140 CHAPTER 7 ABOUT THESE NUMBERS
Varying views of the same numbers
THREE VIEWS OF FINANCIAL TRANSACTIONS
You were promised a gentle start. So let me begin by stating the obvious. You are inter-
ested in the following three types of transactions.
1 Sales
In fact, you should be obsessed with sales volumes, selling prices and the direct cost of
buying, developing or producing the items that you sell. This is what business is all about.
2 Capital outlays
These are primarily spending on productive assets with a life of more than one year; the
secret to future income. I will talk mainly about fixed assets (such as plant, machinery
and equipment), but the same considerations apply to any investment spending (such as
when you take over another company).
Rightly or wrongly – usually wrongly – the numbers in the financial plan
take on a spurious air of accuracy and importance. They usually become key
targets for measuring performance. Retain a healthy scepticism. The numbers
are only best guesses. We are going to see how the same numbers can be made to tell
different stories and how you can help your readers to understand your message.
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The fast track to financial basics
1 Start by remembering that business professionals are familiar with three
types of financial transactions – those relating to sales, operating costs and
capital spending.
2 Review the way that the three types of transactions relate to the three
financial statements – the balance sheet, profit and loss account and cash
flow statement.
3 Remember that you are dealing with the past, present and future. You
usually have incomplete information for the present – such as when you are
preparing next year’s business plan during the current financial year.
4 Before going on to start analysing sales and costs, make sure that you
understand some basic accounting principles.
5 Finally, take a look at the way that you can use computer spreadsheets to
simplify your work.
VARYING VIEWS OF THE SAME NUMBERS 141
3 Operating costs
This is all other expenditure – salaries, wages, stationery, telecommunications – the pain-
ful daily costs of running the business.
These figures are not too hard to pull together, as discussed in Chapters 8 and 9.
THREE FINANCIAL STATEMENTS
By themselves, the three types of transactions just mentioned are interesting. They take
on special meaning when reclassified into three key financial statements. This is a simple
matter of mechanical arithmetic. The three statements are as follows and their relation-
ships are shown in Figure 7.1.
1 The balance sheet
Think of this as a snapshot of your finances at one moment in time, say, midnight on 31
December. The balance sheet shows, in financial terms and to the best of the accounting
world’s ability, the sum total of what you have done in the past and where you are today.
See Figure 7.2 and Balance sheet basics on page 143.
2 The income or profit and loss (P&L) account
This shows the very important bottom line – net income (American usage) or the net
profit or net loss (British usage). US readers will know this as an income statement even
though it includes expenditure. For the sake of avoiding ambiguity I’ll generally refer to
it as the profit and loss account. It records financial flows relating to a specific period,
perhaps a month or a year. The flows are essentially sales income less production costs
and operating costs. The difference is net profit (or loss). Transactions are recorded in the
period to which they relate. For example, rent for May is entered in the accounts for May
even if it was actually paid in advance in April.
3 The cash flow statement
This shows financial flows as and when they actually happen (rent for May paid in
advance in April is recorded in April). It is not unusual for the profit and loss account to
look very healthy at the precise moment that negative cash flow (a big borrowing require-
ment) is strangling the business.
If you are relatively new to all this, you might find it useful to review the
components of various financial statements and see how they fit together.
You could take a look at the balance sheet in Figure 10.2, profit and loss
account in Figure 9.7 and cash flow in Figure 10.3.
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142 CHAPTER 7 ABOUT THESE NUMBERS
THREE TIME PERIODS
The familiar transactions in the first list above (sales, operating costs) – and therefore the
financial statements in the second list (balance sheet, P&L, cash flow) – apply to three
time periods:
the past – historical data from your records;
the present (approximately) – where it is usually necessary to make some
estimations;
the future – which you are about to try to predict.
This might seem painfully obvious. I mention it to draw your attention to the fact that
rarely do you have complete information for the current period. You might begin your
planning in August. Obviously, at that time final figures for the current calendar year are
not available. The usual practice is to estimate them before starting the forecast for the
year ahead.
These figures Create these
statements
For these time
periods
Sales projections
Operating costs
Capital spending
Profit and loss
Balance sheet
Cash flow
Historical
Current
(may have to be estimated)
Forecast
Figure 7.1 Basic relationships
Most people understand profit and loss accounts. The concepts behind the
critical cash flow projection are easy enough to grasp. Balance sheets have
managed to take on an unnecessary air of mystery. For this reason, I think it
is useful to spend a few moments unravelling them. Take a look at Figure 7.2 and the
following text that illustrates the basics.
VARYING VIEWS OF THE SAME NUMBERS 143
Assets
Amounts owned or owed to you
Uses of funds
Debit balances
An increase (a debit)
shows use of funds
Liabilities
Amounts you owe
Sources of funds
Credit balances
An increase (a credit)
shows source of funds
Owners' equity
Capital and retained earnings
What the stakeholders have put in and left in
Figure 7.2 The three sections of a balance sheet
Balance sheet basics
I recall attending a meeting with the general manager of one of the world’s top
200 banks. Just before we entered his office, a senior executive of the bank told me
‘forget the balance sheet, nobody understands them’. This is largely true. Balance
sheets are the least understood of all financial statements.
However, most venture capital providers and most bankers are pretty hot
cookies when it comes to reading balance sheets. The discussion in the following
pages will help you stay at least one jump ahead. I will show you how the balance
sheet reveals if you have enough liquidity – and whether you could sell enough
assets to cover your debts if the crunch came.
The company bean counter buries all manner of interesting information in
balance sheets. They provide a snapshot of the financial health of a business at a
single moment in time. They show what is owned and what is owed. The entries can
be classified under the following three headings.
1 Assets. There are things you own, such as equipment and cash in the bank, and
money that is owed to you by your debtors. You are halfway there if you have
spotted the fact that the bank is actually one of your debtors when you have
funds on deposit.
2 Liabilities. These might seem unwelcome at first glance – amounts that you owe
to your creditors, such as bank loans to you and accounts payable by you. In fact,
these are the funds that help you build your business.
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