The quick death of any young company is often the lack of focus on the right areas of their profit and loss (P&L) statement. Established companies can likely get away with a lack of focus and oversight for a while, but lack of attention to the details will eventually have negative impacts.
The goal of this article is to discuss Your P&L: Where to Focus. Since every company is so diverse we will keep this discussion high level to generate thought starters. Most leaders have some level of understanding of a P&L, though what is sometimes lacking is the diligence of how to monitor a P&L to spot issues and trends.
Major Financial Statements
Financial statements and reporting follow accounting and financial standards established by the Financial Accounting Standards Board (FASB) that are in-line with generally accepted accounting principles (GAAP). There are four major areas of reporting that the company’s financial statements fall into:
- Balance sheets: Measurement of the assets and liabilities
- Income statements: These are your typical profit and loss (P&L) reports
- Statements of shareholders’ equity: Measure of who owns what portions of a company
- Cash flow statements: Measurement of cash entering and leaving the business over time
Each of the financial statements has various key performance indicators (KPI’s) that help to monitor the performance of key measurements within the various statements. These KPIs have various levers that drive the KPIs performance. It is the focus on the levers and KPIs that often distinguishes the best-performing companies from the rest.
Steps to Understanding, Monitoring, and Controlling Your P&L
The success of your business will be highly dependent on the quality of your focus as an organization on understanding, monitoring, and controlling your P&L.
Understanding the P&L
P&Ls may vary in appearance but a typical P&L will contain performance broken down in summary format by categories such as (GAAP will influence the look of a company’s P&L):
- Revenue: This may be broken out in sub-categories and summarized as a total revenue line
- Cost of Goods (COGS): This may be broken out by major categories with COGS
- Gross Profit: This will be Revenue minus COGS
- Selling, General, and Administrative: Cost to run the business such as:
- Salaries: Often broken out by major categories like sales, operations, transportation, marketing, administrative, etc. It is beneficial to break out your benefits costs so that you can understand these costs over time and they may differ based on employee classification type
- Supplies: Depending on your business you may want to break this out for certain departments to better understand the costs
- Operating Income: Is Gross Profit minus SGA
- Tax Impacting Measures: Such as depreciation which can lower your taxable income
- Net Income Before Tax
- Net Income After Tax
As you are analyzing and reporting on your P&L you will want leaders to understand the following key ratios:
- Gross Margin: This is your gross profit ÷ revenue.
- Any line item as a % of Sales: This measurement is often reviewed over time to better understand trends
- Operating Margin: This is operating income ÷ revenue and represents your ability to leverage company resources to improve revenue
- Net Profit Margin: net income (after taxes) ÷ revenue
- Return on Equity (ROE): net profit ÷ average shareholder equity for the period (a measure of return on money that shareholders have invested in the company)
- Return on Capital Employed (ROCE): earnings before interest and tax (EBIT) ÷ capital employed. This ratio determines the efficiency of the capital that is being invested in the company. A higher ROCE represents a better use of capital
- Asset turnover ratio: This is net sales ÷ total assets. This is important to watch as it represents your ability to leverage assets to produce sales
- Inventory turnover ratio: This is the cost of goods sold ÷ average inventory which represents how quickly your inventory is sold and replaced over a given period of time. Inventory that does not turn quickly enough could become outdated and represents tying up cash
- Receivables turnover ratio: Measured as net credit sales ÷ average accounts receivable this represents how many times a company turns its receivables into cash over time. This a key measurement of cash flow which must be monitored closely to ensure a business has the cash necessary for the payment of ongoing operations and investment in inventory.
- Days sales in inventory ratio: How quickly you turn inventory into sales is measured as 365 days ÷ Inventory turnover ratio
Monitoring the P&L
Diligently monitoring your P&L will involve ensuring the following is present:
- Senior Leader Commitment: Your most senior leader will either need to possess strong financial acumen or have the ability to work closely with human resources to hire for talented financial executives. If your leader is not focusing on financials you risk other leaders not focusing as well.
- Senior Leadership Financial Acumen: It is important to ensure that you hire executives with a certain level of financial acumen. An operational leader who is not aware of how their decisions impact sales can quickly implement efforts that undermine a quality experience for the customer that impacts customer retention. Conversely, a super salesperson can quickly erode profits by unwittingly cutting margins in their attempt to grow business. Meanwhile, IT could be implementing extremely expensive capital investments that are not necessary and do not meet the underlying needs of the organization helps to assess where you are today with your analytical capabilities.
- Establishing Measures: One of the most important steps in P&L management is the establishment of the measurements that drive the P&L results. Key Performance indicators vary greatly by company and additionally levers (the measurements that impact KPIs can be numerous and overwhelming. This is where each leader will want to deeply understand how their business drives results on the P&L (and other financial statements). Much has been written about KPIs and measurements and it is recommended that leaders reference these works for ideas and guidance.
- Systems: A company will want to establish the means by which it wants to report on various measures (the systems, format, and frequency). It is helpful if the reporting systems work with the financial reporting systems of the organization to ensure consistency in data and efficiency in processing.
- Training: Since each leader has traveled a different path in getting to their current role it will be important to assess each leader on their skills in the area of financial acumen and develop and incorporate into their Individual Development Plan (IDP) the means to improve the financial capabilities. The following list of books offer leadership and financial-based insights that can assist in better understanding building a culture of financial acumen:
- What the CEO Wants You to Know by Ram Charan
- The Everything Store: Jeff Bezos and the Age of Amazon by Brad Stone
- The Four: The hidden DNA of Amazon, Apple, Facebook, and Google by Stott GallowayMeasure What Matters: How Google, Bono, and the Gates Foundation Rock the World with OKRs by John Doerr
- The Amazon Way: 14 Leadership Principles Behind the World’s Most Disruptive Company by John Rossman
- The Amazon Way on IoT: 10 Principles for Every Leader from the World’s Leading Internet of Things Strategies by John Rossman
- Think Like Amazon: 50 ½ Ideas to Become a Digital Leader by John Rossman
Controlling the P&L
Closely tied to monitoring are the following activities which if regularly executed upon will result in continuous learning about opportunities for improvement to your company’s performance.
- Regular Financial Reviews: Each company will have to identify a cadence for review amongst their various levels of leadership. It is suggested that a master schedule be developed for the various levels within an organization for the regular review of key financial measurements. Following are some suggestions:
- Senior Leadership: At a minimum, a weekly review should occur of the KPIs and levers that drive the business. This allows for quick course correction as needed.
- Mid-Level/Front-Line Leadership and their teams: This is where the bulk of the action happens in any company and depending upon the product or service KPIs and levers may be watched on an hourly or daily basis. Reporting and systems should enable the needs of this level of leadership.
- Organization as a whole: A monthly review of high-level KPIs helps keep all employees in the organization aware and engaged in the success of the company
- Understanding the Expenses: It is easy to over-automate expense payments. It is recommended that front-line managers who have accountability for a portion of the P&L review and approve all expenses that impact their organization, this should include internal transfer charges. When a manager is looking at and reviews every expense to their organization they develop a keen understanding of how their business works.
- Understanding the Revenue: It is critical that sales personnel fully understand how revenue is being generated. This helps to ensure that focus is being placed on the right activities that generate the proper revenue for the organization. Having a level of understanding of the Activity-Based Costing (ABC) of your organization will further help leaders focus on the right revenue that drives your company’s profits. It is important for non-revenue managers to also understand and monitor revenue and ensure that they are adjusting their operational support to meet the revenue demand on the organization.
- Variance Analysis and Course Correction: It is recommended that each manager conduct variance analysis and recommended course correction against the line items on a P&L that they have accountability to. Leadership will want to set tolerances (either a set $ variance +/- or % variance +/-) that the manager will have to explain and provide guidance on how they plan to course correct. This process can sound exhaustive, however, if your company has a focus on attending to all P&L activities with this level of vigor (on a monthly basis) then you will increase your likelihood of success as you will identify any issues or concerns quickly.
- Accountability: Most companies incorporate means by which the performance on KPIs or the P&L is reflected in an employee’s pay or opportunities for advancement. A leadership truism is to provide incentives for the behaviors you wish to have exhibited.
Building a culture of financial acumen builds a foundation of repeatable success. Building this culture needs to start early and have continually nurturing to sustain its effectiveness.
Originally published at https://kamyarshah.com on July 15, 2020.