Hi and welcome to Be The Flagship with our podcast host, Jeff Parsons.
This is where we tackle the day-to-day talent management challenges you face.
And now over to our host.
Take it away, Jeff.
So again, we have Jeff Smith joining us.
We're going to continue the journey today and focus on key financial metrics.
And so Jeff, thank you again for joining us.
Always a pleasure talking to you, Jeff.
It's been a journey.
But you know, today the intent is there may be listeners in operations who hear financial
terms, right?
And I can remember earlier on in my career, you know, and when I couldn't even spell P
and L, right?
And you know, so you learn what those things are.
But there are people listening who may, you know, I hear EBITDA as an example, but I have
no clue what it really is and I don't want to ask any questions because I might appear
like I don't know what it is, right?
So you know, people just go along with it and that's how it's a hard way for people to learn
when you hear these terms and say, well, I don't want to look dumb.
So I'm not going to ask them what that is or how it's calculated or those types of things.
And so there are some of those financial metrics out there, but they're really important to
the success of a business.
And so what I hope we get out of this discussion is your take on what you feel the key financial
metrics are and you know, how they're used and why they're important.
That makes sense?
Yeah, that makes absolute sense.
And I'll just throw in there that that's a common issue with really all professions that
we all have our own language that we speak.
And the challenge that we have as professionals is to be able to communicate with other non-professionals
outside of our profession.
And so it's really important to be able to take your knowledge and put it into a common
person's terms so that we all understand each other.
That's right.
Even an HR person can understand it, right?
So well, if I can understand it, then you're probably good with class of third graders
or something.
We do learn in our career a lot of these terms, but learning the hard way is not necessarily
the best way.
And for listeners who are trying to grow the career, these are really important concepts
to know and to learn and to be able, as you mentioned, it's important for the finance
people to be able to communicate to laypeople in a way where the laypeople understand.
It's also important, it's a two-way street.
It's also important for the laypeople to understand that these are important concepts and to learn
enough about these concepts so that they can converse with finance professionals as well.
That is perfect.
Yeah.
So the first, I guess the first question I have for you, and I've heard it a lot in my
career, is the concept of a balanced scorecard.
So can you talk to the listeners about a balanced scorecard, what it is and how it's used?
Sure.
So I'm a firm believer that you can't run the operation only by looking at financial
results because financial results are a trailing indicator of all the other upstream activities
that you've embarked on.
And also that a strictly financial reporting system can lead to imbalance in your operations.
So in the 1980s, Robert Kaplan and David Norton came up with what they called the balanced
scorecard.
And it took on four different perspectives, the financial perspective, the internal business
process perspective, learning and growth perspective, and the customer's perspective.
And all of this was centered around what your vision and strategy is.
And so their basic theory is that if you look at it from four different perspectives, you
get a more balanced approach to what your operation is doing.
So for example, you would have your financial perspective, which would include what we're
talking about today.
You would have your internal business process, which is talking about how your business operates
and your efficiencies and your processes to be able to accomplish what your goals are.
You've got your learning and growth perspective, which is how is your business setting up for
the future of your operations?
Where do you want to go?
It's more strategic in its outlook.
And then the customer's perspective is how does the customer perceive your business?
What's their experience with dealing with you?
And so if you were to look at only one of those four perspectives, you would get out
of balance.
If everything was about the customer and nothing was about the employees, you would have an
imbalanced organization that would make suboptimal decisions.
And so I strongly suggest that companies use a variety of performance measures and using
the balanced scorecard to keep those perspectives in line.
Having half a dozen metrics per perspective would give you a very balanced perspective
of your business.
Okay, so what you're saying is the balanced scorecard is a means to collect the data and
make sure you're taking into account all those areas that have impact on business success,
not just the financial perspective or internal business processes or customers or that sort
of thing, but it's a more holistic approach.
And you would have financial metrics that measure the finances and you'd have metrics
that measure the internal business processes and customer satisfaction and employee satisfaction
and those types of things.
Is that what you're saying?
Yeah, yeah.
So you would have voice of the customer or net promoter score, those sort of things that
are non-financial metrics that would fall into each of those categories.
And those provide an alternate way of looking at things.
And the beauty of the balanced scorecard is it provides the framework and the discipline
to look beyond just the financials.
Got it.
Okay, well, that makes sense.
So the emphasis is not just on financial metrics, but metrics that measure all aspects of the
business.
That's correct.
Yeah.
Okay.
So what I'm discussing today is just that financial perspective, but I wanted to emphasize
that that's not a complete view of the operations.
So as a finance guy, I can talk at length about the financial perspective, but I wouldn't
want anybody saying that's the only way to look at a business.
Got it.
That makes sense.
Thanks, Jeff.
So another mysterious term out there for some at least is the balance sheet.
And when you hear finance people talk about the balance sheet or refer to it.
So talk me through the balance sheet and its purpose and what it's capturing and why it's
important for business.
Yeah.
And just to give just a brief overview is there's three main financial statements.
There's the balance sheet, the income statement, and the cash flow statement.
Right.
I view the balance sheet as kind of the mother sheet of all the other financial statements
because what the balance sheet does is it takes a snapshot of the business.
It's a picture and a point of time.
And it's what does your business look like on paper?
Whereas your income statement is a view of the activities of the business over a period
of time.
And the cash flow statement describes what happened to your cash over that same period
of time.
So your balance sheet is structured in a way that it balances.
And that's hence the name.
So at its highest level, assets equals liabilities plus owner's equity.
So your assets is what you own.
Your liabilities is what you owe.
And your owner's equity is what you have invested in the business.
And so the three of them have to balance out.
And if they don't, then you've got a problem.
So on the asset side of the balance sheet, you have...
It starts from the most cash oriented, which we at Finance guys talk about liquidity.
The most liquid is the closest to cash, right?
So the top thing on your balance sheet on the asset side is cash.
Then it's accounts receivable, inventories, other current assets.
And so you've got this group of items that's called current assets, which is those four
things that I just mentioned, cash accounts receivable, inventories, and other current
assets.
Then you've got longer term assets, which we refer to as fixed assets, and then other
assets.
A fixed asset would be if I had property, plant, or equipment.
If I have a building, it's going to last me more than one business cycle.
And so we call that a fixed asset.
If I have a machine that's going to last me more than one business cycle, that's also
a fixed asset.
Whereas if I have inventory and I'm going to bring it in, I'm going to transform it
and send it out, that's in current assets because it's going to turn into cash quickly.
Okay.
On the liability side of the balance sheet, you have the same thing, is the most liquid
first, the closest to cash.
And so you have accounts payable, and then you have short term loans.
Other accrued liabilities, which would include payroll and benefits payable, or royalties,
or other types of liabilities that I owe to other companies.
And then I have the current portion of long-term debt.
If I've got a term loan that's five years old or five years out, I take the amount that
I'm going to pay in the next business cycle, the next year, and I reclass it up to current
liabilities because it's going to turn into cash or use cash in the next business cycle.
So those items are current liabilities.
And then I have long-term debt and then other liabilities for a comes out to my total liabilities.
Okay.
So I take my total assets minus my total liabilities, that whatever is left over is what I own as
a business owner, and that's my owner's equity.
So that's a snapshot, if you will, of the company's success, right?
Correct.
Okay.
Or maybe not their success, but it's a snapshot.
It's a snapshot of the company's financial health.
Yeah.
It's a picture in a point of time.
It's a snapshot at a given time.
And so often at the end of a period, December 31st would be when you take the measure of
the balance sheet or the end of a quarter or the end of a month, you would take the
snapshot of the balance sheet.
Got it.
Okay.
And so that's the balance sheet.
You mentioned that there were three, the balance sheet, the income statement, and the statement
of cash flow.
So talk to me about the income statement.
Okay.
So the income statement, if you reflect back to the balance sheet, the owner's equity section,
the owner's equity section is made up of two things.
It's your investment in the company and then any earnings that you retain.
It's called retained earnings.
Your retained earnings change over time.
It's the cumulative amount of all your net incomes over time.
And so the income statement provides that microscope into what happened to your retained
earnings.
And so it's made up of revenue or sales at the top and then your cost of sales, otherwise
known as cost of goods sold.
And that brings us down to what's called gross profit.
Then you have your operating expenses, which is research and development, selling and administration,
and then general, which is accounting and HR and all the supportive functions to come
down to what's called operating income.
Operating income is also termed as EBIT, which is earnings before interest in taxes.
Okay.
Then you have other income and expense, which is your interest in your taxes to come down
to net income.
There's another measure in there that adds back depreciation and amortization expense.
And that's called EBITDA, earnings before interest, taxes, depreciation, and amortization.
So you'll hear that term sometimes when people are talking about results.
Okay.
Yeah.
I've heard that term very often.
Yeah.
Okay.
So that's the income statement.
So how often would you publish the income statement?
Typically on a monthly basis.
And so unlike the balance sheet, the balance sheet is a picture in a point of time.
Yeah.
The income statement is a description of the activities from one time period to the next.
I see.
So your income statement would be a statement, say, for the month, it would be from the first
of the month to the 31st of the month, all the sales, costs, expenses, et cetera, to
come down to net income.
So the balance statement would be a snapshot or a picture at a point in time.
And the income statement reflects the financial health over a period of time.
Correct.
Gotcha.
All right.
Okay.
So that brings us to the infamous cash flow statement.
Yeah.
And the cash flow statement is, I think, one of the most underappreciated statements of
the financial statements because it's hard to understand.
They use terms that are difficult to understand, but it is very valuable, especially if you
are running a business where cash is important.
So the cash flow statement is a description of what happened to your cash over a period
of time.
So let's say if you publish your financial statements once a month and your income statement
is from the first to the 31st, your cash flow statement is for the same time period.
Okay.
Mm-hmm.
And so it starts off with your net income, your net earnings.
And then they add back any non-cash expenses, which is non-cash expenses would be your depreciation
and amortization expense.
And then you adjust for changes in the balance sheet, changes in accounts receivable, changes
in inventory, and changes in accounts payable, which would bring you down to cash flow from
operations.
So there's three categories in the cash flow statement, cash from operations, cash from
investments, and cash from financing.
So your cash from operations deals with those things that are normal to the course of the
business.
Your cash from investing is if you have to buy fixed assets to run your business, those
are investing activities.
And so the change in fixed assets at cost is your cash from investing.
And then how you pay for those investing activities, your fixed assets, is called cash flow from
financing, and that's your change in debt.
So let's say I buy a piece of equipment.
I'm going to have a payment for $100,000.
And so my cash flow from investing would be minus $100,000.
But let's say that I paid $10,000 for it, $10,000 down payment for it, and then I borrowed
the rest.
I would have a cash flow from financing of $90,000, right?
Because I paid $10,000 straight out of it, but I borrowed $90,000.
Somebody else's money paid for my fixed assets.
And so I had an inflow of cash based on that loan.
So when you add all those together, you've got your cash from operations, you've got
your cash from investing, cash from financing.
So that equals your total cash flow.
And how that relates to your balance sheet is if you take your beginning cash balance
plus your cash flows equals your ending cash balance.
Okay.
So, Jeff, we've talked about the balance sheet, the income statement, and the statement of
cash flows.
Let's take a quick break.
And then when we come back, we'll delve into each of those in more detail.
At Flagship Talent, we work with our clients to find and place the right talent.
What do we mean by the right talent?
We mean we find talent who will commit to your organizational goals and align with your
values and behavior expectations.
Talent who will perform to your expectations.
Talent who will stay and grow with your organization.
How are we different from our competitors?
We offer the lowest fee structure in the industry.
We offer the best talent guarantee in the industry.
We provide selection and interviewing support to our clients at no additional fee.
We want to save you money, deliver high quality talent, become an extension of your organization,
and be your preferred provider of talent acquisition solutions.
To learn more, contact Jeff Parsons by email at jeff at flagshiptalent.com or by phone
at 1-800-530-4189, extension 101.
Okay.
We're back with guest speaker, Jeff Smith.
So Jeff, how do you know where to go to get the financial data you need to resolve an
issue, to make a decision, that sort of thing?
How do you know what's good?
How do you know where to find the data that you need?
Well, so all of the, most of the financial information comes straight from those three
financial statements.
Okay.
And so your accounting department is going to have a ERP, an enterprise resource planning
system.
And that will include the financials, right?
And so at the end of every month, the accountants go in their back room, they do all their accounting
stuff and out popped these three financial statements.
Gotcha.
Now, taken out of context, you don't know whether it's good or bad, right?
If somebody said to me, well, Jeff, I have a 30% gross profit.
Is that good?
Mm-hmm.
And the answer is, I don't know, right?
It could be good because if I looked at what you've done in the past and 30% is an improvement
over what you've done in the past, then maybe it's good, right?
If I look at what your budget is and 30% is right at where your budget is, then it could
be good.
If I look at what your peers are doing out in the industry and they're all making a 50%
margin and you've got a 30% margin, then maybe it's not so good, right?
So we have to have comparisons in order to understand financial metrics.
And so the things that we compare to is actual versus budget, this period versus last period,
this period versus the same period of last year, which then allows you to understand
seasonality.
And then your results versus your competitors' results or your results versus industry best
practices.
Those are kind of your comparison points where you're looking at things.
And so you don't want to compare it to just one thing.
You'll want to compare to a couple of different things in order to get a good understanding.
And so understanding where you've come from, understanding where you've projected that
you're going to, and understanding what others in the industry are doing are good comparisons
to understand whether it's a good or bad result.
Gotcha.
And I'm certain that those comparisons are really important when you're trying to get
additional financing or when you're looking at M&A activity or that sort of thing as well
to improve the financial health of your business.
Yeah.
One thing I would caution as well is not to get too tied to the metric itself.
Learn about the story behind the metric.
And give you an example.
Okay.
When I worked for manufacturing companies, purchase price variance, otherwise known as
PPV, is a big metric for the supply chain people, especially the purchasers.
But they get all stressed out about it.
They're like, oh, I can't show a negative PPV.
And where the result is the result.
So let's say that the price of steel goes up.
And that ends up resulting in a negative purchase price variance because the purchase price
variance compares your actual amount that you paid for a product to the standard cost
of the product, the expected price that you're going to pay.
If your actual is different than your expected, then it's going to have a variance, either
a positive or a negative variance.
And so understanding that the price of steel goes up, that's beyond our control.
So if we have a, say, a product that has a whole bunch of steel in it, then we're going
to have an increase in overall costs.
We're going to have a negative PPV.
It's not that it's good or bad.
It's how do you explain it, right?
We explain that the price of steel has gone up.
It's out of our control.
We're going to have this negative variance for the rest of the year.
So we're going to have to figure out other ways of adjusting for it.
Right.
And I know from experience that sometimes companies make decisions on, as an example,
raw material purchases, right?
And as you mentioned, steel, but it may be okay.
The price of oil is down and so our oil-based raw material prices are lower.
We need to pre-buy and build our inventory.
And I believe that's one of the more frustrating thing for the lower level, entry level operations
leaders because they don't understand, well, this month they want us to build inventory,
next month they want us to sell off inventory.
They can't piece it together.
They think that the people, the senior leaders don't really know what they're doing.
But you make a decision to pre-buy raw materials that you know you're going to need over time
and it will have an impact on your financials, but you have to be able to tell the story
of why, you know, what the impact is, why it's there and what you're doing to remedy
it, right?
Yeah.
And you have to make a balancing decision based on the carrying costs of holding that
inventory versus the benefit of pre-buying at a lower cost.
Right.
That's right.
Okay.
So, good discussion there.
Going back to the balance sheet, you know, what are some of the metrics that are tied
to the balance sheet?
So on the balance sheet, there's two types of metrics.
There's what's called liquidity metrics, which talk about how you're managing your cash versus
that management metrics, which talk about how you're managing your investments.
Okay.
So on the liquidity side, we have the one thing you'll hear often is working capital.
That's right.
Working capital is current assets minus current liabilities.
So if you remember back to the balance sheet, it's cash, accounts receivable, inventories
and other current assets.
Yeah.
Current liabilities is accounts payable, prepaid or accrued liabilities and other liabilities.
So your assets, current assets minus your current liabilities equals your working capital.
Your current ratio is your current assets over your current liabilities divided by,
and that gives you a, instead of a dollar value, it gives you a percentage.
Percentages are easier to compare to other businesses in the industry because they're
all different sizes, right?
So if you would just have dollar amounts, then it's sometimes hard to manage because
it's out of context.
Right.
Okay.
Days sales outstanding.
That's another one that you'll hear a lot of, DSO.
That measures how you're collecting on your revenue.
So I sell product to my customer.
They're not coming in with a suitcase full of cash.
We invoice them, they owe us and typical terms are net 30 days, net 45 days, something like
that.
So we have accounts receivable, those things that people owe us.
And so how long does it take for us to collect on it?
So days sales outstanding is your accounts receivable over your revenue times your number
of days.
So it'd be like, you know, accounts receivable over your sales for the year times 365, which
will give you a number of days that it takes to collect on your receivables.
Okay.
Your day sales in inventory, which every operations person should understand, is similar to that.
It's your inventories over your cost of goods sold times the number of days.
And that's how many days worth of inventory do I have on hand?
Right.
I'll give you the caveat there is that that does not stratify your inventory and every
operations person should have an understanding of what they have in inventory, whether they
have slow moving items in inventory, whether they have obsolete items in inventory.
And so this is just a very high level picture, but it's incumbent on the operations person
to understand the details behind the inventory.
Right.
Days payable outstanding is accounts payable over cost of goods sold times the number of
days.
So that's how long do I take to pay my vendors for the inventory that I bought?
So if we bring all that together into one metric, we have the cash conversion cycle,
which is really, really useful, especially when you're in an expanding business, because
your cash conversion cycle is your day sales outstanding plus your day sales and inventory
minus your day's payable outstanding.
And so that's how much time does it take me to turn my investment in inventory into cash?
So if I buy inventory on day zero and it takes me 30 days to convert it to a saleable asset
and then I sell it and it takes me 45 days to collect, that's 75 days of total inventory
to cash.
And I have accounts payable and say I've negotiated 30 day terms.
Well, I can then take out 30 days out of that 75 days.
So 45 days would be the amount of time it takes me to take to turn an investment in
inventory into cash.
That's really important if we're expanding because say my baseline sales is $1,000 and
I want to increase my sales to $2,000.
Well, if I've got 45 day cash conversion cycle, I need to have at least a month and a half
worth of access to cash in order to fund that increase in sales.
Does that make sense?
It does.
It makes sense.
Yeah.
So before we move away from liquidity, liquidity issues or having low liquidity would be the
problem that pushes a company potentially into let's say bankruptcy, worst case scenario,
correct?
Yes.
Yeah.
And the awkward conversation is that you can have a company that's very successful that
goes bankrupt.
Yeah.
Because if you're expanding and they don't have access to cash in order to fund their
expansion, then they're going to get themselves into trouble.
Right.
Or if their cash is, or if it's all tied up and you're not getting your receivables collected
and you're expending cash in payables, more cash than you're bringing in, then you get
yourself into trouble as far as liquidity is concerned.
Correct.
Yeah.
Okay.
That makes sense to me and I've had clients with that issue.
So well, Jeff, I know by my mentioning bankruptcy, we've sort of ended this episode on a down
note, right?
But it had to be said and it was excellent discussion today.
So thank you again, Jeff.
And next week is our final episode of episode eight of Finance and Operations with guest
speaker Jeff Smith.
If you want to get in touch with Jeff Smith, you can do so via email at Jeff, that's G-E-O-F-F
dot Smith at dynamic strategy LLC dot com.
So join us again next week.
I promise you we won't be talking about bankruptcies or funerals or anything so dire and so dark.
We'll have a great discussion next week to wrap up our series on Finance and Operations.
In the meantime, thank you for listening and work hard to be the flagship in your industry.
Thanks again.
See you next week.
Bye.
Thank you for listening to this episode of Be the Flagship with Jeff Parsons.
We hope you enjoyed it.
If you did like it, please subscribe and share with others.
Until next time, take the step to become the flagship in your marketplace.