year
from the Dollar Sales Projections by Month Worksheet 2.4 (shaded box
on bottom right for both years). For other categories, enter the projection
number from each budget notebook page and the actual numbers from
the previous year that you added to each budget notebook page.
66 Set High Standards



Worksheet 2.7
Income Statement Projections
Current Year % of Actual % of Fixed (F) or
Notebook Item Projection Sales Last Year Sales Variable (V)?
Sales
Cost of Goods Sold
Beginning Inventory
Materials purchased
Salaries & wages
Production supplies
Temporary help
Shipping supplies
Mailing & shipping
Less Ending Inventory
Total Cost of Goods Sold
Gross Profit (Sales ’ total cost
of goods sold)
Gross Profit % (Gross Profit/
Sales)
Sales & Marketing Expenses
Salaries
Sales commissions
Direct mail
Advertising
Publicity
Consulting
Other sales & marketing
expenses
Total Sales & Marketing
Expenses
Overhead Expenses
Personnel
Salaries
Bonuses
Payroll taxes
Group life & health insurance
Workers compensation
insurance
Employee benefit plans
67
Creating a Budget Everyone Can Use and Understand



Worksheet 2.7 (Continued)
Current Year % of Actual % of Fixed (F) or
Notebook Item Projection Sales Last Year Sales Variable (V)?
Officers™ salaries
Employment expense
Training
Temporary help
Total Personnel
Facilities
Rents
Property tax
Repairs & maintenance
Utilities
Property & liability
insurance
Total Facilities
Administration
Accounting services
Automobiles
Bank charges
Computer supplies
Charitable contributions
Depreciation & amortization
Dues & subscriptions
Interest expense
Legal services
Licenses
Miscellaneous
Office supplies
Other professional services
Telephone
Travel
Total Administration
Total Overhead Expenses
Income (before taxes)
Income Taxes
Net Income
68 Set High Standards



Calculate the percentage of your total sales that each category makes up
by dividing the total number at the bottom of each box by the total sales
box at the top. You should have percentages for each of the items except
sales.

The last column of Worksheet 2.7 requires that you determine whether
your costs are fixed or variable. Variable costs are costs that are directly
impacted by sales. These costs are expected to change, more or less, in
proportion to the change in sales, for example, sales commissions. Fixed
costs are all those that are not variable”they don™t change as the level of
sales increases or decreases. An example of this is rent. Some costs may
have both a variable piece and a fixed piece, for example, utilities, which
go up as equipment is used more to meet production demands but are
relatively fixed for most of the office. For purposes of this analysis, ex-
penses that are in doubt should be classified as fixed.



Reality Check

Consider these questions about your income statement projections:


• Are you satisfied with the dollar number and the percentage at
the bottom of the page?

• Are these numbers higher or lower than the previous year?

• Compare these percentages with industry norms. Are you higher
or lower than others in your industry?

• Are category totals as a percentage of sales higher or lower than
you would expect?

• Have you questioned numbers that seem wrong to you? Do you
have backup calculations or information for all the numbers?



BALANCE SHEET PROJECTIONS

A balance sheet is a statement of what the company owns and what it
owes at a fixed point in time. The balance sheet can be illustrated by a
simple formula with three elements:

Assets ’ Liabilities = Owner™s equity
69
Creating a Budget Everyone Can Use and Understand



Making It Happen

Make a list of your assets and liabilities in the following categories. As-
sets can be current, fixed, or intangible. Liabilities can be short or long
term. What your business is worth or how much value you have built up
in the business is the owner™s equity.


Assets

Current Assets
• Your cash.

• Cash from loans or investors.

• Inventory”list type and value.

• Deposits paid upfront (such as rent and security).

• Other expenses paid upfront to be used over time (such as annual
insurance premiums).

• Accounts receivable”credit you give to others who will buy from
you now and pay later.

Fixed Assets
• Real property.

• Improvements to your location.

• Equipment.

Intangible Assets
• Intellectual property rights”copyrights, trademarks, patents
(list type and estimated value).


Liabilities

Current Liabilities (less than two years to pay back)
• Notes payable (such as bank lines of credit and equipment loans
that will be fully paid back in less than two years).

• Credit given to you to buy what you need now and pay later (ac-
counts payable).

Long-Term Debt (more than two years to full repayment)
• Bank Loans.
70 Set High Standards



Owner™s Equity
If your assets are greater than your liabilities, you have equity or worth
in your business that you should list on your balance sheet projections. If
your liabilities are greater than your assets, you have negative equity.
Many businesses start with negative equity, but all businesses should
seek to increase equity each year.



Reality Check

Consider these questions about your balance sheet projections:

• Are your assets greater than your liabilities?

• Over the life of your business, have your assets increased or de-
creased?

• Over the life of your business, have your liabilities increased or
decreased?

• What is the owner™s equity of your business? Has it increased?
Do you have a goal for how much you would like your business to
be worth?
71
Creating a Budget Everyone Can Use and Understand



BREAK-EVEN ANALYSIS

Worksheet 2.8 determines the sales level at which the company neither
makes a profit nor suffers a loss. Break-even analysis can help to identify
problems and avoid or lessen losses by acting proactively rather than re-
actively. Obviously, the sooner you recognize that the company is operat-
ing at less than break-even operations, the sooner you can begin to cut
fixed costs and take other measures to restore profitability.

Some companies use break-even analysis to evaluate their overall profit
goal. It is a simple-to-use tool to relate sales to profit. Break-even analysis
is driven by the relationship of costs, volumes, and profits.

Break-even analysis offers a consistent way to test proposed transactions,
consider alternatives, or make decisions. Most of the information required
to determine your break-even already exists in your annual budget.


Making It Happen

Use the previous Income Statement Projections Worksheet (2.7) to deter-
mine which costs are fixed and which are variable. For Part I of Work-
sheet 2.8, determine the variable cost percentage by one of two ways:

1. Divide the total variable costs by projected sales.

Variable cost
= Variable cost percentage
Sales


2. Using historical financial statements, divide all variable costs
by sales to derive each variable cost as a percentage of sales.
Then add all of these percentages to obtain a total variable cost
percentage.

Example:
Materials: 50 percent

Production: 10 percent

Direct labor: 10 percent

Sales salaries: 15 percent

Total variable cost: 75 percent
72 Set High Standards



Worksheet 2.8
Break-Even Analysis
Part I
% of Salesa
Variable Expenses
Materials purchased
Production supplies
Shipping supplies
Mailing & shipping
Sales commissions
%
Total Variable Cost %
Contribution Margin Ratio
(100% minus the total variable cost %) %
Fixed Costs
Monthly $
Annual $
Break-Even Sales Level
Monthly $
Annual $

Part II
Annualb Monthlyc
$ $
Fixed Expenses
Personnel
Salaries & wages ’ Cost of sales
Salaries ’ Administration
Bonuses
Payroll taxes
Group life & health insurance
Workers compensation insurance
Employee benefit plans
Officers™ salaries
Employment expense
Training
Temporary help
Total Personnel Costs $ $
73
Creating a Budget Everyone Can Use and Understand



Worksheet 2.8 (Continued)
Annualb Monthlyc
Sales & Marketing Expenses
Salaries
Sales commissions
Direct mail
Advertising
Publicity
Consulting
Other sales & marketing expenses
Total Sales & Marketing Expenses $ $
Facilities
Rents
Property tax
Repairs & maintenance
Utilities
Property & liability insurance
Total Facilities $ $
Administration
Accounting services
Automobiles
Bank charges
Computer supplies
Charitable contributions
Depreciation & amortization
Dues & subscriptions
Interest expense
Legal services
Licenses
Miscellaneous
Office supplies
Other professional services
Telephone
Travel
Total Administration $ $
Total Fixed Expenses $ $
a
From Income Statement Projections worksheet (2.7), current year projection, % of sales column for vari-
able expenses only.
b
From Income Statement Projections worksheet (2.7), current year projections column.
c
Current year projections divided by 12.
74 Set High Standards



The goal of Part II is to determine the contribution margin ratio to add
back into Part I. This ratio is calculated by taking the complement of the
variable cost percentage or simply by subtracting the variable cost per-
centage from 100 percent.

Contribution margin ratio = 100 percent ’ Variable cost percent

Now you are ready to calculate sales break-even level. To do this, divide
total fixed costs by the contribution margin ratio.

Total fixed costs
Sales break-even level =
Contribution margin ratio




Reality Check

Consider these questions about your break-even analysis:

• If sales begin to decline, at what level will you start to lose
money?

• If you increase fixed costs by $X, how much additional sales will
you need to generate to cover these costs?

• If you lower the variable cost percentage, what impact will it have
on profits?

• If you want a profit of $X, what level of sales will you have to
achieve?

• Are there months where your projections are less than break-
even on sales?




W H AT ™ S N E X T

In the next chapter, I cover how to look at what really happens after
you complete the budget and go back to business. I discuss how you
can interpret financial data to ensure your company is on the right
track. I also cover how to share financial information and budget re-
quirements with your employees and how to make this information
relevant and useful to them.
3
UNDERSTANDING
THE NUMBERS


The expectations of life depend upon diligence; the
mechanic that would perfect his work must first
sharpen his tools.
”Confucious




A primary goal of every business is to make enough money to stay in
business. Making money can be defined in two ways: making a
profit and generating cash. Profitable businesses usually generate cash,
but not always. Unprofitable businesses sometimes generate cash, but
not often.

Either way, in reviewing your finances, you look at both profits and cash.
This chapter takes you through this review by stressing three points:

1. The importance of tracking variances from budgeted amounts.

2. The importance of cash in running any business.

3. The central role of developing key financial indicators and com-
municating them to coworkers.

Choosing your key financial indicators depends on the kind of business
you run and whether your company is young or mature. As a rule, cash is
king for a young company; many start-up owners fear running out of
cash more than anything else. In a mature company, sales and growth
may become the main concern. When a company goes public, showing a
good return on assets may become paramount.


75
76 Set High Standards



FLYING BLIND

The owners of many new businesses fly blind, concentrating on the day-
to-day essentials at the expense of reviewing the numbers and planning
ahead. Once they start reviewing and planning, they discover that the
process brings unexpected payoffs in reaching their goals because it
forces them to identify what they want and to determine the means by
which to get there. Effective managers develop their own methods for
gauging performance, and they define performance in accordance with
their short- and long-term goals. They may consider daily revenues, for
example, or catalogs mailed, cash balance, and payroll.

The small business owner must become intimately involved in the daily
dynamics of the business. This familiarity provides a long-term blue-
print for keeping the company vital because the key to implementation is
in the details.



Essential Financial Measurements

The following are six essential measurements of financial well-being for
most businesses:

1. Revenue dollars. Are total sales up or down for the period?

2. Gross profit margin percentage. One of the profit indicators you
look at first, this measurement takes into account only the costs
directly related to the product manufactured.

3. Net income. Always a key indicator of financial performance, net
income reflects sales and costs, profit and loss”the best places
to start any analysis.

4. Cash position. Especially in the early years of a company™s his-
tory, liquidity has more importance than any other financial
benchmark. But whatever the maturity of your company, it pays
to watch how much money you have in the bank at least weekly
and maybe even daily. If you have a line of credit, how much of
the line is in use and how much is available becomes an impor-
tant part of your available cash calculation.

5. Net worth. This indicator, which tells the owner™s equity (or in
publicly traded companies, shareholders™ equity), is simply assets
minus liabilities. It includes equity put into the business through
77
Understanding the Numbers



the sale of stock or retained earnings. It helps you consider the
best ways to allocate equity and assets to reach your goals.

6. Accounts payable days and accounts receivable days. Many experts
call these leading indicators because they give you a read on what
your cash position will be next month. However, accounts re-
ceivable are sometimes collected more slowly than payables
come due, in which case your cash position might become tight.

Your management of receivables and payables profoundly affects cash
flow. Poor management here can kill almost any company, no matter
what the size, and good management pays big dividends.

Just by managing receivables well, even in a small company, you can gen-
erate tremendous amounts of cash”in today™s volatile economy”and this
is essential.

Another way to look at the receivables/payables ratio is as a measure of
your financial department™s efficiency. Your accounting people must
make sure the company pays its bills and collects its receivables on time.



TRADITIONAL FINANCIAL STATEMENTS

The traditional financial statement has two components”the income
statement and the balance sheet. The income statement shows your
sales and expenses and profit and loss for a given period, usually the
month, quarter, or year. The balance sheet shows net worth; it also details
items such as inventory, fixed assets, accounts payable, and accounts
receivable.

Another important financial statement, not always prepared by small
companies, is a statement of cash f lows. This statement shows the details of
how cash increased or decreased during the period and where it went.

Make sure financials are prepared monthly, preferably by the tenth of the
following month at the latest. Learn which pieces of information in them
are relevant to your business and concentrate on those. Don™t ignore what
the numbers tell you and, above all, believe them; good or bad, the num-
bers are important. In addition, don™t hesitate to shape the reports you get
to suit your ends. Accountants tend to work by habit, and they sometimes
prepare numbers for business managers without giving much thought to
78 Set High Standards



making them truly useful. You need to make sure the reports you get are
truly useful for making decisions about your business.

In all cases, your financial statements look backward to show the pres-
ent”namely, your position as of their date of preparation. Finally, don™t
forget, if you have a bank loan, the bankers will be looking at these num-
bers as well to make sure you can pay off your debt.



Setting Your Own Key Indicators

Implicit in this discussion is the fact that your concentration on the fi-
nancial statements may blind you to opportunity. Budgets set cost tar-
gets, leading some managers to spend their time controlling how much
the operation spends and ignoring how much it earns now or might
make in the future. They monitor money going out, and they don™t take
into account issues such as trends, the big picture, or the business under-
lying the profit and loss statement, which shows results. Worse, they ig-
nore the balance sheet, which shows your financial position.

This single-mindedness can hamper your business. It turns an organiza-
tion inward, values rule above initiative, and lead managers to query
trivial variances while they ignore harder-to-identify, companywide prob-
lems or opportunities.

Therefore, financial measurements must always be balanced against
measures of operations, product development, and marketing.

One way to counteract this is to develop specific key indicators for your
business. A key indicator answers the questions: How well are we really
doing? If you were managing the business in crisis mode and you had to
focus only on the essentials, what would you need to know? What num-
bers or other data would you want on your desk every morning? It is
worth spending significant time identifying your business™s true key in-
dicators and making sure you have that data available to you consistently.



CASH FLOW IS CRITICAL

Many small business owners don™t think about all the strategies and tools
available to them when they run into cash flow problems. Instead, they
react by trying to boost sales. They chase revenue, and cost is damned. In
79
Understanding the Numbers



so doing, they overextend themselves seeking new business and fail to
serve their best customers. This can harm cash flow”the last thing a
company needs if liquidity is already a problem.

There are several strategies for maximizing cash flow. Controlling ex-
penses is chief among them.

Many business owners see expense controls as a sign of trouble, but they
aren™t. The absence of cost controls is a sign of trouble.

If you find your business short of cash, look to your balance sheet and
study receivables and inventory, both of which are common drains on
cash flow.



Managing Your Receivables

It is important to carefully track customers who bought your company™s
product on credit but haven™t paid as they have agreed to within a spe-
cific time. The older the bills get, the less likely they will be paid.

It™s essential for managers to have a plan to get people to pay, and the
first step in that is to know who owes money, how long they™ve owed it,
and how much they owe. Sometimes the top 20 can account for most of
the money owed to a company if it has several large customers.

Doing something as simple as concentrating on getting paid by these
people can have a significant impact on raising a company™s cash posi-
tion. Consider keeping a list of the customers who owe you money and
rank them from the largest dollar volume to the smallest. Enter the top
10, from largest to smallest on this worksheet. Keep track of their pay-
ments and who is responsible for contacting them. What percentage do
your top 20 receivables represent of accounts receivable? Are any of the
customers on the list still buying on credit? Do you have limits as to how
much credit you will allow?

Perhaps the best use of accounts receivable days and payable days as a
management tool is to compare the two. Average the time it takes to pay
your bills and the time it takes to collect. If it takes longer to collect ac-
counts receivable than pay your bills, in effect, you™re subsidizing cus-
tomers. If it takes longer to pay than collect, you™re effectively making
money from the process.
80 Set High Standards




W I T H R E C E I VA BLE S ,
A F E W BA S IC RU LE S A P P LY :

• Develop a good credit-checking system.

• Send your bills out faster, and follow up with phone calls when
an account becomes overdue.

• Establish a strict collections schedule and follow it faithfully.

• If your cash flow is strong, you may be willing to give extra
time to pay in exchange for additional compensation.

• Keep managers and employees informed when collections be-
come difficult with products they develop, make, or sell. They
may help with strategies for collecting. They may also know
something useful about the customer that will help in collec-
tion efforts.

• Don™t be afraid to pick up the phone and call the company
president.

• Don™t wait too long to get attorneys involved if all else fails. A
legal letter and some minimal action can often bring about
quick payment.




Managing Your Inventory

Another cash drain is excess inventory. Without adequate controls over re-
ceivables and inventory, it™s entirely possible for a company to make a
profit and still go out of business. Whenever and as much as possible, you
should integrate inventory management with customer service and deliv-
ery programs. The object is to keep as few units on warehouse shelves as
you can.

The cost of carrying inventory is expensive. Some manufacturing com-
panies pay 25 to 30 percent of the value of their inventory for the cost of
borrowed money, warehouse space, materials handling, staff, and trans-
portation expenses related to maintaining it for one financial quarter”
three months.

These numbers shock people. Once they realize how expensive inventory
can be, they look at it differently. Many owners and managers never
81
Understanding the Numbers




S C RU P U LOUS MON I TOR I NG

Unity Forest Products, Inc., a California-based lumber company,
thrives by scrupulously monitoring its cash flow and related items
such as inventory, accounts receivable, and accounts payable. In a
volatile business, it combines efficiency, knowledge of its cus-
tomers™ needs, and close attention to financial detail to succeed.

Unity started as a bootstrap operation run by a collection of long-
time mill workers who didn™t fear competing with the industry™s big
players. Lumber is a heavily capitalized, low margin business, and
bootstrappers don™t usually have the money to get in the game. CEO
Enita Elphick and her crew needed $1 million to get started. In 1987,
when starting out, the management team had only $350,000 in cash.
For a short time, Unity bought lumber from sawmills, subcontracted
the resawing, and then sold the wood wholesale to lumberyards.

Elphick had refined a just-in-time inventory management concept
into a five-year business plan that depended on weekly cash flow
projections”unusual for any start-up, let alone one in a volatile
commodity business. Unity claimed it could turn inventory over
every 10 days; the industry average was 58. The company also
claimed it could collect accounts receivable in 10 days; the industry
average was 27.

Management looked everywhere for cash to build a new mill but
had trouble persuading lenders to back its plan, which lenders con-
sidered so aggressive that they doubted its projections. Wells Fargo
approved a $150,000 credit line that Unity never touched. Finally,
the bank lent Unity the cash to get started.

Elphick offers her customers a 1 percent discount if they pay within
10 days. In turn, it gets a 2 percent discount from suppliers if Unity
pays within 10 days. Competitors see that Unity has figured out
that the most significant expense in the lumber industry is carrying
a lot of inventory.

Unity also keeps close track of receivables. At one point, a customer
who owed the company $40,000 was about to declare bankruptcy.
Unity managers drove several company trucks to the customer™s
plant and repossessed the lumber before sheriff™s deputies could
arrive to lock up the facility. This tenacity and attention to detail is
in part what makes this company thrive.
82 Set High Standards



make this realization because the cost doesn™t show up on any statement,
and, therefore, they have to calculate it themselves.



FOLLOWING WHAT MATTERS

There™s nothing like a brush with disaster to show you what matters and
what doesn™t, as the Wisconsin-based Carson Pirie Scott department
store chain learned during a bankruptcy reorganization in 1991. The ex-
ercise taught management to improve performance by paying close at-
tention to the company™s real-time financial position, which is key in
retailing with its turnover and stiff competition.

Michael MacDonald, then chief financial officer, tracked sales and cash
position on a weekly basis. As he said, “You really have to manage a busi-
ness on a detailed basis and on a frequent basis. You don™t just look at it
now and again. You have to look at it all the time”every day.”

The company used a five-inch-thick business plan to chart its way out of
bankruptcy. Its creditors insisted that the retailer remain wary of vari-
ances from budget. The business plan became the company™s road map
away from disaster. “There™s an axiom in retail that says retail is detail,”
MacDonald says. “You need to track sales on hand on a very detailed
basis. We have pretty sophisticated methods to check what sizes and col-
ors are selling.”

For key indicators, managers chart sales per square foot, comparable-
store sales growth (to show market share), and operating profit as a per-
centage of sales and earnings.

As MacDonald points out, cash and inventory “require continuous fine
tuning and monitoring.” The challenge is to make sure that the shortage
of cash doesn™t choke off the flow of in-demand products.

He describes the goal of his financial scorekeeping bluntly: “The main
purpose of a business is to maximize shareholder or investor value.” He
watched a number of indicators to achieve that end, all tied to what the
company called the three keys to successful retailing”effective merchandis-
ing, giving the customer a positive shopping experience, and marketing.

The attention to detail paid off. Within two years, Carson Pirie Scott had
earnings of about $33 million on sales of $1.15 billion”not stellar numbers,
83
Understanding the Numbers



but on target with management™s goals to avert disaster. By 1998, it had be-
come an acquisition target, and its 55 stores became part of Saks, Inc.



When Numbers Lag Performance

One key to the success of the Carson Pirie Scott effort was its ability to
limit an important shortcoming in financial analysis”the fact that the
numbers lag actual performance. For example, the company knew that if
it tracked expenses only at the end of each quarter, it would do so too late
to make a difference.

The financials also can™t answer qualitative questions such as those that
go into the formulation of your company™s vision statement. In addition,
you may well find that your financial statement and balance sheet don™t
address other matters of concern to you. You need to create your own
key indicators to measure your success in quality, market share, or cus-
tomer satisfaction.

If you are puzzled by what the numbers say, find experienced guidance
to help you make the analysis. Sometimes your accountant can help; oth-
erwise, a consultant who has run a company in your industry or a group
of other CEOs or people experienced in business may help you see some-
thing you can™t (or don™t want to) see.



SHARING FINANCIAL INFORMATION WITH EMPLOYEES

As a business leader, you™ll inevitably face the question of whether to
share information about company finances with your employees and
how much. Progressive managers make it a priority to educate staff on
company finances. They make budgets widely accessible, at least within
the confines of company facilities.

Still, it scares many managers”even progressive ones”to be open with
the financial statements. As a rule, many people feel uneasy sharing
money matters under any circumstances, considering them wholly per-
sonal. Moreover, many companies operate in such competitive fields that
they risk a great deal if they bandy about their financial information.

Although I certainly advocate sharing financial and other key indicator
data with employees, I don™t think it makes sense to give them financial
84 Set High Standards



statements. Financial statements are documents meant for investors and
accountants. Instead, what employees need is data relevant to their jobs.
They also need to have this data analyzed in terms of the trends so that
they can see how their work is impacting the company™s prosperity.

Share numbers with your employees that will initiate clear action, and
prepare and present a short, written analysis of those numbers. It is vital
that each employee see a connection between not only his or her job but
also each individual action and your financials. This will impress on
each employee the fact that in business, virtually every action has a fi-
nancial impact.

Many owners and managers are experts at product costs but ignorant of
everyday, nonspecific business costs. You can hire consultants or profes-
sional staff to study your costs of labor, capital, and the rest, but you still
need a basic approach to these issues. Furthermore, you have to know
how to judge the results of their work.

Financial realities sometimes conflict with your vision and mission
statements. When this happens, you may have to acknowledge the limits
of quantitative analysis. Look to your business plan and vision and mis-
sion statements for guidance in making cost analyses.



TOOLS FOR UNDERSTANDING THE NUMBERS

To complete the exercises and worksheets in this section, you™ll need:

• Your income statement and balance sheet.

• A list of accounts payable.

• A list of accounts receivable.

You may need to gather other data as well. The worksheets and formu-
las that flow from this information will help you compare projections to
actual sales and expenses through your fiscal year, analyze cash flow,
calculate and analyze various financial ratios, and determine key finan-
cial indicators and other information critical to owners, managers, and
employees.

Put together, the worksheets and exercises provide you with useful fi-
nancial tools and the framework for a monthly reporting package that
85
Understanding the Numbers



will allow you to monitor your company™s performance from many dif-
ferent perspectives and take some appropriate actions.

The worksheets in this section that will help you get a handle on under-
standing the numbers for your company are:

• Year-at-a-glance income statement.

• Year-at-a-glance balance sheet.

• Year-at-a-glance financial analysis.

• Budget variance report.

• Same month last year variance report.

• Analysis of cash position.

• Key financial indicators.

• Financial report to employees.

The following measures will help you to determine where you should be
satisfied with your financial reporting:

• Do you have good cash management?

• Do you have timely and accurate financial data to review?

• Does the data you have help you make decisions? Do you need
more? Do you look at all the data you receive each month?

• Is your company performing well compared to industry standards?

• Do you meet with employees at least once a month to review vari-
ances and trends?
86 Set High Standards



YEAR-AT-A-GLANCE INCOME STATEMENT

Financial reports done by your accountants are useful for comparing this
year to last year, but they don™t tell you whether there is a big variation
from projection and which month the variation may have occurred. If
there is a large variation in one month, the year-to-date numbers are off
the rest of the year after that point.

The income statement tells you how well your company has done over a
period of time. It shows both revenue and expenses and arrives at a net
income number at the bottom of the page.

Worksheet 3.1 on pages 88“89 synthesizes a number of important numbers
into one form and on just one page. It offers a visual way to look at every-
thing at once, which helps you think about business activities over the
course of a whole year. Large variances should become quickly apparent.



Making It Happen

Using Worksheet 3.1, I find myself better prepared to ask pointed ques-
tions about budget items. I can compare them to other items, even other
budget variances, and research important deviances from what I expected.

Some of these items may result from miscoding and similar technical
problems, however, rather than expenses being much different than ex-
pected, but even glitches become easier to detect when the numbers run
alongside one another.

Enter actual sales and expense numbers each month throughout the
year. Calculate the monthly average column by taking the number of
months so far this year and dividing by that number. This tells you if
your monthly average is over your original budget and whether your cur-
rent month is above or below average.



Reality Check

Consider these questions about your completed worksheet:

• Are your expenses what you expected, or are there large
variations?
87
Understanding the Numbers



• Does each month look comparable, or are there large differences
month to month?

• Do particular items seem out of line with the others in the report?

• Can you see trends that run across your business functions?

• Are there certain budget items that make sense compared against
one another? For example, an increase in direct mail expense, fol-
lowed in a month by a spike in revenue. What do those compar-
isons mean about your business functions?
Worksheet 3.1




88
Year-at-a-Glance Income Statement
Month Monthly
1 2 3 4 5 6 7 8 9 10 11 12 Total Average
Sales
Cost of Goods Sold
Beginning inventory
Materials purchased
Salaries & wages
Production supplies
Temporary help
Shipping supplies
Mailing & shipping
Less ending inventory
Total Costs of Goods Sold
Gross Profit
Sales & Marketing Expenses
Salaries
Sales commissions
Direct mail
Advertising
Publicity
Consulting
Other sales & marketing
expenses
Total Sales & Marketing Expense
Overhead Expenses
Personnel
Salaries
Bonuses
Payroll taxes
Group life & health insurance
Workers compensation insurance
Employee benefit plans
Officers™ salaries
Employment expense
Training
Temporary help
Total Personnel
Facilities
Rents
Property tax
Repairs & maintenance
Utilities
Property & liability insurance
Total Facilities
Administration
Accounting services
Automobiles
Bank charges
Computer supplies
Charitable contributions
Depreciation & amortization
Dues & subscriptions
Legal services
Licenses
Miscellaneous
Office supplies
Other professional services
Telephone
Travel
Total Administration
Total Overhead Expenses
Income ( before taxes)
Income Taxes




89
Net Income
90 Set High Standards



YEAR-AT-A-GLANCE BALANCE SHEET

Worksheet 3.2 illustrates items in your balance sheet in a format for easy
analysis, month to month. It™s a statement of what the company owns at
a fixed point in time. It remains important to look at changes occurring
from month to month because there is a direct relationship between
changes in balance sheet and cash flow.

The Year-at-a-Glance Balance Sheet allows you to track balance sheet ac-
counts for trends. It also allows a measurement system to track goals you
may have to decrease inventory or decrease accounts receivable (both of
which would increase cash).

The most important accounts to focus on are cash, accounts receivable,
inventory, fixed assets, and accounts payable. More obscure accounts
such as other assets generally don™t change much month to month, so you
don™t need to focus on them. This format allows you to see important
changes if they occur.

More aggressive owners and managers pay close attention to accounts
receivable and payable on this worksheet. Accounts receivable and
payable affect cash flow in mercilessly direct ways:

• If accounts receivable goes up, cash goes down.
• If inventory goes up, cash goes down.
• If accounts payable goes down, cash goes down.
• If fixed assets go up, cash goes down.


Making It Happen

Find the following items from your monthly balance sheet and enter each
month on the worksheet. You will usually find these items on the balance
sheet categorized as current (usually one year or less) or long term.

Assets
Current Assets
Cash.
Accounts receivable”money owed to you by your customers.
Inventory”your product waiting to be sold, either at your location or
at a store.
Worksheet 3.2
Year-at-a-Glance Balance Sheet
Month
1 2 3 4 5 6 7 8 9 10 11 12
Assets
Cash
Accounts receivable
Inventory
Prepaid expenses
Other current assets
Total Current Assets
Fixed Assets
Accumulated depreciation
Net fixed assets
Intangible assets
Other assets
Total Assets
Liabilities
Current portion long-term debt
Notes payable
Accounts payable
Accrued liabilities
Other current liabilities
Total Current Liabilities
Long term debt
Other liabilities
Total Liabilities
Equity
Common stock
Paid in capital
Retained earnings
Total Equity




91
92 Set High Standards



Prepaid expenses”items such as insurance or taxes (e.g., an insurance
premium is paid upfront for a whole year; this entry spreads it out over
the policy period).
Other current assets”miscellaneous items such as rent deposits.
Fixed assets”real property, equipment, and leasehold improvements.
Accumulated Depreciation.
Net Fixed Assets.
Intangible Assets”good will, intellectual property (rights, trade-
marks, patents).


Liabilities
Current Liabilities (an amount you owe to someone else, generally to be paid
within one year)
Notes payable.
Accounts payable.
Accrued liabilities.


Long-Term Debt
Equity
Retained earnings”the amount of net income the company has earned
and kept since the first day of the business, less dividends to share-
holders.


Reality Check

Consider these questions about your completed worksheet:

• Are your accounts receivable and accounts payable accounts up
or down over the period?
• Are there sharp variations during certain peak periods or seasons?
• Is your cash consistently at a comfortable level for operating the
business?
• What is the current trend in inventory levels?
• Has your company acquired fixed assets in accordance with capi-
tal budgets?
93
Understanding the Numbers



YEAR-AT-A-GLANCE FINANCIAL ANALYSIS

This exercise pulls together useful information from both the balance
sheet and income statement and calculates some ratios to give you an
idea of the financial health of the company and how it changes month to
month. The ratios included here are generally computed for whole indus-
tries. It is useful to compare your numbers to your industry.

The balance sheet items are asset management related and tell you how
well you are doing increasing the value of what you own. The income
statement items are related to profitability and tell you how well you are
doing in that area.

Worksheet 3.3, as with the other year-at-a-glance worksheets, gives you a
quick indication of how things are changing over time. The problem with
financial statements is that you can™t tell whether things have gotten bet-
ter this month or worse. These worksheets will let you know immedi-
ately if there is a sudden downturn or a trend in that direction so that
you can take corrective action.


Making It Happen

Find the numbers for the first four categories from your income state-
ment and enter them for the appropriate month. Also enter the number
of people you currently employ. Divide sales by number of employees to
get the number for the last category under the income statement, sales
per employee.

Enter the numbers for the first three entries under the balance sheet col-
umn. The remainder of the categories are calculated as follows:

Sales. Take this item from your income statement.
Gross profit margin. This ratio is sales minus cost of goods sold divided
by sales.
Pretax profit. Take this item from your income statement.
Cumulative net income. An aggregate of the monthly income figures
listed for the year to date, this tells you how close you are to your pro-
jections for the year.
Number of employees. Take this item from your payroll projection work-
sheets.
94
Worksheet 3.3
Year-at-a-Glance Financial Analysis
Month
1 2 3 4 5 6 7 8 9 10 11 12
Income Statement
Sales
Gross profit margin
Pretax profit
Cumulative net income
Number of employees
Sales per employee

Balance Sheet
Total current assets
Total current liabilities
Working capital
Current ratio
Sales to assets
Return on assets
Debt to equity
Accounts receivable days
Accounts payable days
Inventory turnover (annual)
Inventory turn days
95
Understanding the Numbers



Sales per employee. This number divides sales figure by the number of
people the company employs to generate that figure. This is a popular
tool for determining a company™s efficiency”though standards change
dramatically by industry.

Total current assets. Take this item from the balance sheet.

Total current liabilities. Take this item from the balance sheet.

Working capital. The amount by which current assets exceed current
liabilities.

Current ratio. A basic test of solvency, you obtain this number by divid-
ing the current assets of your company by current liabilities.

Sales to assets. A measure of how aggressively the business pursues
sales, this figure (total current assets divided by sales) helps analysts
determine how much unrealized sales potential a company might have.

Return on assets. This figure (pretax profit divided by total assets)
compares profit with the amount of assets used to earn that profit. Ac-
ceptable figures vary from industry to industry.

Debt to equity. This figure (total liabilities divided by net worth or
shareholders™ equity) relates the company™s debt to the strength of the
equity in the company by owners or stockholders.

Accounts receivable days. First, divide sales by accounts receivable to ob-
tain accounts receivable turnover. Then, divide 365 by the turnover
figure. The result (also called collection period ratio) indicates how
many days others are taking to pay you.

Accounts payable days. First, divide cost of goods sold by accounts
payable to obtain accounts payable turnover. Then, divide 365 by the
turnover figure. The result indicates how many days you™re taking to
pay your bills. It also tells analysts about your company™s liquidity.

Inventory turnover (annual). This figure (cost of goods sold divided by
the inventory item from your balance sheet) provides an indicator of
how many times a year your company turns over its entire inventory.

Inventory turn days. Obtained by dividing 365 by the annual inventory
turnover figure, this figure gives you a time period to compare directly
with the accounts receivable and payable numbers listed previously.

This worksheet will be very valuable when you™re dealing with poten-
tial lenders or investors. In this context, financial analysts sometimes
96 Set High Standards



ask for ratios not included on this worksheet. Some of the most impor-
tant include:

Current liabilities/inventory. Obtained by dividing current liabilities by
the value of current inventory, this figure tells managers how much
the company relies on funds yet to be obtained from unsold invento-
ries to meet its debt obligations.

Net sales/working capital. By measuring the number of times working
capital turns over annually in relation to net sales, this ratio provides
information about whether the business relies too heavily on credit to
maintain its sales effort.

Return on investment. This figure prorates net profit by an individual
investment vehicle™s percentage of a company™s total capitalization. It
tells investors how soon they will recoup their money; it tells man-
agers what form investments should take (limited partnerships, pre-
ferred or common stock, etc.).

Current liabilities/net worth. Considered by some lenders the most im-
portant test of a company™s solvency, this figure indicates the amount
due creditors within a year as a percentage of the investment in the
business by owners or stockholders.



Reality Check

Consider these questions about your completed worksheet:

• Which numbers are trended in a positive direction and which in a
negative direction? Are your ratios in line with industry averages?

• Which ratios concern you most? Are these issues that require im-
mediate solutions (e.g., the current ratio) or long-term solutions
(e.g., sales per employee)?

• Is the overall financial condition of the company getting better or
worse?

• Can unusual or negative trends be explained satisfactorily?

• Are there other ratios that are particularly important to your
business that should be included?
97
Understanding the Numbers



BUDGET VARIANCE REPORT

Managers go through all the effort of making a budget each year, but un-
less they compare their actual financial picture to what they budgeted,
doing the budget remains a meaningless exercise. Budget variance is a
wake-up call for managers to make midcourse corrections and to replan
for the remainder of the year. With any variance, a manager should inves-
tigate what™s gone right or wrong and hold people accountable for their
spending.

Worksheet 3.4 gives an easy way to compare actual numbers each month
to budget numbers, both for that month and the year-to-date (cumulative
for the whole year). This worksheet is also useful for employee meetings
and board of directors meetings.



Making It Happen

Enter your budget numbers for each item for the current month. Then
enter the actual numbers that correspond to each category. In the third
column, take the difference between the two (actual minus plan), and
enter it in the $ variance column. For expense items, a negative number
means you™re under budget and a positive number means you spent
more than you expected. Last, calculate the percent variance by divid-
ing the $ variance by the plan $. A negative $ variance will result in a
negative percent variance. Complete the whole exercise again for year-
to-date numbers.

Notice that all the reports in this section have the same categories in the
same order as the original budget. This makes comparisons between
budget and actual much easier.



Reality Check

Consider these questions about your completed worksheet:

• Are there variances from budget of 10 percent or more (and/or
$1,000 or more)? What accounts for these?

• If these variances are in the year-to-date column, are they also in
the current month, or did they take place in a prior month?
Worksheet 3.4




98
Budget Variance Report
Month-to-Date Year-to-Date
Plan ($) Actual ($) ($) Variance (%) Variance Plan ($) Actual ($) ($) Variance (%) Variance
Sales
Cost of Goods Sold
Beginning inventory
Materials purchased
Salaries & wages
Production supplies
Temporary help
Shipping supplies
Mailing & shipping
Less ending inventory
Total Cost of Goods Sold
Gross Profit
(Sales ’ Total cost of goods sold)
Gross Profit % (Gross profit/Sales)

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