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Our parents and teachers told us not to compare ourselves to others. While comparisons can be negative, as a measurement tool to assess and improve financial performance, they’re invaluable.  Financial statements tell a story in numbers rather than in words and comparisons are vital to telling that story.  It’s reading time, numbers style.

In last week’s post, I mentioned the importance of viewing income statements not just in dollars but also in percentages of sales.  But to take our analytical skills to the next level, we need comparisons.  Here are some useful comparisons when it comes to the P&L:

Comparing across different periods to identify trends:

• Current year vs. prior year (a/k/a YOY – year over year)
• Current month vs. prior month
• Current year to date (YTD) vs. prior year to date
• Trailing twelve months (TTM) vs. prior year

Comparing our numbers to competition:

• Us vs. competition

Here’s a YOY comparison of an income statement in dollars and percentage of sales.  The YOY change in dollars and change in each line as a % of sales is in yellow.  The YOY change in dollars; i.e., (Current Year – Prior Year) / Prior Year) is in green.  Below this table is a step-by-step breakdown of the story as it unfolds.

The story begins here, with Sales.

Sales increased $8M over 2011 sales, a very impressive 67% growth rate (8M/12M).

Cost of Sales represented 60% of Sales in 2012 versus 55% in 2011.  As a result, Gross Margin declined by 5 percentage points, from 45% to 40%.  That 5% on $20M of sales would have generated $1M in additional gross profit and net profit. It’s not a good sign when expenses such as Cost of Sales are advancing at a faster rate than Sales.  In this case, Cost of Sales grew 82% while Sales grew 67%.

We’re approaching the middle of the story now and you can tell it’s not going to have a great ending.  Even the attainment of great operating efficiencies and containment of overhead expenses is not likely to overcome such a big drop in Gross Margin, because individual expenses like rent, sales commissions, office salaries and such pale in comparison to the size of cost of sales.

Operating Expenses (Overhead) increased $2.6M in total overall dollars (which was necessary to operate a growing company) but decreased as a percentage of sales from 40% to 37%, which is good as it indicates that overhead is growing at a slower rate than Sales (54% growth in overhead versus 67% in sales).

Operating Income remained the same YOY (not good given the Sales growth) and Operating Margin decreased 2 percentage points, from 5% to 3% (because the same operating income over a bigger Sales number reduces the operating margin).  This is a disappointing development and shows a decline in the management of the business.

Now we’re at the end of the story.  Net income dollars were the same YOY, despite sales increasing 67%.  This means that the company spun their wheels, increasing sales without adding to the bottom line. It took on more overhead and more risk to support its growing sales.  It used working capital and likely borrowed funds or leased more space to accommodate its growth.  But without adequate gross profit to cover the overhead, it was all for naught.

Gross margin is the culprit in this story.  Had gross margin stayed the same as it was in 2011 (meaning an additional 5% of sales), gross profit would have been $1M higher in 2012 and net profit would have risen another $1M to 7% of sales.

Management must analyze gross margin by product (stock-keeping unit (SKU)) to identify which products are dragging the overall gross margin down.  It must also compare YOY changes in the general ledger accounts that are grouped in sales and cost of sales to see which YOY increases in those items exceeded the YOY increase in sales.

None of the above revelations would have been possible were it not for comparing the most recent year’s P&L to the prior year.  Without such trending, the story would be incomplete and the company would be at risk.

What’s the moral of the story? Know your margins.  If you do, your story will likely have a good ending.

My last post began the climb to a higher understanding of your income statement and how to use it to make more money.  This post takes us to the next rung on the ladder of income statement intelligence by presenting some basic P&L analysis.  By the end of it, you will know how to tell if the products or services you’re selling are profitable or if you’re losing money on them.  You can then take action on the troublemakers to increase your bottom line.

If you’re an owner or manager, this kind of analysis is critical to your success and should not be delegated away.  If you suffer from arithmophobia (a real word meaning fear of numbers or arithmetic), don’t let it get the better of you and read on with me.

Now let’s do some analysis.  Let’s assume this is our income statement in dollars.

Immediately we can see we’re a $3,000,000 company (refers to our revenues) and we’re profitable (net income is $240,000).  But looking at these numbers on their own in a vacuum just tells us the SIZE of our company’s revenues and expenses and whether the company’s profitable or not. So to know more, we present each line item as a percentage of sales as follows:

Here’s where things get interesting.  Now we can see that of every dollar of sales, 40 cents goes to expenses directly associated with purchasing and delivering the goods or services we’re selling (i.e.; cost of sales = 40%).  What’s left is gross profit, called gross because it’s before deducting operating expenses as opposed to net profit, which is after deducting operating expenses.  Gross profit must be enough to cover operating expenses and other expenses such as interest expense and still have some left as our profit.  Gross profit as a percentage of sales is the most CRITICAL of income statement ratios for managing profitability and is called Gross Margin.

Here’s why it’s so important a ratio.  It helps us determine if the products or services we’re selling are profitable enough on a gross basis to cover our overhead and leave us with our desired profit.  If we source a new product that will give us gross margin of 40% knowing that our operating expenses cost us 48%, then we should reject such product.

If we look at the gross margins of individual products or services that make up our product line, we’re likely to identify some that do not earn sufficient gross margins.  These should be addressed immediately.  If our overhead has been streamlined as much as possible and can’t be reduced materially, then either we can increase the sales price, reduce our purchase cost, or discontinue the product.

Another important income statement ratio is net margin, which is net income as a percentage of sales.

Let’s say we want to earn a net margin of 10% of sales next year.  How much must our gross margin be to allow us to earn a 10% net margin?  Working backwards, let’s calculate it.

This means that our Cost of Sales can’t be more than 38% of the sales price to yield a gross margin of 62%.

Let’s say that our cost of sales is composed of the following:

If we know that shipping costs us 10% of sales, and we need a total cost of sales percentage of 38% to make our gross margin of 62% and net margin of 10%, then our purchase cost of goods cannot exceed 28% of sales price.

So if we have a product we can sell for $10, we can’t pay more than $2.80 for it (28% purchase cost).  Otherwise, we’ll lose money on each sale and no amount of volume will make this product tolerable.  The more we sell of a losing product, the more we lose.  This is valuable to know and should inform us in pricing our goods, negotiating prices with vendors and deciding which products to keep and which to drop.

So thus far, the key takeaways are to know how your income and expense accounts are grouped in your income statement and the percentage each line item in your income statement bears to sales (i.e.; your margins).  Make sure your income statement groupings are consistent with your industry’s practice and are informative enough to run your business.  If you have any questions, ask the CFO.

In my next post, we’ll delve a little further into how income statement analysis can make you more money.  In the meantime, do you know what’s in your margin?

This blog post is the first in a series that deals with how to utilize your income statement to make more money.  But before I dive into that, let me begin with a quick refresher.

The income statement (a/k/a operating statement, statement of operations, profit and loss statement and P&L), tells the story of how well you’re operating your business.  By operating your business, I mean generating sales, controlling expenses and maximizing net profit (a/k/a net income).  In short, the income statement is your report card grading how profitable you are.

Like school report cards, the income statement grades your performance over a period of time (month, quarter, year, trailing-twelve-months (TTM)).  It condenses all your sales and expense transactions into useful line items, which then enable you to price your goods or services adequately. Knowing what is included in each line item is vitally important to managing your profitability.

Here are the typical line items in an income statement.

Net Sales equals gross sales plus freight charged to customers less sales discounts given to customers less sales returns by customers.

Cost of Sales equals all direct costs (raw materials and labor) plus indirect costs (manufacturing plant and warehouse costs) required to get the products you sell produced or services you sell delivered.  In addition to these product costs is the cost of shipping such goods to the customer, which are also included in cost of sales.  In short, all costs directly related to your products or services sold are costs of sales.

Gross Profit is Net Sales less Cost of Sales.  It is the amount of money earned by delivering your goods or services and must be sufficient to cover the operating expenses of running your company plus earn you a profit.

Operating Expenses include research and development costs plus sales and marketing costs plus general and administrative costs (e.g., purchasing, customer service and accounting staff, office rent and supplies, legal and accounting fees).  In other words, these are costs of running your business as opposed to costs of producing and delivering your product or service (i.e., cost of sales).  It is commonly referred to as overhead due to the pressure, I suppose, that owners feel having all these expenses hanging over their heads and needing to generate enough sales and gross profit to cover them.

Operating Income equals gross profit less operating expenses.  It differentiates income derived from operating your business as opposed to non-operating income and expenses.  It is the number used by banks to determine how much debt-service your company can pay.

Other Income and Expenses includes non-operating P&L items such as interest or dividend income, extraordinary income or expense, and interest expense.

Companies group things differently.  One company might include an expense in cost of sales that another company includes in operating expenses.  There is no absolute right way to do it, but I recommend that you group things similarly to your competition so that comparisons to their numbers and industry data are as apples-to-apples as possible.

Enough terminology.  Are you ready to add to your wallet?  Then visit my next post where we’ll take financial management to the next level.

The head of accounting and finance is the Chief Financial Officer (CFO), who quarterbacks and oversees all of the accounting and finance functions below them AND serves as strategic advisor to the CEO.  Most businesses don’t have a CFO.  Yet extremely rare is the company that doesn’t need one.  There are just too many spinning plates in accounting and finance for a company to do them all well without a leader.  Head coaches hire assistant coaches. CEO’s hire CFO’s, COO’s, CMO’s, and CTO’s.  Operating without such a leader is like putting a car in drive without a driver.  It’s going to zig-zag, possibly crash, and not arrive at its desired end point.

Look at the accounting org chart (job descriptions for each) below and see how many moving pieces there are to manage.  Each of those positions requires a specialist.  No generalist can do all of them well.  You might think your business doesn’t need all of those disciplines, that that’s for big companies.  If so, show me one of those functions your company doesn’t need.

Affording all of that is another thing altogether.  The good news is that you don’t need to hire each of these positions.  Full-time staff should be strategically hired to perform a combination of some of these job functions.  The rest can be cost effectively outsourced on a part-time basis.  Oh sure, you’re thinking, where am I going to find all those part-timers that have the desired expertise and are available on a part-time basis for just the amount of hours their tasks require?

That’s where a corporate financial management firm (CFM firm) such as CFO & Co. comes in.  We are the rest of your accounting department, filling in gaps that exist.  You don’t need to live “without” anymore.  You can cobble together all that you need for way less than you think.  Why?  Because it’s available part-time for just the hours you require.  All of those job positions handle vital tasks but not all of them are full-time jobs.  Some may require an hour or two a month, others eight hours a month, and still others maybe none this month and four the next month.  You can have total flexibility but still get the expertise you require.

That’s why we like to say we’re your financial Swiss army knife, a multi-purpose tool to tighten the nuts and bolts of your business, cut costs, open new opportunities, and file on time, to name a few.  If you would like some ideas on how to have better financial management in your company, let us show you how our clients are using us and achieving dramatic returns on their investments.

How do you know if your accounting and finance department is missing key functions and thus, leaving critical value-adding tasks undone?  This post will help you answer this question correctly.

Below is a highly detailed accounting and finance organization chart that you might see at a large company.  Read the related job descriptions and focus on the tasks performed.  You’ll quickly see that you need these tasks done.  But you don’t need the whole org chart FULL-time.  That’s where filling in the gaps with part-time experts delivers the value you seek.

If, as Stephen Covey put it, you begin with the end in mind (for most of us, it’s making more and working less), let us help you assess how to get all these tasks done by consolidating them amongst your internal staff and outside part-time consultants.

A recent Interim role

We were already serving as the part-time CFO when suddenly our client terminated its accounting staff, leaving an interim void to be filled. Because of our familiarity with the client’s business, books and personnel, we instantly stepped in and provided an accounting safety net and while we were at it, installed some financial infrastructure that was missing. Here’s the story.

Background. Our client had evolved from a start-up and hired us as their CFM firm.  Our CFO was serving as their part-time CFO, advising their CEO and quarterbacking their financial management.  When the crisis arose, our staff stepped in as their interim accounting department, getting bills paid, billing customers, paying payroll, assisting in office and human resource duties and closing their books.

Improving the systems.  First, we organized the Accounting, HR and Office Management areas (i.e., the back office) that showed signs of neglect.  Next, consistent with best practices, we improved the chart of accounts by grouping items in a more organized way and we set up project costing.  Using our templates, we implemented month-end closing work papers that documented the contents of all balance sheet accounts (this is the foundation of a good closing process).

During this time, we noted an unsustainable systemic weakness and inefficiency in expense reimbursements to the client’s widespread workforce. We initiated the issuance of corporate credit cards to employees and implemented our expense report template and policy to streamline and tighten up this vital function. We then set up online banking to download the many credit card transactions for easy coding and entry into the general ledger.

The happy ending. Finally, through our many contacts, we introduced our client to an outstanding Bookkeeper/HR Manager/Office Manager who they hired.  We then oriented her to the accounting and HR systems that we had refined while serving as their interim accounting department and seamlessly handed it off to her.  She inherited a more structured and streamlined department than existed prior to the crisis and was able to immediately hit the ground running.  Nary a beat was missed during this time and crisis was averted.

In this example, having us as their CFM firm proved quite valuable for this client.  It was like having insurance against a disaster.  We truly were their financial Swiss army knife.  CFO advice plus interim accounting services plus introduction to their new employee.  And all without fixed overhead.

Let’s look at a recent Task we handled

Background.  A real estate developer bought a valuable piece of property in a hot area and brought in a joint venture partner to assist with capital. The developer became the General Partner (GP) and the capital partner the Limited Partner (LP).

The JV gave the GP and LP a preferred return on their capital investments and thereafter they split profits 90% LP / 10% GP. As an incentive to the GP to maximize profits from the project, the JV provided a waterfall (a bonus arrangement) split of profits on a graduated scale (the more the profit, the more the GP’s split of the profit increased). Legal papers were drafted but the partners were struggling to agree on the definitions of financial terms and formulas for determining the waterfall split of profits. The GP asked CFO & Co. to assist in clarifying such terminology and formulas.

An ounce of prevention is worth a pound of cure. Well-informed and intentioned attorneys often put financial terms and formulas in their agreements, but as in this case, sometimes their terminology and formulas don’t provide the accountants the clear road map needed to later execute such calculations. Misinterpretations between parties happen as a result. Such misinterpretations can be easily avoided by putting the “accounting” specificity into the document.

Our remedy. After gaining an understanding of the deal from conversations with our client and reference to the financial model of the deal, and then reading the documents, we sussed out the true workings of the waterfall calculation. Working with the legal team, we defined the terms and described the calculations in a way that was both clear and concise. Both parties were satisfied.

For their investment of a couple hours this task took us to complete, the client clarified the crux of the financial terms of their agreement and avoided potentially disastrous confusion down the road. A simple task like this is one of the ways clients gain an advantage by using us as their CFM firm.

With hurricane season upon us, I want to walk you through a recent engagement with a technology-reliant e-commerce retail client in South Florida who was concerned about saving his business should it sustain a total loss after a fire or natural disaster.

Disaster planning can be emotionally difficult for owners, which, in addition to our expertise, is why they engaged us to help. We’re less emotional about it and can get it done quickly and expertly. And once in place, it’s there forever.

The bottom line is that if a disaster occurs, you could easily lose your business, your income and your wealth. The same will be true for your employees and investors.

Business interruption insurance isn’t enough

Our e-commerce client had business interruption (BI) insurance. But as we thought about the aftermath of a disaster, it became apparent that even with adequate limits of BI insurance, they could still lose their business after a total loss. Why? If consumers visit their website to buy product and it’s down for any more than a few days or a week, even loyal customers will buy from their competitor’s website. So speed to full restoration is a much better solution than relying on BI insurance.

Find an alternative location and line up key service providers

Assuming their office and warehouse were destroyed, what would they do? They would need to replace their warehouse and office space, inventory, office furniture and equipment and communications capabilities. And they would need the money with which to do so. So here are a few of the steps they’re taking in advance to be able to regain full capacity immediately after a disaster:

• Searching for contingent warehouse space within one hour away so their employees can continue working

• Lining up an out of town IT firm to jet in and replace their equipment and connectivity (they’re assuming their local IT company will either be down or stretched too thin to immediately address their needs)

• Maintaining a healthy line of credit with a bank with which to fund inventory replenishment and restoration of operations ahead of receiving a check from the insurance company (which could take weeks if a major storm hits)

 Beneficial by-products of disaster planning

During our disaster planning, we came up with an idea that could potentially kill two birds with one stone. This client’s warehouse in South Florida services all of its US business. We realized that it might make sense logistically to open a second warehouse in the western US to save inbound and outbound shipping costs. Such a facility might then serve its disaster recovery needs too by being up if the South Florida facility is down, or visa-versa.

A project like this disaster plan need not be expensive. Brainstorming about the aftermath of a disaster and writing a skeletal list of advance measures to take could be done for as little as $1,000.

We can assist you in the rest of your risk management too, including insurance. If you want help calculating property and business interruption limits and purchasing insurance in the optimal way, we can do so quite affordably.

This is just one more example of the kinds of projects we can do for you on demand, and a la carte.