Determining the value of your business: recasting the income statement
Valuing your business is something you’ll need to do if you’re about to sell it off. There are several ways to value a business, but the most reliable methods are based on cash-flows rather than profits. Here’s a piece from the You’re the Boss blog in the NY Times which gives a good example of one cash flow based method. The method uses the income statement/profit & loss account as a starting point to work out what’s often termed the owners’ cash flow. This is turn is`often combined with a multiplier (e.g. a number of years) to derive a value for a business.
What is management accounting?
This is a question which as an academic I could spend a long time on, but let’s keep it simple. If you open a text book on accounting you’ll get something like ‘management accounting is the branch of accounting which provides information to managers to help them make business decisions’. It earlier times, the term cost accounting was used, as the provision of cost information was most prevalent in the work of what today we’d call management accountants.
In a larger business, it’s easy to imagine one or more internal accountants working to provide information on costs, revenues etc. to managers. In a smaller business it’s more difficult to picture this, and I believe the lack of management accounting is a major issue for lots of small businesses. Take a typical sole trader as an example. They typically trade away during the year and make the annual visit to an accountant to find out how much profit they made. But this routine trip is not about management accounting; it’s more about making sure accounts are prepared and taxes on profits calculated. Any business needs much more regular information than this to make key decisions. As mentioned, a typical management accounting task might be to have regular and detailed information on costs – without this a business might not even know if it is making a profit or not. While I admire the dedication and zeal of many budding business owners and entrepreneurs, sometimes a dose of reality is needed on business decisions. Management accounting information does this. For example, many businesses fail because they expand too quick. A typical scenario for a small business might be increasing the work force by adding another employee. Let’s assume the wages amount to £/€/$ 35,000. What management accounting would do is look at the effect of this extra cost of profits, revenues and existing costs e.g. are extra sales needed to cover the cost and how likely are they to occur. Let’s forget about the term ‘management accounting’ for a moment. The point I am making is that accounting (i.e. financial/monetary) information is an essential part of any business decision. What we call it does not matter. But, smaller and/or new businesses don’t seem to do enough of this. How can thus be improved? Well there’s a whole host of things, but in my view the simplest thing any small business can do is make full use of the data it already has. Rather than just going to an accountant annually, prepare accounts on a quarterly or monthly basis. While this may be a daunting task at first thought, there are plenty of accounting software packages out there to help e.g. Quickbooks, Sage and TAS. More regular accounts will at minimum identify losses or poor profits at an earlier stage.
(In-)Corporate(d) Social Responsibility
Corporate social responsibility (CSR) is a term used to describe how a business sees its responsibilities towards things like its workers, the environment, the community, customers and so on. If you look on the website of most large businesses, or in their annual reports, you’ll find something about the how the business operates in a responsible manner. Many such businesses have a separate CSR manager who reports directly to the board of directors. Mike Brooks writes in the June (2010) edition of Financial Management how some companies don’t adopt this approach, but instead have CSR embedded throughout the company. A big advantage of having CSR embedded throughout a business is that projects or plans need not be evaluated separately from a CSR perspective. Instead, being a socially responsible organisation is embedded in all roles and business processes. This method, according to Brooks, moves CSR away from a once a year mention in the annual report to something that’s hard-wired into the organisation.6 traits of successful small businesses
Here’s a recent article from Inc. magazine on some research which tries to identify the characteristics of successful small business.
Guardian Life Report Identifies Six Traits of Successful Small Businesses.
Don’t loose sight of profits and cash flows – how Lego revived its outlook
The Danish toy company Lego, has had to do a bit of re-building of late, according to Time (June 7th, 2010). Lego has been around since 1932 and has given many generations endless hours of fun (or peace if your a parent!). The product was created by an unemployed Danish carpenter (Ole Kirk Christiansen) and he patented it in 1958. Today, as anyone with kids knows, there are so many high-tech toys that compete with traditional toys like Lego, which has education and learning at its heart. This in fact was one of the contributors to Lego making large losses (e.g. $450 million in 2004) – focusing too much on the educational value of its 14,000 unique stock items. In 2004, a new CEO Jorgen Knudstorp, took the helm. He quickly reinvigorated the company by not forgetting one of the basic lessons of accounting and managing a business – the bottom line counts. There were lay-offs, plant closures and new licensing deals (Star Wars, Harry Potter for example) and some efforts to adapt the product to the digital age e.g. an online website where children can design their own creation and order a physical copy. The result – profits were $440 million in 2009. So don’t forget, now matter how good your product or service is, it can only survive if the bottom line is positive and generating cash!Performance indicators in small businesd
Measuring performance of any kind means a target, plan or standard must be in place to measure against. Any business, large or small needs some kind of a plan. In the accounting world plans equals budgets – yes those annoying things! A budget is plan expressed in money terms. Usually budgets for incomes and expenditures are set for a year and each month the business performance is measured against the budget. This is common practice in many businesses but how useful the comparison of results versus budget is depends on how good the budget was in the first place. Should a business complement measuring against budgets with other types of performance indicators? Yes is the answer. Larger businesses use many indicators of performance other than comparing to budgets or profits. For example, a key performance indicator for an airline is”bums on seats”. This is something that can be measured by flight, day etc and related to the costs of running the airline. Could a small business do something similar? Sure it can. Here’s an example for a business I know. This business automates entrances gates for residential and business customers. It offers both installation and maintenance services. As a small business, the owner does not have the time (or staff) to do detailed plans and compare these to actual performance. But, he does know the costs of running the business. So he equates costs to a number of service calls or installations needed per week. For example he knows he needs to do 5 service call to cover wages. One installation and 5 service calls covers all costs and makes a profit.This is a little easier to track and relates the work done to performance in terms of covering costs. It might not be 100% accurate, but it’s a good guide. So what performance indicator would you use for your business?
Thinking about costs and revenues when setting a price
Here’s a great example of how you need to think about costs when setting a price for a product or service. During the recent volcanic ash cloud over Europe (April/May 2010), many travellers were left with no option but to hire a car to drive home. One result of this was that 100’s of hire cars from Spain and Portugal ended up in places like Kiel and Rostock in Northern Germany as people from the Baltic states and Scandinavia tried to get home. To get these cars back to their places of origin was a problem. So what at least one major hire car company did was to offer cars for hire for €1 per rental period (incl. the fuel in the tank) once they were going south. Over a few weeks 70-80% of the fleet were back to where the needed to be or a lot closer. But surely no profit could be made at a price of €1. No, none was, but think about the costs saved by not having to hire additional car transporter trucks to carry the cars 1000’s of miles! So the “profit” was made by saving costs.Risk in business
Any business faces risks at some time or another. Some may be easy to avoid or foresee, and thus measures can be taken to avoid or reduce them. Student Accountant (the ACCA’s student magazine) of June 16th last includes a feature on the recent volcanic ash cloud take caused chaos over European airspace on April this year. It might be something the airlines had not really thought about before now, but you can bet they now include disruption from volcanic ash in their assessment of business risk. The estimated losses from the disruption are in excess of $1bn – not exactly what the already recession hit airline sector needed. Can all business risks be eliminated ? Of course not, but businesses can try to minimise or reduce risks. As mentioned in the article, a four point TARA model can be used to assess risk:
No Accounting for startups?
While having a regular look on inc.com, I found this interesting blog post from Steve Blank’s blog. He writes that financial statements are not the best thing to use to monitor a start-up business. Sometimes banks or venture capitalists insist on things like regular income statements and balance sheets. While I don’t think it’s right to say “no accounting”, there is a point in the pieces in that a start-up might be much better served concentrating on more important performance indicators. Have a read and see for yourself.
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