Monday, July 16, 2012

There's a reason they're called financial "statements"

A good friend of mine teaches his accounting students to "make the financial statements talk." This advice is brilliant in its simplicity, yet seldom followed in finance departments around the globe.

Instead, the typical financial review is comprised of a senior financial person passing out the income statement and balance sheet. While the managers around the table stare blankly at the list of numbers, the finance person, usually renowned for his ability to captivate an audience with his charisma and eloquence (think "Bueller … Bueller"), walks everyone though the income statement as follows:

Revenue increased by 2.1 percent, fueled by 2.8 percent growth in our Central region, partially offset by a 7 percent decline in our Mid-Atlantic region. SG&A increased by $50,000, as a result of an arbitrary expense allocation from the corporate office of $200,000, partially offset by a $150,000 cushion we had on the balance sheet in the event of an arbitrary expense allocation from the corporate office.

Usually this is met with awkward silence and confused expressions. It's no wonder why. The financial statement did not clearly communicate what management needs to know to understand the economic performance of the company and make good business decisions based on it.

A properly designed set of internal financial statements will, on the other hand, be able to speak for itself. To achieve this communication, financial statements must be built on a standardized hierarchy that promotes ACTION. This hierarchy strives to create financial statements that are:

Accurate
Complete
Timely
Influencing
Obfuscation-free, and
Non-GAAP

The first three points -- accurate, complete, and timely -- are exactly what they sound like. I won't bore you with explaining those, so I'll pass over them and unfold the remaining three tenets and why they're crucial for developing an understandable and actionable financial statement.

Just the (relevant) facts

Internal financial statements must avoid containing too much or too little detail. An overabundance of detail can bog management down with irrelevant information and detract from more important issues. Not enough detail can cause management to gloss over issues, preventing the team from immediately addressing problems.

When deciding whether to include a piece of information in a financial statement, the litmus test for the appropriate level of detail should be whether the information influences a business decision.

Eschew obfuscation

The purpose of internal financial statements is to provide management with financial information to guide decision making. Obviously, any inaccuracies and confusion work contrary to this goal. You are not doing the business a favor -- or, for that matter, doing your fiduciary duty -- by fooling anyone into thinking things are better or worse than they are. There should be no place in the financials for waste or inefficiency to hide.

Further, the financials should include relevant comparisons (actual versus forecasted results, profit margins, inventory turns, and any other KPI's relevant to the business) and trends (period to period) to provide management with the most insight into the business's performance and current condition.

Another recommendation is to ensure all reports -- daily flash reports, weekly dashboards, and monthly reports -- include the same KPIs for monitoring and running the business. This approach ensures consistent reporting of financial and operational data and avoids creating any disconnect between reports.

Mind the GAAP

Every company I've worked for in my 30+ year career prepared financial statements in accordance with GAAP, but none used them to run the business. (By the way, I am always amused by the "Generally Accepted" part. Generally accepted by whom? No one has ever asked my opinion!)

I understand the need to have GAAP financials for external purposes. But often the accounting treatment of revenue, leases, capitalized cost, contingent liabilities, and other metrics makes this data less than useful, and sometimes misleading when using it to make business decisions.

In addition, one purpose of GAAP is to put all companies' financials on the same platform so you can compare a retailer to a manufacturer to a financial services company. In the real world, this homogenization has little to no value to management responsible for understanding what is happening in their business.

That's because every company has its own set of KPIs, in addition to volume and price, that are crucial to understanding the real economic performance of the business. When I was in the hazardous waste industry, those KPIs were treatment costs, transportation expenses, tipping fees, and other landfill costs. In landfills, KPIs include cost per cubic yard of permitted airspace, price per incoming ton, and compaction ration. For car washes, it's about upsells, labor per car, and damage claims.

At Stroll, some of our most important KPIs include customer lifetime value (LTV) and its significant components, which we carefully monitor using sophisticated analytics. This allows us to develop marketing strategies to acquire the maximum contribution margin from a given media budget.

Further, we utilize a proprietary internal reporting methodology that simultaneously measures the total margin earned from a given media spend (regardless of when it manifests itself as either cash or GAAP income); projects cash availability for future media programs; forecasts near- and long-term staffing needs for our fulfillment and call centers; and monitors compliance with budgets, operating goals, and debt covenants.

The challenge for financial people is to use their creativity, in conjunction with their knowledge of accounting, finance, the business, and the industry, to design a system of financial reporting that tells the right story, at the right time, and in the right way to promote the right actions!

Taken together, the tenets embodied in the ACTION hierarchy can guide you to creating financial statements that succinctly articulate your operational results and arm management with the knowledge and insight they need to make decisions that favorably impact the business.

So make your financials talk, but don't let them ramble, go off on tangents, or tell fairy tales, and you just might live happily ever after.

No comments:

Post a Comment

To prevent spam, all comments are moderated. Please allow a few minutes for your comment to be reviewed and approved.