What You Need To Know
So far we have looked at short-term cash issues; what generates cash in the long term, however, is profit. This chapter therefore attempts to demystify the terms surrounding financial information and, in so doing, to show how you can use financial information to understand and control your business.
The two key areas you should measure and understand are profitability and financial stability. Profitability includes the types of costs you incur; gross profit, contribution and breakeven; profit improvement; and cost drivers. Financial stability considers liquidity and gearing.
The keys to using financial information, therefore, are as follows. You should:
- use profit centres;
- control and analyse cost trends;
- use cost information;
- quantify management decisions;
- use management accounts;
- monitor returns; and
- monitor your working capital cycle.
Having measured your performance, it is important to realise that the absolute results for any company at any particular date tend to be less important than the use of the information to measure trends over time (e.g. growth) and to benchmark performance against others. You should also appreciate that financial figures are produced as a result of what you are doing to run the business. They are the symptoms and evidence of what is happening, not the cause of what is happening.
However, once you are measuring your financial performance you can set financial targets for your business (e.g. reducing your average debtor payment time to 45 days by the end of the first quarter) as part of your plan, and use this financial information to monitor your progress. And the actions you will have to take to make these financial results appear will be real actions in the real world, such as setting tight credit terms for your customers, issuing statements, picking up the telephone to chase in the money when it is due and putting customers on stop if they don’t pay.
Profitability
Profitability means measuring whether you are making any money, finding out what you are spending money on and understanding how much business you need to have in order to make a profit.
Types Of Costs
To understand your profitability, you must understand your cost structure. There are various types of costs for any business (see
Figure 16). Fixed costs are, of course, not fixed in the long term (you can move factory or hire and fire factory staff) and will eventually reflect levels of production and activity. A profit and loss account, however, will only divide costs into two broad areas:
Businesses differ as to how they categorise direct fixed costs as either cost of sales or overheads. If you do not include all your direct fixed costs in calculating your cost of sales, you risk underestimating your costs when it comes to setting prices or tendering for contracts. The result of continuously selling at less than your true cost of manufacture (i.e. at a loss) is, inevitably, failure. It is generally best, therefore, to include your direct costs as fully as possible in establishing your cost of sales.
Fig. 16.
Types of cost.
If your production volumes swing significantly between periods, however, you will need to be careful in using cost of sales to establish a meaningful ‘contribution’ figure for sales, and you may find it best to treat all fixed costs as overheads for the purpose of calculating break-even levels.
Gross Profit And Break-Even
The first important profit figures are your gross profit and gross profit percentage as these are used to calculate break-even.
Example
Company K sells each of its widgets for £150. Its cost of sales per widget are:
- raw materials (£50)
- labour and manufacturing costs (£50)
Its gross profit per widget, therefore, is £50. Based on gross profit/sales, its gross profit percentage is 33.3% or £50/£150.
Company K has overheads of £1,000 per month. As its gross profit per widget (or ‘contribution’ towards covering overheads) is £50 per widget, it has to sell 20 widgets a month (£1,000/£50) before the total contribution is sufficient to cover all the overheads, (or to ‘break even’).
Its break-even turnover is therefore £3,000 per month (£150 x 20).
This break-even has used ‘accounting figures’ based on costs taken from the profit and loss accounts. However it is often useful to redo this exercise to calculate a ‘cash break-even’, stripping out the key costs that do not represent cash (e.g. depreciation) and replacing this with the real cash item (e.g. lease payments).
Example
Company K’s overheads include a £100 depreciation charge and a £50 HP interest charge per month. The HP payment per month is in fact, £250 (£50 interest and £200 ‘capital’ payment). So Company K’s overheads restated on a cash basis are as follows:
As a result, its break-even turnover on a cash basis is 22 widgets or £3,300 per month.