Is it possible to make a profit and not have any cash? Is it possible to make a profit and not have a good return on investment? Is it possible to have cash without making a profit?
The answer to all three is yes, but, not for very long. It is like sitting on a stool with three legs of different lengths. The long term success of your business requires that all three legs of the stool be equally balanced.
So, how do business owners make sure that all three legs are in balance?
First, business owners should know there are two basic views on profit. There is the “financial” view which is traditionally presented in the following financial statements:
1. Income Statement
2. Balance Sheet
3. Statement of Cash Flow
Conveniently, there are three statements and three legs of the stool, each having a direct correlation to the other. Financial statement information helps business owners measure financial outcomes, like return on investment or liquidity. Financial statements also help monitor historical data or trends and serve as a benchmark for budgeting. Business owners need to have a proper understanding of how the statements work and also have access to timely reports in order for the financial statements to be most effective.
That said, some basic financial definitions:
The Income Statement reflects activities over a period of time; for example, one month, one quarter or one year. Business owners are often very familiar with this statement and use it to keep score of how well their company is performing. The basic equation is Revenue – Expenses = Profit.
On the other hand, the Balance Sheet is a snapshot of a business’ financial position at any particular point in time; for example, September 30, 2013. The basic equation is Assets – Liabilities = Equity.
For those starting to fade with financial information overload, yes, the Balance Sheet matters. This sometimes comes to a surprise to those business owners who are primarily focused on the Income Statement. Companies can have strong Income Statements with upside down Balance Sheets and struggle to grow or secure financing from lenders.
I’ve had many conversations with business owners who have strong Income Statements and strong Balance Sheets but insufficient cash.
The Statement of Cash Flow usually perks business owners back up because cash flow is often an area of business that keeps business owners up at night. Of the three financial statements, this one is often the most critical to business owner’s decision making, but can also be the most challenging to understand. Simply stated; the Statement of Cash Flow is the link between the Balance Sheet and the Income Statement.
But, if it were only that simple; most business owners will testify timing of income and expenses is imperative. When income exceeds expenses, there is profit but only if the income is collected is there adequate cash to cover expenses to keep the business operating – darn those “aging” accounts receivable.
As you can see, profit and cash flow are not always synonymous or in alignment. Understanding how to convert profit to cash flow is critical. Again the Income Statement keeps score during a certain period of time and the Balance Sheet shows what the business is worth on any given day but the Cash Flow Statement measures real time movement of money and mirrors the reality that many business owners face managing the ongoing demands of operating a business. Having a strong understanding of your financial statements allows business owners the ability to make more informed decisions.
Now back to the second view on profit, the business “performance” view. The business performance view is a reflection of day-to-day activities or business drivers. There is no statement per se, but rather leading indicators or key performance indicators (KPIs).
These indicators help business owners look forward to help influence or drive financial outcomes. This nontraditional equation is People X Process = Profit.
The reality is most business’ profitability depends on how well its people consistently perform specific activities. Measuring leading indicators provides business owners with real time information to make critical decisions and also provide feedback to its people about their performance.
Business owners understand what drives their company’s success even if they don’t always have a financial statement on hand or understand everything the financial statements are saying. There are literally hundreds of potential KPIs to monitor but because each business is unique, it is important to identify KPIs specific to your business.
For example, an orthodontist can predict profit by the number of new patient consultations are scheduled because he has measured the percentage of new patient consultations that result in actual new patient starts. In real time, he has an indicator to gross profit.
Instead of knowing the practice wants to improve the bottom line by 10%, the practice now has an activity that links with a financial outcome. The team’s goal is to schedule five new patient consultations daily.
People typically perform best when they understand the rules of the game and how the score is being kept. So, by linking business drivers with financial outcomes, businesses can identify key activities that drive the bottom line and measure the results.
Measurement drives performance.
In summary, understanding how financial statements are linked coupled with identifying business drivers helps business owners better manage key performance indicators and drive financial outcomes.
So how is your team performing? Do you know your “financial” score?