What are the danger signals to watch out for

A potent use of financial statements is to provide information
about issues that might adversely affect trading performance in the
future. This can most readily be achieved by studying trends from one
year to the next. Clearly, a deterioration in return on equity will concern
investors, but on its own it does not tell us why this is happening
or if future trading is being put in jeopardy. Trends in gearing, asset
turnover, and profit margin are far more useful in this respect.
Is there an increase in gearing?
Increases in gearing could potentially improve return on equity.
However, this must be viewed in the context of the potential risks.
T What is the ‘interest cover’?
This is calculated from the income statement, by dividing operating
profit by interest payable. In the case of Maykem & Sellem,
operating profit is $20 million and interest payable is $2 million,
providing an interest cover of 10. This tells us that the company
is earning ten times more profit than the interest currently
being paid. The higher this figure, the less chance there is of the
company being unable to meet its future interest commitments.
T What is the sales growth from one year to the next?
Weak sales growth could lead to deteriorating profits for
investors if interest payments are increasing.
Is there a decrease in asset turnover?
Falling asset turnover is often a precursor to cash flow problems.
T What is happening to fixed assets as a percentage of sales?
T What is happening to current assets as a percentage of
sales?
Either of these percentages increasing tends to be the first indicator of
assets becoming less productive. If cash is being unnecessarily tied up
in assets, this could affect the company’s ability to generate cash in the
future

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WHAT CAN YOU LEARN FROM FINANCIAL STATEMENTS

T Asset turnover
can be established by combining long-term funds in the balance
sheet with sales in the income statement
T Profit margin
can be established by combining sales in the income statement
with profit in the income statement
T Cash flow
can be established by combining cash receipts and cash payments
in the cash flow statement
The bare bones
The balance sheet, income statement, and cash flow
statement must be continually monitored and analyzed
if a business is to deliver a healthy return on equity.
How can financial statements
be used to help manage a business?
Not only can financial statements tell us a how a company is
progressing, they can also provide information that management can
use to enhance the return to shareholders in the future.
T Balance sheet
The balance sheet provides information on two issues that can
have a dramatic impact on the need for shareholders’ funds:
I It shows how funds have been invested in assets
I It shows how funds have been raised
Management should use this information to keep assets to a
minimum (but without jeopardizing sales), thus keeping the
need for shareholders’ funds to a minimum. Also, gearing
should be maintained at appropriate levels to provide a
reasonable return to shareholders, while not exposing the company
to unnecessary risk

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Is cash flow important

Having established that profit is not the same as cash flow, we
now need to understand the relevance of cash flow. We have noted that
the sales and cost figures included in the calculation of profit do not
necessarily bear any relationship to when cash is received or paid out.
This is evident when looking at the first month’s operation of your pen
business. In January the profit was nil (indicating that wealth was
unchanged), even though the amount of cash decreased.
This highlights a very important issue in business. For a regular
business to survive, it needs two things – it needs to make a profit to
provide a return to its investors, but it also needs to generate cash flow
to pay its expenses as they arise.
Even if you are generating a loss, you can continue to trade if you
have adequate cash flow. However, if you run out of cash, the game is
over! It’s a simple rule – no cash, no business.
The bare bones
There are two essential criteria for a regular trading
business to survive:
T It must generate profit
T It must generate cash flow
Stripping it down to basics…
Sound financial management is a prerequisite for business success.
The role of financial management in most businesses is to translate
business ideas into profit. Profit should not be confused with cash
flow:
T Profit measures changes in wealth
T Cash flow measures changes in cash balances
Given that these two concepts are not measuring the same thing, the
way they are calculated differs

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WHY PRODUCE FINANCIAL STATEMENTS

redirect their attention back to counting the hairs growing out of people’s
ears, fantasizing about dating the newest employee, and guessing
who has the most expensive suit in the room.
Why does the very mention of a financial presentation instill
boredom in an audience even before it starts? If marketing executives
had designed financial statements, they would no doubt be filled with
dazzling images and memorable slogans. If information technology
specialists had designed these documents, they would probably contain
flow charts showing logically how all the parts of the business fit
together. However, we have to face facts. Financial statements are
designed by accountants, which means we have to make do with
lengthy tables of figures coupled with technical jargon that most people
don’t understand.
Believe it or not, financial statements are inherently exciting documents
because they tell you how a business has been trading. A set of
annual accounts is a summary of everything a business has done during
the previous year. Investors should be clamoring for these reports
to find out what is happening to their wealth. Managers should be
equally enthusiastic to find out how successful they have been at managing
the business. Financial statements can tell you what is going
right and what is going wrong. Although they may at first sight appear
rather bland, you will discover you can extract a lot of valuable information
in a very short period. In this chapter we are going to examine
the most commonly encountered financial statements, what
they tell us about a business, and what all the jargon means.
What is the role of financial statements?
Financial statements enable investors to assess how effective a
business is at providing them with a return on their investment. It follows
that these documents ought to be answering the questions
investors want addressed. Therefore, to appreciate financial statements,
you need to think like an investor.
What motivates investors is their rate of return. Simply being
told how much profit a business has made during a period is not
much use on its own. To decide whether or not this figure is

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WHICH ARE THE FIGURES THAT COUNT

T Raising funds to finance assets
T Turning assets into sales
T Turning sales into profit
In Chapter 4 (‘How do you measure financial success?’), we were
introduced to return on equity as a measure that can be applied within
any business to assess how effectively investors’ funds are being turned
into profit.
Let’s consolidate these concepts. The first stage of the profitmaking
process is all about raising cash from shareholders and in the
form of borrowings in order to finance assets. The second stage is all
about turning these assets back into cash in the form of sales. These
first two stages are therefore all about cash management. It is only the
third stage that is true profit management: ensuring that the sales generated
result in increased wealth for the shareholders. Return on equity
provides a measure that allows us to assess how effectively the entire
process is being managed. This places us in a position to develop a
coherent view of any business.
STAGE IN PROFIT-MAKING IMPACT ON CASH PERFORMANCE
PROCESS AND PROFIT MEASURE
Raising funds to finance assets
Turning assets into sales Cash management Return on equity
Turning sales into profit Profit management
A common failing in many businesses is an obsession with
profit management while disregarding cash management. Given that
two out of the three stages in the profit-making process hinge on cash
management, this explains why many companies run into cash-flow
difficulties. It is impossible to generate a sustainable return on equity
without sound management of both cash flow and profit. This is
because return on equity links the two concepts: it looks at how effectively
cash raised from investors is being turned into profit.
Having a coherent view of a business enables us to identify the
four key figures that drive it. To do this, let’s revisit the Edible Plate
Company, introduced in Chapter 3, where you raised $50,000 from
shareholders and $50,000 as a loan

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HOW DO YOU MEASURE FINANCIAL SUCCESS ?

This ratio comprises two elements: the amount of profit made
and the number of shares in issue. When a company sets a profit target
for the year this will directly affect the way the business is managed.
If it is an aggressive target, management will be under pressure to generate
lots of sales and keep a firm grip on costs. If it is an easy target
managers can be more relaxed because, even if sales fall slightly or
costs start to increase, the profit target will still be achieved.
Now let’s turn our attention to the other determinant of earnings
per share: the number of shares in issue. What effect does this have on
how a company is run? The answer is simple – it doesn’t! Most managers
probably haven’t got a clue how many shares are in issue in their
company; nor do they care. Earnings per share is an investors’ measure:
shareholders want to know how much profit is being earned on
each share they hold. This is of no relevance to managers (unless, of
course, they are also shareholders).
From a managerial viewpoint, what is relevant is the funds
received in exchange for the shares. When shareholders invest $5 million
in a company, for example, its managers must decide what they
are going to do with that $5 million. This does affect how the business
is managed. It follows that managers find it far more useful to look at
profit in relation to shareholders’ funds invested, rather than in relation
to the number of shares in issue. This has led to the development
of a measure known as ‘return on equity’ (often abbreviated to ROE),
which looks at profit as a percentage of shareholders’ funds:
Profit
Return on equity = x 100%
Shareholders’ funds
A SMALL MATHEMATICAL POINT
Whenever a calculation ends with the expression ‘x 100%’, this means
that the result should be multiplied by 100. In other words, it should be
expressed as a percentage (literally ‘per one hundred’).
‘Return’ is just another word for profit, while ‘equity’ is an alternative
term for the owners’ money invested in the business

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WHAT CAN YOU LEARN FROM FINANCIAL STATEMENTS?

T Asset turnover

can be established by combining long-term funds in the balance

sheet with sales in the income statement

T Profit margin

can be established by combining sales in the income statement

with profit in the income statement

T Cash flow

can be established by combining cash receipts and cash payments

in the cash flow statement

The bare bones

The balance sheet, income statement, and cash flow

statement must be continually monitored and analyzed

if a business is to deliver a healthy return on equity.

How can financial statements

be used to help manage a business?

Not only can financial statements tell us a how a company is

progressing, they can also provide information that management can

use to enhance the return to shareholders in the future.

T Balance sheet

The balance sheet provides information on two issues that can

have a dramatic impact on the need for shareholders’ funds:

I It shows how funds have been invested in assets

I It shows how funds have been raised

Management should use this information to keep assets to a

minimum (but without jeopardizing sales), thus keeping the

need for shareholders’ funds to a minimum. Also, gearing

should be maintained at appropriate levels to provide a

reasonable return to shareholders, while not exposing the company

to unnecessary risk

Read More