THE FINANCIAL STATEMENTS
KEY FINANCIAL INDICATORS
ACCOUNTING ISSUES
WHAT-IF ... SENSITIVITY MODELS
TIMING MATTERS
JUSTIFYING INVESTMENT
SCORECARDS AND VALUE MANAGEMENT

ACTIVITY: KFIs Quiz

Research has shown that active recall, pushing yourself to recall new information rather than simply going over it again, has a big positive impact on learning and long-term memory. Also by trying to answer questions, you gain new insights and expose gaps in your knowledge.

So here is a short active recall activity. Click on the  heading to check your answer.

Return on Investment (ROI) ratios divide a profit figure by either an investment figure or an asset figure.  For instance:

or

Essentially the calculation is measuring what returns have been generated for a given level of investment or the use of particular assets.

Profit divided by sales.

DSO = Days Sales Outstanding and is another term for Accounts Receivable Days – the average number of days it takes customers to pay.

Note – this is an average. Dramatic improvements in DSO could be achieved by managing particular customers differently.

Funding days – or Working Capital Days – are the number of days between customers paying us and us paying our suppliers, taking into the level of inventory.

The Working Capital Requirement takes into account COGS, and so the level of sales, and the funding days.

In this example:

We can see that $149,317 is tied up in working capital. We can calculate this as a percentage of sales. If sales are $800,000, then working capital is 18% of sales (149,317/800,000).

This means that for every $1 increase in sales, the business needs to find an extra $0.18 in working capital – otherwise it runs the risk of over-trading and it may run out of cash.

This is a critical mistake that many small businesses make.

When new shares are issued, the earnings of existing shares are diluted – the pie has to be cut into smaller slices. That is not too much of an issue if existing shareholders acquire the new shares, but if they do not, then their position is weakened.

The other reason for borrowing rather than issuing new shares is that borrowing enables the shareholders’ funds to be leveraged. Providing the return generated is greater than the cost of borrowing, borrowing makes sense. Except, of course, there is an increase in risk.

The table below shows that when debt is 80, there will be interest payments of 8, reducing profit to 12 (20-8). However, since the shareholders have only invested 20, they have a return of 60% versus only 20% if the business is funded entirely by equity.

Inventory days are the number of days on average stock is held before being converted into a sold product. The higher the figure, the more money is tied-up in stock – not a good thing.

However, high stock levels may provide commercial benefits:

  • the ability to deliver quickly, offering an edge over competitors
  • it protects against problems in the supply-chain
  • stock may have been bought in bulk earning significant discounts

We have to look for the story behind the number before jumping to conclusions.

Perhaps increased spend has:

  • resulted in lots of new orders that have yet to be invoiced
  • opened up new markets – but it’s early stages yet
  • stopped sales falling even further – it is a declining market and the company has done much better than its competitors
  • protected existing sales against aggressive competitors who have invested significant sums in advertising and offering discounts. It is not the quality of the marketing, it is the competitive situation that is to blame

I could go on … the message is clear: always look for the story behind the numbers. 

You may have additional ideas but here are my thoughts:

 The accounting system originated as a means for recording transactions. It struggles when there is no direct transaction and so it fails to take into extremely important intangible assets and performance drivers, such as:

  • brand
  • relationships
  • skills
  • systems
  • experience (what doesn’t work!)

 What is the value of an asset – in the accounts, Net Book Value is the purchase price less depreciation to date. But there is a difference between value and worth:

  • isn’t it worth what a potential buyer would pay you for it
  • the same asset may have a different value depending on how it is used – business model

 There is an emphasis on short-term thinking – hitting KFI targets at the expense of long-term success. For instance, training can result in skills which enhance productivity for many years, and yet are treated as an expense, coming straight-off this year’s profits. And the same is true for investments in marketing, building relationships, developing systems …

 The KFIs can exist in a vacuum, failing to take into account what is happening in the market place. And this works both ways. A manager may be congratulated on increasing ROI – and yet competitors are earning higher returns. It may not be clear at the time that other factors are affecting the KFIs.

 The KFIs are historical – aren’t future orders of more interest?

 KFIs measure results, not drivers. It isn’t enough to know that ROI is down, I want to know why. So KFIs should be used alongside non-financial scorecards to gain a better understanding of what drives performance. For instance, customer satisfaction, employee morale, brand awareness …