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Oct 25, 2024 Financial reporting can be confusing to the average small business owner. They didn’t train in it, and the professionals they hire to help them with it often focus on tax rather than managerial accounting. There are a lot of numbers on those financial statements. If we can get the management team to focus on seven key financial metrics and consistently improve performance on them over time, the impact can be significant.
Inflation, rising interest rates, tight labour market, supply chain issues…it’s never been more important to understand your financial reporting than now. Why does it have to be so complicated? It’s like they invented a whole other language just to confuse us. Let’s have a quick quiz:
Q1. What’s the difference between an Income Statement and a Profit and Loss Statement (or P&L)?
Nothing! Accountants have a frustrating tendency to use different words to describe the same thing. Oh, and by the way, a Statement of Income and Statement of Operations are also synonymous with Income Statement. They also use words weirdly.
Q2. If I receive a deposit for services, does it show up on the P&L or the Balance Sheet?
Balance sheet. A deposit is a liability (shouldn’t it be an asset – oh wait, it’s an asset too!). It doesn’t even make it to the revenue category on the P&L until you deliver the service. Yes, we have the cash, but we also have an obligation to provide the service. You don’t get to recognize that cash as “revenue” until the work is done.
The point here isn’t to come down on accountants – they have a job to do and in small business we often hire them to optimize for tax efficiency, not realizing there’s a whole world of managerial accounting we may be missing out on. It’s also not to come down on businesspeople – they got into business to do their thing, not learn a new financial language.
Managerial accounting helps companies understand the story behind the numbers and how to run a more efficient and effective organization based on what the financial statements show. A small business that is running in a relatively stable market can get away with not understanding their numbers for a long time. They’ll be leaving a lot of money on the table, but they probably won’t realize it. But add in some changing market conditions and the urgency to understand the numbers amps up considerably.
James Clear (known for his very worth while read Atomic Habits) relays the story of British Cycling and it’s rise to success in the Tour de France. With this simple story he illustrates that a series of 1% increases in performance can lead to exponential growth, and similarly a series of 1% declines can have a catastrophic impact. This holds true in business as well.
Take, for example, a small engineering firm that does about $3m in revenue at about a 45% gross margin. A 1% price increase will lead to an extra $30,000 in net profit. That’s a lot of money! If cash flow is a concern, paying bills just 1 day later and collecting receivables just 1 day earlier will improve cashflow by $15,000, which is also a lot of money for a small business.
Every business manager looks at the P&L. They might not understand what they are looking at or how to impact it, but humans like to keep score and revenue and profit are easy ways to do so. And they are important numbers, they’re just not the only numbers. A manager has four levers when it comes to impacting profit. Don’t worry about all the weird technical terms, just consider the actions you can take to impact the numbers for the better.
Definition: Revenue refers to the total amount of money generated by a company or an organization from its normal business operations. It represents the income received from selling goods, providing services, or any other primary activities undertaken.
AKA: Sales, Income, Gross Revenue (total revenue earned by a company before any deductions, such as taxes or expenses), Net Revenue (revenue remaining after deducting any returns, allowances, discounts, or refunds), Top Line, Gross Sales.
Where to find it: Income Statement
Owner: Head of Sales & Marketing
How to impact: Prices, volume.
Definition: Gross Margin % measures the profitability of a company’s core operations. It represents the percentage of revenue that remains after deducting the direct costs (Cost of Goods Sold or COGS) associated with producing or delivering goods or services. Gross profit margin is a key indicator of a company’s ability to generate profit from its fundamental business activities.
AKA: Gross Margin, Gross Profit Margin, Gross Income Margin, Gross Profit Percentage, Gross Operating Margin, Gross Margin Percentage, Gross Profit on Sales.
Where to find it: Income Statement. To calculate the gross profit margin, you subtract the direct costs from the revenue and then divide the result by the revenue.
Formula: Gross Margin = (Revenue – Cost of Goods Sold) / Revenue
Owner: Head of Operations
How to impact: Increase efficiency, improve purchasing,
Definition: Overhead percentage, also known as overhead ratio or overhead rate, is a financial metric that measures the proportion of overhead costs incurred by a company in relation to its total sales or revenue. It provides insight into the efficiency of a company’s operations and the extent to which overhead expenses impact its profitability.
AKA: Overhead Rate, Overhead Ratio, Operating Expense Ratio, Indirect Cost Percentage, Burden Rate.
Where to find it: Income Statement. To calculate the overhead percentage, you divide the total overhead costs by the total sales or revenue and then multiply the result by 100 to express it as a percentage.
Formula: Overhead Percentage = (Total Overhead Costs / Total Sales or Revenue) * 100
Owner: Head of Finance
How to impact: Negotiate fixed costs, review software license spend.
Definition: Operating profit is a financial metric that measures the profitability of a company’s core operations before considering interest and taxes. It represents the profit generated from a company’s normal business activities, excluding income or expenses from non-operating activities.
AKA: Operating Income, Operating Earnings, Earnings Before Interest and Taxes (EBIT), Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA), Operating Profit Margin, Bottom Line
Where to find it: At the bottom of the Income Statement. Operating profit is calculated by subtracting operating expenses, such as cost of goods sold, salaries, rent, and other overhead costs, from operating revenue.
Formula: Operating Profit = Operating Revenue – Operating Expenses
Owner: Entire management team.
How to impact: Move the other three indicators.
You can survive with mediocre people, strategy, or profit. If you run out of cash though, you’re done. While the finance department can raise cash in a variety of ways, management in general has three levers to pull when it comes to improving cashflow.
Definition: Receivable days is a financial metric that measures the average number of days it takes for a company to collect payment from its customers after making a sale. It represents the efficiency of a company’s accounts receivable management and cash flow cycle.
AKA: Average Collection Period, Collection Days, Account Receivable Days, Cash Conversion Cycle, Trade Receivable Days, Days Sales Outstanding (DSO)
Where to find it: It’s a formula that uses both the Income Statement and Balance Sheet. Receivable days is calculated by dividing the accounts receivable balance (Balance Sheet) by the average daily sales (Income Statement).
Formula: Receivable Days = (Accounts Receivable / Average Daily Sales)
Who owns it: Head of Sales (agreeing to payment terms) and Head of Finance (collecting faster)
How to impact: Change payment terms, increase collections activity.
Definition: Inventory days measures the average number of days it takes for a company to sell its inventory or convert it into sales. It provides insight into how efficiently a company manages its inventory.
AKA: Days inventory outstanding (DIO), inventory turnover days.
Where to find it: Balance Sheet (inventory) and P&L (COGS)
Formula: Inventory Days = (Average Inventory / COGS) x Number of Days in Period. Here’s a step-by-step breakdown of how to calculate inventory days:
The result will provide you with the average number of days it takes for the company to sell or turnover its inventory.
NB: If your business is in the Service Industry and your accounts do not show Inventory, consider estimating the amount of unbilled work if it is material ((Average Amount of Unbilled Work / COGS) x Number of Days in Period).
Who owns it: Head of Operations
How to impact: Improve efficiency, increase time reporting frequency.
Definition: the average number of days it takes for a company to pay its suppliers or vendors after receiving goods or services.
AKA: Days Payable, Accounts Payable Period, Trade Payable Days, Supplier Payment Period, Days Payable Outstanding (DPO)
Where to find it: Payable days is calculated by dividing the accounts payable balance (Balance Sheet) by the average daily purchases (Income Statement).
Formula: Payable Days = (Accounts Payable / Average Daily Purchases)
Who owns it: Head of Finance
How to impact: Negotiate payment terms, delay payments.
How are you performing today? Don’t worry if your financials aren’t up to date yet, don’t worry if it’s been an unusual month or year – all we want is a benchmark to measure progress against.
(Note: your bookkeeper should be able to get you financials 10 days after the last day of the month. If they can’t, there’s a process problem in there, and possibly not due to the bookkeeper but due to inefficient operations reporting).
It might look something like this:
| Benchmark | Goal | Actual | |
|---|---|---|---|
| Revenue | |||
| GM% | |||
| OH% | |||
| OP% | |||
| Days AR | |||
| Inventory Days | |||
| Days AP | |||
You’ll leave the “Goal” column blank for now, but keep it as a place holder.
In the first meeting, introduce the scorecard and brainstorm actions your team could take to improve by 1%.
You got into business for a lot of reasons, but one of them was to make money. If you’ve been in business for at least three years and would like to know more about your specific company’s cash story, or you’d like help implementing a monthly financial meeting, book an appointment with us and let’s chat. It’s the repetition that gives the power.
Bellrock offers business leaders a unique perspective on strategic challenges. We also translate that perspective into actionable plans that improve results and train managers on execution. Our purpose is to develop life-long relationships and raving fans. If you found this article valuable, don’t be stingy. Share
Tara Landes is the Founder of Bellrock. She has spent over 20 years consulting and training in small to medium-sized enterprises. A sought-after speaker on a wide range of business topics, Tara has delivered workshops and seminars at conferences and industry associations across Canada. Tara obtained a BA (Honours) in Political Science from the University of Western Ontario (UWO) and earned an MBA from UWO's Richard Ivey School of Business.
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