A jeweler’s ability to develop and control an organization financially is vital to its success, but too many jewelers leave financial management to others—or until it’s too late to avoid disaster. And even if you’re doing “just okay,” why not do “great” and start capturing all those dollars you’re leaving on the table? Why not make it a priority to work at developing the skills and discipline that will make it happen?
My firm, Business Resource Services, has developed a process that I call “Profit Mastery.” In the next few months, this series of articles will make that process available to those who are ready to stop just surviving and start thriving. This month, we’ll introduce the seven areas that can make or break a company and focus on the first area—accurately monitoring your financial position—and also begin developing some action steps.
The Seven Deadly Sins of Poor Financial Management
Failure to consistently and personally monitor your financial position. You leave financial scorekeeping to someone else because you don’t use the information anyway. But who’s at risk? Does your accountant co-sign your bank notes? I know, financial statements reflect the past, and any enterprising jewelry owner thinks of the future—it’s tomorrow that matters. But tomorrow is the sum of a series of yesterdays, and if you don’t know where you’ve been, you won’t know where you’re going.
Failure to price properly and know your costs. If you set your prices based on what your competition is charging, that presumes he or she knows his or her costs. By the time you figure out where you are, you could both be broke!
Failure to distinguish between net profits and cash flow. Managing cash may be boring, but it’s the most valuable financial exercise any owner can perform. The working capital cycle—cash to inventory to accounts receivable and back to cash—must be managed. How long is it from the time the dollar leaves the till until you get it back? What do you do in the meantime? And what impact on this cycle does two points of gross margin—or a half-turn of inventory—have?
Failure to plan properly for growth. Many owners believe the solution to cash problems is more sales. They’re wrong. Growth generally magnifies problems. Furthermore, growth normally creates the need to borrow, which brings us to…
Failure to borrow properly. As a former banker, I can tell you that there is a right way and a wrong way to borrow. The Profit Mastery program hinges on control. Control is a function of decision making, and decisions depend on information. You’ll learn what you need to know from your financial advisors in order to make informed decisions.
Failure to address legal and tax issues. With regard to business organizations and state, local, or federal tax authorities, any errors are usually sins of omission, not commission. Poor initial planning when the business is begun is another common error. Too many owners launch a business without a sense of purpose and direction, relying instead on the “jump and hope” philosophy.
Failure to plan for transition. Some day, you will come to the end of your business career. What will you do with your business? Too many people invest 30 or 40 years in building a business, but barely 30 minutes in planning what will happen when they’re gone. Take time to do it right. And start now to build value in your company so you’ve got something worthwhile to bequeath to the next generation of jewelers.
The first deadly sin: why it happens, and what to do about it. Jewelry owners make management decisions every day without consulting their best source of information—their companies’ own financial statements. More typically, they get statements from their bookkeeper or accountant because they have to report income and expense for tax purposes. Does this sound like you? You get an annual statement and turn to the third page, bottom. If there’s no “red ink”—and no big tax to pay—you heave a sigh of relief, assume it’s okay for another year, and toss the statement in the bottom left-hand drawer to gather dust with all the others.
That’s the first “sin.”
Financial management begins and ends with those statements. Your company’s strategic plans and operating decisions ultimately boil down to a bottom line that’s measured in dollars and cents. That’s what financial statements are all about.
From a financial perspective, we’re all in the business of money management. We may design and repair jewelry, sell estate pieces, or carry 20 designer lines, but all that activity ends up in someone’s financial statement, either as a plus in the profit column or a minus in the loss column. One permits survival, the other doesn’t—at least, not for long.
But first you have to read them. For those who don’t know how to read a statement or interpret it properly, here’s a quick lesson:
Balancing act. Financial analysis begins and ends with financial statements. The two basic statements you need to understand are the balance sheet and the profit-and-loss statement.
The balance sheet functions as a historical record of activity from day one in your business. It’s like a snapshot of the business at a point in time, usually the end of an accounting period. It reveals three things: assets (what the business “owns”), liabilities (what the business “owes”), and net worth (what the business is worth on paper). This fundamental relationship is summarized in the formula: Assets = Liabilities + Net Worth (see diagram, page 86).
There are several issues worth noting. First, the left-hand (assets) side is broken down into three basic sections based on the time frame in converting assets to cash:
Current assets are those that normally will be converted to cash within one year—such as cash, accounts receivable, and inventory. These three assets interact to create the working capital cycle—cash to inventory to accounts receivable and back to cash. This cycle will become critical as we delve further into financial management, or if you’re a retailer with no accounts receivable but still have inventory to manage. In current assets, you also typically find a category called “prepaid expenses,” such as rent and insurance, that you “use up” over the course of a year.
Fixed assets represent those tangibles upon which the activity of the business turns—such as land, buildings, fixtures, furniture, and vehicles. With the exception of land, fixed assets are depreciated—or written off—over the “useful life” of the items.
Intangibles, the third asset category, include such items as goodwill and franchise rights.
Your “total assets” is the combined total of current, fixed, and intangible. All of your assets are placed on your books at cost or fair market value, whichever is less. Thus, you can see the possibilities for distortion in either direction. For example, appreciated real estate might be undervalued at cost, and “dead stock” inventory could be overvalued at cost. From your banker’s perspective, interpreting what he or she sees is not always easy, especially since business owners have been known to fudge.
Assets have to be bought, and that’s where the right-hand side comes in. Liabilities reflect funds in the form of loans (supplied by creditors), and net worth reflects funds in the form of capital investment and retained earnings (supplied by the owners).
Liabilities also are classified into short-term and long-term, depending on whether they are paid within one year:
Current liabilities—such as accounts payable, notes payable, and accruals—are paid within one year. Accruals are simply a way of saying, “I know I owe it, but I haven’t written the check yet.”
Long-term liabilities—such as mortgages or equipment loans—are those that will be repaid over a period exceeding one year. Total liabilities are the sum of both your current and your long-term debts.
The last section of the balance sheet is the one labeled “net worth.” There are two primary components: owner’s contribution (capital stock) and retained earnings. Retained earnings are those after-tax earnings that are kept (“retained”) in the business to finance the acquisition of new assets. There are two important things to remember about retained earnings: First, they are cumulative (that is, a record of all earnings since day one); second, they are not usually cash. Retained earnings really represent funds available to purchase new assets, and in many cases they’ve been spent before you get them.
So, a balance sheet is a record from day one and measures what the company owns and owes at a given point in time. The key financial issues relating to the balance sheet are liquidity/solvency, financial risk, and asset management.
Why does a balance sheet balance? Because of a system of double-entry bookkeeping, each entry is checked by a balancing entry (except, of course, for mistakes, oversights, and fraud). In any case, it’s the document your banker wants to see first—so you need to know why and how it works.
Making a statement. The profit-and-loss statement is simply the result of operations over a given period, usually one year. The primary benchmarks are gross profit and net profit. Gross profit measures what remains when the cost of goods used is subtracted from sales, while net profit measures what remains when operating expenses are subtracted from gross margin. The key financial issues relating to the profit-and-loss statement are pricing, margin maintenance, and expense control.
Probably the most misunderstood issue—and the primary reason financial analysis doesn’t occur—is the relationship between the balance sheet and the profit-and-loss statement. Most people can’t explain it; many don’t even realize there is a relationship. It’s shown here:
THE BALANCE SHEET / PROFIT & LOSS STATEMENT CONNECTION
|Total Current Assets|
|Total Fixed Assets (net)|
|Total Current Liabilities|
|Total Long-Term Liabilities|
|Total Net Worth|
Total Liabilities and Net Worth
|– Cost of Goods Sold|
|– Interest and Other Income|
|Net Profit Before Tax|
|Net Profit (after tax)|
At the end of each year, your accountant closes out all of the income and expense accounts to produce “net profits after tax.” This amount goes directly into retained earnings, and then you start all over again on income/expense. Thus, the profit-and-loss statement represents only one year at a time; however, a balance sheet—like a diamond—is forever.
Why would anyone care about any of this? Because we can use this information to see where we’ve been and where we’re going. The goal? Planning and control. The tool? Analysis of the relationships and trends—in the form of ratios, which we’ll discuss in the next article.
Think of it as the financial counterpart to your annual physical, with four steps:
accumulate and format information;
analyze for cause and effect;
establish an action plan to address problems or opportunities.
These elements are worthless as effective management tools unless they’re well prepared, accurate, and current. This puts the burden on your accountant, who should supply you with up-to-date financial facts in a language you can understand—like English.
You also should insist that these expensive reports arrive when they can do you the most good. In a fast-paced economy, statements even a couple of months old are obsolete. Insist on monthly financial statements, including a profit-and-loss statement and a balance sheet, delivered to you no later than the 15th of the following month. Make it your goal to review them within a business week and come back to your accountant immediately with any questions or changes. And don’t let pride keep you from asking about anything you don’t understand. You’ll be more embarrassed if your business fails because you couldn’t or wouldn’t ask for clarification.
Since you’re ultimately responsible for gaining adequate financial information, here are some suggestions to help get you in the financial loop:
Put your records into an organized system, or hire someone to do it.
Computerize your accounting system. Not sure what’s best for your business? Ask colleagues both in and out of the industry.
Don’t tolerate being last on your accountant’s list for statements. Set target dates for monthly, quarterly, and annual statements and stick to them.
Respond in a timely manner to your accountant’s requests for information.
Have an accounting system that reveals—rather than conceals—information. While taking prudent steps to minimize taxes is perfectly reasonable and legal, make sure you know your true situation in terms of revenue and expenses, assets and liabilities.
For example, those of you with an S-corporation structure might make additional distributions in the form of owner salary and bonuses before year-end to reduce taxes on profit. However, when it comes time to communicate with your banker or compare yourself to industry standards, you’ll need to make adjustments that reflect your true profit prior to your year-end distributions.
Remember the acronym GIGO: “Garbage in, garbage out.” Your results—and the usefulness of your information—are only as good as your system.
The most practical method of statement analysis (the focus of next month’s article) is to assemble as many years of financial data as possible (ideally, three or four) and transfer all of these balance sheet and profit-and-loss statement figures to a spreadsheet. A spreadsheet is a method of laying out several years’ worth of financial data in an easy-to-compare format. Next month I’ll show you how to do that and how to analyze what is on the sheets and look closely for trends.
The heart of every worthwhile financial analysis is the interrelationship of the numbers in the form of ratios—in other words, comparing key ratios against company trends as well as industry averages. It’s not as mysterious as it sounds, and it can be enlightening—sometimes disturbingly so—in terms of the trouble spots disclosed.
Find those spots, and half your problems are licked. After you deal with your trouble spots, you’ll be ready to set reasonable goals and objectives for your store.
And, in the process, you’ll use your financial statements to good advantage—reading them, analyzing them, interpreting them, and making decisions based on them. The goal is to add accurate financial data to your own built-in decision-making process, which includes “gut feelings” and intuition.
Taken together, the balance sheet and profit-and-loss statement represent the best picture of your company’s financial status. Your challenge is to monitor them consistently and interpret them accurately and do it now. In the coming months, I’ll show you steps to take once you have good financial data.