Finance for non financial managers
Finance is one of those areas where the arcane terminology and concepts can present a barrier seemingly so formidable that many people are tempted to file it away as ‘too difficult’ before even starting to investigate. In this tutorial I want to highlight the fundamentals of finance and explain these in some depth. It would be wrong to describe these as the ‘basics’ because it implies that, as your understanding advances, these areas become less important. What is covered is as important to the owner of a newsagent as it is to the CEO of a blue-chip multinational corporation: both types of business can fail for the same types of reasons. It is more accurate to describe these areas as the top priorities, to be kept in the foreground no matter how far up the career ladder you advance.
Understanding the Limits of Financial Information
One of the first things to understand about a set of financial accounts is that the information is not as robust as commonly believed. The amount of judgement involved in preparing some of the figures would surprise most people if they knew it. I should immediately point out that I’m not suggesting the numbers are incorrect in any way. The judgement that will have been exercised will have been the management’s best judgement, and it will have been subject to audit. But it will still be a judgement and, as such, open to error or misinterpretation.
This is relevant because some numbers in the accounts are less prone to judgement than others and consequently more reliable. For example, in most industries, ‘turnover’ (I’ll use the more familiar term ‘sales’ from now on) is the least susceptible to judgement. Of all the numbers in the accounts, sales figures are the most robust, but even sales are not completely unambiguous. For example, if a company gives a discount coupon when it makes a sale, it is a matter of judgement how many people will redeem that coupon and therefore how big that discount will in practice turn out to be. Such schemes can be a big part of some industries where the difference between net sales (the figure in the accounts) and gross sales (sales before discounts) can be quite significant. Most difficult of all is in long-term engineering projects. Here the decision about how much income in, say, a four year construction project, to ‘recognise’ in any single year can have a major effect on reported sales turnover. And finally, I’ve worked in companies where shipments around the year-end were held back or accelerated to ‘smooth’ the results towards a certain sales target. However, leaving aside all these exceptions, as a general rule you can have the highest confidence in the sales figure.
Wariness of the figures should increase the further down the Profit and Loss Account you go. Again, let me be clear. I’m not suggesting the figures are manipulated. Rather, the necessity of making judgements multiples. It’s probably more accurate to think of the net profit in a profit and loss account as managements’ peer-reviewed ‘best guess’.
And a balance sheet? How solid is that? Well, from an audit point of view, it’s probably had the most amount of time spent on it, with each number independently verified, although there is judgement here too. It is however only a snapshot for that day. The next week, or month, it could change significantly, so I’m afraid the balance sheet also is vulnerable to significant swings in the numbers.
I worry I’m making matters more confusing, instead of helping. If so, I don’t apologise. It’s important to have a healthy scepticism of financial figures. You have probably read about companies that have lurched from a seemingly healthy position to an unhealthy position. Assuming there is no fraud involved, how could this happen unless the financial figures were in some way flakier than they had previously appeared? Confusion about sudden changes is probably the biggest turn-off for people trying to interpret financial information. Understanding why this might happen, and living with this apparent ‘flakiness’, is the first step to de-mystifying financial information.
What Can I Rely On?
Actually, by themselves, a set of financial accounts don’t tell you very much. You have to make comparisons either with previous years or with other figures in the accounts before insights start to reveal themselves.
Sales
The very first thing to look at is sales. Are these rising or falling? Answering this simple question tells you quite a lot about the company. Whatever the answer, the next question you should ask yourself, is ‘Why?’ And instantly we’re back in the realm of the limitations of financial accounts: the numbers won’t tell you why sales are rising or falling. You have to reach that conclusion yourself by other means. This is why non-financial managers have no reason to lack self confidence around financial figures. They have the same capacity as an accountant to dig for reasons behind sales trends. What is the company’s market share? What are its competitors doing? What is their marketing strategy? These are all general business questions that any experienced manager can address. Being able to interpret the financial accounts enables you to ask right questions, but the answers will lie elsewhere.
Profitability
Unlike sales, where customer demand influences the outcome, profitability is, to a much greater extent, under management control and, probably as a result, gains greater attention. Here there is one metric above all that you should be aware of: gross profit margin (which I’ll shorten to the more commonly used ‘gross margin’. Gross margin is expressed as a percentage. It is calculated by dividing gross profit by sales. It contains a lot of information and should be monitored closely. Even small changes in gross margin (ie fractions of a percentage point) can be a cause for concern or celebration.
Gross margin represents the profit made on every £1 of sale. It is the measure of profitability that most closely aligns to the concept of ‘variable’ profit. This concept simply means that if sales goes up 10%, the gross profit will go up 10%. Understanding relationships of this kind are critical to understanding how your business works, and allows you to carry out forecasting, financial modelling and scenario planning. For these more advanced techniques the non-financial manager would expect to work together with a finance colleague and so awareness of the usefulness of gross margin is all that’s needed here.
The first thing that gross margin tells you is something about the nature of the business. Unfortunately this is where experienced accountants will have the advantage over non-financial managers. When you’ve worked in several different industries or just studied the accounts of different companies, you start to understand that gross margins follow certain patterns which, taken together, give you a frame of reference against which to compare the gross margin in any single company with what you might expect in their industry and come to a judgement whether their profitability is ‘good’ of ‘bad’.
If a company has a high gross margin it means it is charging its customers a significant premium over the costs it directly incurs in getting their product or service into their customers hands. As you might guess by now, the next question is ‘Why is it able to do that?’ There can be many reasons. The least palatable is that it is simply in a monopoly position in its market and can ‘get away with it’. Microsoft’s gross margin in 2011 for example was 78%. Another explanation is that the company is supplying a premium product which is highly valued by their customer. Apple’s gross margin in 2012 is 44%. The most common explanation is borrowed from economics. If a company is adding a lot of value to its raw costs, then it is reasonable to charge a higher price. This is why gross margins tends to follow trends from industry to industry. For example, a manufacturer takes a lot of raw materials that are not worth anything on their own and turns them into a highly valued product – a bottle of whisky, for instance. Manufacturers tend to have high gross margins (40%+). A wholesaler imports a lot of products from manufacturers in different countries. These raw materials have already had a lot of value added to them by the manufacturer, but still, the wholesaler’s knowledge of a complex supply chain and willingness to hold stock that can be easily distributed in smaller quantities, adds significant value. Wholesalers tend to have moderate gross margins of, say, 20%. Retailers buy in finished products from wholesaler’s warehouses and stack it on to shelves for consumers to buy. In the whole value chain, they are probably adding the least value. Retailers tend to have quite low gross margins. Tesco’s for instance in 2013 is 6%.
With this background knowledge it becomes easier to interpret the financial accounts of any one company. For example, if you are looking at a manufacturer with a gross margin of 25% then very possibly the company is in trouble.
To fully appreciate why movements in gross margin are important, you need to know more about the costs that come ‘below’ gross margin. Principally these are overheads, but included in this category could be interest payments and tax. The crucial insight is that these costs are, within the short-term at least, fixed.
There is nothing more dangerous to business than fixed costs. To labour the point, these are costs you need to settle no matter what’s happening to your sales. They are potentially terminal if you don’t keep them under control. For our purposes, it’s important to understand that, because your fixed costs are, well, ‘fixed’, the effect of any changes in gross profit is magnified, in both directions. The table below illustrates this ‘leveraging’ effect.
It is because of this magnifying or leverage effect that even small changes in margin are to be closely investigated.
Having placed gross margins in context and explained why small changes can have a big impact, there are more subtle investigations or questions that can be made from looking at gross margins and considering what other information is available, either in the accounts themselves or in your wider knowledge.
There are a number or reasons why margins can change. Companies like Easyjet and Ryannair for instance have been able to increase margins without headline price increases. This has been achieved by pricing little extra services such as ‘speedy boarding’, charging for use of a credit card, for example. They may not have advertised this information but if you can see their gross margin increase you can infer that this is what might be going on in the background. Staying with the airline industry, if you know fuel prices are increasing and you see an airline’s margins decreasing, you can infer that they are unable to pass on these price increases to customers and profit margins are getting squeezed.
There are lots of questions of a similar nature that can be asked. If a drug company’s margins are falling, are some of their patents expiring? If a company is investing heavily in its brand advertising, can you see it having an impact by sustaining already high margins, or even increasing margins by increasing its brand appeal? The accounts won’t answer these questions, but many of the things the company will be doing or considering would be expected to show up in the gross margins at some point, so it’s always worth keeping your eye on this metric.
Mysteries of why Profit does not equal Cash
Probably the biggest single source of confusion for non-financial people is the apparent inconsistency between ‘profit’ and ‘cash’. It is absolutely critical to be aware that these are not the same thing and that a profitable company can go bust just as an unprofitable company can carry on trading for a surprisingly long time before it eventually succumbs.
Intuitively, profit must equal cash, right? ‘Broadly correct’, is how I’d answer that. Here’s why:
If we ran a market stall, buying and selling all our stock each day, in cash, and never had to fork out for any assets such as a new van, and paid our taxes to the tax man at the end of the day, then the profit we make would indeed accumulate in our bank account as cash. However, modern businesses are a complex interaction of transactions carried out on credit, where huge investments in fixed assets have to be made, loans are taken out and have to be repaid, and where some transactions, such as tax, are settled quarterly or annually. In this environment, there may be little or no correlation between profit and cash.
Cash Flow
Because cash flow can follow a quite different pattern to profitability, you have to monitor both separately. There are metrics, like ‘return on capital’ that trying to blend both concepts into the one measure, but I’d recommend the non-financial manager ignore these and just accept the fact that you need to follow both measures separately.
Where can you find out about the company’s cash position? Unfortunately, this is not always as easy as you’d think. The balance sheet doesn’t always help because often cash is netted off against loans to arrive at the unhelpful term, ‘net debt’. However, there is a third report in any set of financial accounts and it’s called the ‘Cash Flow Statement’. This starts with the same intuitive position that profits equal cash to which it makes several adjustments that, cumulatively, add up to the net change in the company’s opening and close closing cash position. Unfortunately, some of these adjustments may be expressed as movements in opening and closing balances, so you have to keep your wits about you. Nevertheless, you may find some interesting things in a cash flow statement and it repays some investigation. For example, if the company’s loan account was £1m last year and £0.5m this year it means that £0.5m of cash was used to pay down a loan. Equally if fixed assets were £20m last year and £25m this year, it means £5m cash was used to fund capital expenditure. The balances will show up in the balance sheet and the cash flows should show up in the cash flow statement.
Managing Cash Flow
So, finally, we arrive at what really is the basic component of any business: managing cash. I’ve left this to last because most non-financial managers will probably not be asked to worry about cash flows in their jobs, and profitability will be closer to their ‘day job’ or conversations around the boardrooms. Nevertheless, there’s only one reason businesses go out of business: they run out of cash. And this applies no matter how big or small the business. Because so much of my consultancy life has been working with companies under some manner of financial pressure, the cash position is often the first thing I look at, even before profitability.
For the non-financial manager, there are two things to focus on when managing cash flow. The first is capital expenditure, the second is loan activity. There are metrics that can help here but, it is just as easy, to monitor the raw data.
Capital expenditure can kill a business. These are large one-off payments for fixed assets such as equipment, vehicle fleets, new warehouses or refurbished offices. In a short space of time, capital expenditure (sometimes shortened to ‘capex’) can drain a sizeable bank balance, turning it negative.
In financial theory, it can make good sense to finance such long-term assets with long-term loans, so having loans per se, is not something that should cause you concern about the financial health of the business. However, you should seek information (it may sometimes be in the notes to the accounts) on what terms the company has borrowed. A company may have financed the building of a 30 year-life factory with shorter-term, say 5 year, borrowing. In this case you need to be confident that the money will be there to repay the loan in 5 years. Also, although it’s a little technical, loans frequently come with conditions called ‘covenants’ that place restrictions on the company that, if broken, may grant the loan provider powers over how your business is run which will be unwelcome and could trigger bankruptcy. The non-financial manager doesn’t necessarily need to know the details; awareness of the risks is sufficient to ask the right questions.
It is a theme in this tutorial that the really interesting information is not in the financial accounts. When it comes to cash, what you really want to know is a cash flow forecast. Unless you’re on the inside of a business’s management team, you won’t get this information, but it is one of the most important pieces of information that your finance team will produce.
Summary
There are three priorities the non-financial manager should focus on when seeking to interpret a set of accounts:
I. Sales
II. Profitability
III. Cash
The financial accounts will help you ask the right questions but never forget the answers will lie elsewhere. A set of financial accounts are a record of the past but the things that help you determine whether a company is in good or bad health are usually concerned with the future. Interpreting accounts is just the beginning of your investigations.