Why Financial Statements Don't Make Sense.

Ask any small business owner and we will tell you that “we don’t use financial statements”, “I confess that I don’t know how to read them”, or “they just don’t make any sense”. Are small business owners ignorant, uneducated, or dumb? No. Our financial statements are dumb!

In fact, we small business owners are so smart that we actually figure out other ways of tracking our businesses just so that we can make sense of our cash flows and survive an extremely competitive environment. We will micro manage by product, class of service, or sales category. We’ll track sales by week, month, or quarter; we’ll track cash flows, expenses and anything else that give us a clue as to the health of our companies; all without the aid of regular financial statements. So why, then, is the very tool that seems so universally sought as the standard benchmark by big business, stockholders, bankers, and all financial institutions so important to them and so totally useless to us?

It’s because they are made by accountants for accountants. It’s just like lawyers making our laws. It’s designed to keep them in business and keep us guessing! And it is all due to the format which was somehow deemed to adhere to a standard which they figured was great for quickly analyzing a business’s credit worthiness; the insidious generally accepted accounting principles (GAAP). Statements so formatted are typically for external use (read that for your bank or lending institution) and gives them some assurance that the reports have been prepared in accordance with a common set of ground rules. That’s fine for them but does nothing for me.

So why are they confusing, hard to read, or just not in sync with our needs? The answer is that they use absorption costing. Simply put, that means that some fixed overhead expenses are allocated directly to all products, both those that are sold and those still in inventory. The result is that an expense can be held as an asset until it is sold. You may have already paid that expense, but it won’t show up on your statements as an expense until the allocated inventory has been sold. By now you’re probably thinking “no wonder these reports were confusing, they’re nuts”!

Is there a solution? You bet there is! Keep in mind that accountants are all about compliance. They consider their work to be all about documenting a company’s financial records for external users such as banks, tax agencies, and the like. They often figure that by getting the tax filings done, statements prepared, and everything nicely balanced their job is done and all that is left is to bill the client. If that is true in your case, then you are letting them off the hook too easily. You should also be asking for some reports that would actually make sense in helping run your business. Those same statements your accountant has prepared can often be easily reformatted into something just a little more intuitive using the Contribution Approach. Simply stated, this avoids allocating fixed overheads to unsold inventories and actually deals with period costs as they occur. Chances are that your accountant already has the data needed to re-issue company financial statements using variable costing instead of absorption costing. For many companies all you need do is request those statements in addition to those already issued. Statements showing contribution margin and realizing fixed period costs as they occur not only make more intuitive sense, they actually give you information which you can use in the decision making process. Gee, what a concept; a financial statement that you can use!

At this point I’ll add the standard disclaimer that I’m not an accountant and I’m not attempting to give anyone financial advice. What I am doing, though, is urging you to speak with your accountant and ask them if they are capable of creating financial statements which are more suitable for your internal use. There are a number of different tools one can use to measure and improve one’s performance. Variable Costing, Cost Volume Profit (CVP) Analysis, Theory of Constraints (TOC), Lean Six Sigma, and other tools may or may not be appropriate depending on your particular circumstances. Being able to measure your business’s performance is one of the keys needed to unlock the doorway to improvement. Creating reliable metrics requires accurate data that is usable. Don’t settle for statements that you only pass along to placate others. Insist on statements you can use in your every day decisions!

Bob Banasik is a senior business advisor and an accredited associate of the Institute for Independent Business, and can be reached at bob@bestbusinessassociates.com .

© 2009 Best Business Associates LLC

Facing economic downturn in business

When the economy takes a downturn, or if a business simply experiences a downturn in sales, many businesses react by cutting back budgets in order to conserve funds in the face of declining sales. It is an instinctive reaction that is often scorned by would be advisors. They say things like “when things slow down, that is the best time to keep up with your advertising efforts”, citing the fact that there might be less competition in the marketplace therefore one who continues their efforts would logically stand out and achieve greater results.

Baloney! There is a reason that your instincts might lead you to conserve your resources, cut back on expenses, and reduce advertising budgets. Your instincts have probably served you well in the past, why should you start ignoring them now? If you examine your decisions, they are probably based on sound reasoning. If something is not working why would you continue doing it? If your advertising is not pulling its weight and not bringing in the results intended, why continue? Albert Einstein once said “The definition of insanity is doing the same thing over and over again and expecting different results”. If a smart guy like Al thinks it’s a bad idea, I’m betting you might agree.

So what are these would be advisors thinking anyway? Are they nuts? After all, it’s not their money they’re spending, is it? The answer is…they are both right and wrong. They are right in that one may not be best served by “hunkering down” and cutting budgets and just waiting out the downturn in hopes of “things getting better”. They are wrong in recommending simply staying the course in hopes of the same “things getting better”. Something has to change.

Chances are that when sales decline there are one or more reasons why that has happened. It’s easy to blame it on the economy, especially these days. But so what? That doesn’t change your need to pay rent, payroll, or even, perhaps yourself! No matter what the reason is, it is your job as CEO to examine or re-examine the market and determine a course of action. Your goal when you started your business was probably not just to “ride the market and hope for the best”. It was more likely something on the order of maximizing talents and efficiencies in order to satisfy some market need with a high value proposition. My premise to you is that nothing has changed! At least, nothing should have changed, but it obviously has. That is why sales decline. It is not because of bad economies. It is not because of recessions. Those are all symptoms of what the other guy is experiencing. That is what has happened to the financial markets, the housing markets, construction, and who knows what else. They have lost their value propositions! It just so happens that your market may have been influenced by that, but that doesn’t change anything for you. Your job is still to provide high value efficiently, right?

So simply advertising that which you have done in the past would be kind of crazy if things have changed, right? See, your instincts were correct! And you were half right! You got the part right about stopping doing what was not working. You just forgot to start doing that which you must do in order to grow. You must re-connect with your target markets and find out what they now value most. And by the way, you must continue to grow, because the alternative for any business is ultimate failure or an orderly exit. Either way, that party will be over.

So what should you do? Just what you’ve done in the past…or at least, what you should have done in the past. Your customers form their unique value proposition by combining direct input from their perceptions of your company’s offerings with their needs or desires. If, in their mind, that unique value proposition (UVP) is higher than those they form with alternative suppliers then you get the business. It is that simple. You control the Unique Selling Proposition (USP) which your company exudes in the form of product/service breadth/depth, pricing, availability, personalized service, or perhaps other factors that your customers perceive have value. And this is exactly what I find has changed when sales decline! Through time, a disconnect is formed between that which we feel has the greatest value perception in our customers’ minds. In short, what turned them on in the past is no longer working. They now value something different. It may be similar or quite different. The point is, over time we tend to lose touch with that most precious connection with our customers and also those who are not currently our customers, but could be if we “only knew”!

Getting back in touch with those two groups, customers and potential customers, and finding out just what they most value today in their supplier is often an epiphany. It is rarely that which worked ten years ago, and is rarely what you think it is today. Strategic marketing is not a task. It is not a tactic. It is an ongoing discipline designed to ensure that all your company’s messages and contact points are germane. It is only through knowing what your customer values today that you can advertise messages which are effective in bringing desired results.

When sales decline it is time to cut back on that which is not working. It is also time to dig into the marketing puzzle to find out why and what needs to be changed. USP, VOC, SWOT are tools used to scientifically arrive at solutions to those questions which make your tactical marketing efforts more efficient and productive. Even in a “bad” economy, businesses need to grow. If your company’s sales are flat or declining, take action now before your party is over!

© 2009 Best Business Associates LLC