SERIES 3 – Practical Guides to Operating as a v-CFO
Adding Value with Effective Financial Reporting
For any business to be successful the management team needs access to accurate insights into the business. The management and the business owner will need to spot problems when they first emerge, recognise threats, see what is working and look for emerging opportunities.
When a business owner understands the reality of the actual business performance, there will be a platform from which decisions can be made based on facts rather than speculation and anecdotal evidence. Reporting is the key to achieve this and without the right information collected in the right way, effective analysis and planning is impossible.
There are two important aspects to business reporting:
- Visibility of past performances and using this data to map a course for the future
- Business planning for the future and knowing what is around the corner
The three key financial statements
In any business there needs to be access to the three most basic of financial reports;
- The Balance Sheet
- The Cash Flow Statement
- The Profit and Loss Account
These three statements will give invaluable information that can be used to manage a company.
The Balance Sheet will show what the company owns and what the company owes at any particular point in time.
- This report can reveal the net value of a company, which is particularly useful when it comes to selling a business
- Highlight the current and long-term debt
- Asset management; how effectively the company manages its assets through liquidity ratios which assesses the ability a business has in transforming assets into cash
- It reveals the overall health of the company and its ability to service its debts
- Lenders will use this information to establish the credit worthiness of a company
- Investors too will look at the Balance Sheet as a means to assess the stability and liquidity of the target.
The main tool used to gauge a company’s profitability is the Profit and Loss. This report allows the entrepreneur, or management team, to understand the steps necessary to improve profits, for example focusing on more profitable product lines, or to target cost cutting exercises. Investors will use the Profit and Loss report to assess the return they can expect and the level of risk that investment may be subject to.
The profit and loss report can be used to assess the Gross Profit (GP) as well as net profits (NP) and observing these trends will allow an organisation to make the business changes necessary to maximise profitability. These profitability measures can be used to see how well an organisation is performing in the market place by bench marking against other competitors. Similarly, internal benchmarking will allow the organisation to compare profit margins to previous periods and see where costs are increasing, or selling prices are coming under pressure
The Cash Flow Statement reveals how a company spent its money and where the money comes from during a period of time. Typically, the flows are considered in three sections; business operations, financing and investing. The cash flow statement reveals whether or not a company has the cash to cover its daily trading activities, pay bills on time and maintain a positive cash flow
How to Interpret Financial Statements Using Ratios
Financial statement can be interpreted by using ratios. These ratios can be calculated from the profit and loss statement and balance sheet, but not the cashflow statement
The ratios measure performance and are expressed as percentages rather than raw numbers, which mean any entity can be compared with another business in the same field. These ratios help answer questions such as, are your operating expenses too high, are customers paying on time, are the levels of inventory too high, is there too much debt. Investors will also look at these ratios and assess whether these standards meet the requirements they usually lend against
There are broadly four categories of ratios to assess a company’s performance:
- Liquidity – these reveal whether a company can meet its ongoing financial obligations
- Profitability – these evaluate the ability of a business to generate profits
- Leverage – which show how extensively a business is using debt
- Efficiency – how efficiently key balance sheet assets are being used
Current Ratio: This gauges how a business is able to pay its current liabilities by using current assets only. A ratio of less than one may mean that a company could run out of cash within the ensuing twelve months
Quick ratio: Also known as the acid test ratio, focuses on immediate liquidity and assesses the extent to which a business can pay current liabilities without relying upon the sale of inventories
Defensive Interval: This is a period of impending insolvency and shows the number of days a business can survive if no more cash flowed into it. This would typically be between 30 and 90 days depending on the industry in question
Liquidity ratios allow the entrepreneur to assess whether working capital has increased, or decreased. What were the factors that influenced these changes. Are there any trends that are emerging when comparing previous periods?
Profitability ratios measure a company’s ability to generate a return on to resources at hand. They reveal whether a company is as profitable as it should be
Gross Profit Margin: Is a measure of the profitability after selling a company’s goods or services after subtracting direct costs
Operating Margin: This is also known as EBITDA (Earnings Before Interest, Tax, Depreciation and Amortisation). This is the profit after deducting indirect costs from the gross margin. If gross profit margins are rising and operating profit margins are falling, this will indicate that there is some leakage in indirect costs that needs addressing. EBITDA is a figure many investors look in valuing a company.
Net Profit Margin: Also known as the return on sales. This shows the profit delivered for every dollar of sales delivered. It can show whether the business is making enough sales volume to cover the fixed costs and leave a profit.
Decreasing profit margins over a number of years can indicate changing market conditions, increased competition, changing technological advances requiring additional investments. Very low margins can indicate that a business may be vulnerable to market shocks.
Return on Assets: This shows how effectively a company utilises its assets to generate returns
Return on Net Worth: Also known as Return on Investment (ROI). This determines the rate of return on invested capital. Investors will use this ratio to compare against other investment opportunities
These ratios measure a company’s vulnerability to risk, a leverage ratio of more than 2:1 will intimate financial weakness. Highly leveraged companies are usually considered to be more risky
Debt to Worth Ratio: This quantifies the relationship between the capital invested and the funds provided by creditors, so the higher the ratio the greater the risk to an existing, or future creditor. The lower the ratio the greater the ability of the firm to borrow money now and in the future
Times Interest Earned Ratio: This assesses the ability of a company to meet its interest payments and evaluates the ability to take on more debt
Efficiency ratios assess how well a company manages its assets;
Accounts Receivable Turnover: This calculates how many times accounts receivable are paid and re-established over an accounting period. The higher the number the faster a company is collecting its receivables and converting these debts to cash
Accounts Receivable Collection Period: This number reveals the average time it takes a company to collect money from its debtors
Accounts Payable Turnover: Shows the number of times in an accounting period a company repays its payables to creditors. The higher the number indicates an organisation is holding onto money longer and could intimate difficulty in paying creditors
Inventory Turnover: How many times in an accounting period a company sells its inventory. This is a good figure to calculate and measure over time to draw out issues such as overstocking and stock obsolescence. Faster turnovers are seen as a positive trend showing that sales are increasing and warehousing costs are efficient
Inventory Turnover Days: This measure identifies the length of time it takes to sell inventory. The fewer the days the higher the sales
Sales to Net Worth: This shows how many sales dollars are generated with every dollar invested in the company
Debt Coverage Ratio: This shows the ability of a company to satisfy its debt obligation and its ability to take on even more debt
The Main Reasons for Poor Financial & Business Reporting
There are many reasons businesses have poorly developed reporting abilities. It may be that they do not have access to an accountant that understands how to interpret data into a report that the senior management team can understand. They may not have the time or the ability to implement systems that can effectively capture the data needed.
Without doing the hard work of establishing systems and procedures to deliver accurate reporting will prevent a whole host of hardships in the future. Without an effective reporting system perpetuates a danger of confusion and the wrong decisions being made
Having business data at the fingertips of the business management will mean that anomalies can be spotted with ease. The future trajectory of the business is understood and course adjustments can be made to ensure the goal destination is met
A reporting system will assist in answering the questions that are key to managing the operations of a firm;
- How effective is the management team at controlling costs?
- Which products and services are the most profitable?
- Which are your most profitable customers and what proportion of the business do they represent
- How many sales need to be achieved to reach a breakeven point?
How can a v-CFO Improve a Company’s Reporting?
Most organisations have some level of reporting in place, but all too often the systems that need to be in place to capture data efficiently and accurately are just not there.
A v-CFO will not only be able to set up the systems required to run the business reporting, but will also identify those KPI’s required to manage the company on a daily basis. Those KPI’s can also be non-financial as well as financial in nature;
- Management accounts should be produced within 14 days of the end of each month so that data is fresh and relevant. The v-CFO can set the processes in place that will mean this goal is achieved
- Clear reporting around sales and marketing showing with clarity of what is working and what is not
- Sales leads per day
- Advertising spend yield
- Leads converted to sales ratio
- Sales per person
- Sales by region
- The v-CFO can establish operational reports that can monitor activity and pin point areas of improvement
- Implement procedures that highlight expenditure and allow management to understand their responsibility to meeting budgets and goals. Instilling a sense of cost consciousness within the organisation
- Develop budgets and forecasts with the involvement of the company’s management team and aid in the continuous profitable growth of the business
- Educate the management team on financials and financial reporting and help in driving attention to those areas of the business that can promote growth and profitability
- Identify fixed and variable costs and assist the management team in ways of controlling them
- Assess trends in the market place to make course adjustments in the budgets and forecasts where necessary to avoid knee jerk reactions and fire fighting at the last minute
The benefits of an entrepreneur, or a company’s management team having access to high quality financial management reports is a way of adding significant corporate value. Good reporting exposes weaknesses and opportunities within all the different sections of a business and allows the company to address risk and take advantage of those opportunities.
A v-CFO as an outsourced resource can accelerate the implementation of effective financial reporting and deliver real value in a space of time and cost which is far less than most company owners realise.
PARTNER & DIRECTOR OF ACCOUNTING & CFO SERVICES