Sunday, February 6, 2011

CFO Services - Financial Numbers Can Play Tricks

If a baseball bat and ball together cost $1.10 and I told you the bat costs one dollar more than the ball. How much does the ball cost?

Most people say the ball costs 10 cents. The right answer is the ball costs 5 cents with bat costing one dollar more than the ball or $1.05 for a total cost of $1.10.

The reason why I bring this example up is because financial numbers can play tricks on you. It is the job of a Part Time CFO to understand all of the tricks numbers can play and help the business owner understand and interpret the financial statements properly so better business decisions can be made.

Reading and understanding the financial numbers on financial statements can play tricks on you. Many times a company is making money so the P & L looks good, but they have poor cash flow. This is the case usually because the cash cycle is too long (The cash cycle is the time frame between the outlay of cash for inventory (and material and labor) and the ultimate receipt of cash from customers). These time frames need to be compressed. Some of these issues to compress the cash cycle involve negotiations with the trade for better terms as well as stricter company credit policies for faster accounts receivable turnover. Sometimes a solution can also be extending payroll from weekly to bi-weekly or even monthly where it is legal to do so. Some clients also need an inventory purchase and receipt plan as they may be overbuying inventory.

To understand better how profit does not equal cash watch the following six minute and 30 second presentation:

Profit Does not Equal Cash Presentation

Another trick that financial statements and financial numbers can play is in understanding the equity section of the balance sheet. This is the section of the balance sheet that values the difference between assets and liabilities. A high equity balance can be deceiving if a high percentage of assets are made up of intangibles like goodwill, non-competes or patents and trademarks. A high equity balance can also be deceiving if a high percentage of assets are made up of machinery, equipment or other fixed assets that depreciate in actual value faster than the accounting depreciation calculation.

Accurate gross profit margins on your P & L can play tricks on you. Understanding what needs to go in cost of goods sold and what is a direct cost of the product or service is very often done incorrectly. For example many business owners in the trades such as construction, electricians, plumbers etc… and who are in manufacturing do not put direct labor in cost of goods sold. This is leaving out a direct cost of the product or service and without it will inaccurately overstate gross profit margins which can lead to poor business decisions.

Helping the business owner read and understand their financial statements in order to make better business decisions is a CFO Service that needs to be done early in the process. Remember, financial numbers can play tricks on you.