The whole book comes down to one very simple idea:
Measure results, change activities.
In other words, it’s the activities your business carries out that produce results – good or bad. The only way to know if you’re performing the right activities is to measure the outcomes.
That measurement will allow you to make changes to your activities…then measure again, and so on and so on.
The measurement in business is in the form of financial statements. The problem is most business owners either don’t get their financial statements in the right format or don’t know how to interpret them correctly.
Your job as the business owner is to take the numbers and translate them back into activities. If you don’t know what activities caused the numbers, you have no hope of changing them.
The three financial statements
The balance sheet
The balance sheet tells you what stuff the business has (cash, equipment, inventory, property) and whether you own it or owe it.
The income statement
Also known as a “profit and loss report”.
The income statement tells you what you’ve sold during a period of time, and what costs were associated with making those sales.
It doesn’t tell you about the timing of cash changing hands, so it tells you about the theory of your profitability.
There are two presentations of the income statement that are rarely used, but should be:
- “Common sizing”, which means converting every number into a percentage of total revenue. For example, if revenue was $1m and your rent was $25,000, rent was 2.5% of revenue.
- “Dollars per unit”, which means dividing every line item by a meaningful unit. For example, the unit could be the number of customers served. Knowing it costs you $45 of labour to serve each customer can start you thinking about ways to cut it, in a way that you can’t when you just see one big overall figure.
The cash flow statement
As the name suggests, this tells you about movements in cash over a period of time.
There are three types of cash: operating cash, investing cash (from buying or selling assets), and financing cash (from taking out or repaying loans, or taking money from an investor).
Linking them together:
- The balance sheet is a “big picture” snapshot of what a business owes and owns on a particular date.
- The income statement tells the story of how the “current period earnings” line on the balance sheet came to be how it is.
- The cash flow statement tells the story of how the “cash” line on the balance sheet came to be how it is.
Revenues are how effectively management is using the business’ assets.
Profits are a result of how efficiently management is controlling expenses on a given amount of revenue.
How you run your business during the good times is a a great indicator of how well you’ll survive the bad times.
The aim of a business is to acquire assets that are highly effective at producing revenue, then efficiently convert revenue into profits.
For businesses without significant assets (like service businesses), an alternative definition is “profit per employee” or “profit per payroll dollar”.
The rates of growth of each number are important. For example, we’d like:
- Assets (or payroll dollars) to remain the same
- Revenues to grow by 10%
- Profits to grow by 20%
- Cash flow to grow by 30%
We don’t want assets to grow by 30%, revenues by 20% and profits by 10%. That means the business is becoming less efficient and effective.
Cash and profits
You can’t spend profits, only cash: profits are a theory, not a fact. So the aim is really to convert assets into cash flow.
Profits and cash have nothing to do with one another. It’s possible to have £200k of profits and no cash (maybe a customer hasn’t paid yet), or £200k of cash and no profits (maybe you’ve not paid a bill yet, or you’ve just borrowed money).
The easiest way to increase profits is to cut expenses. If your business has a 10% profit margin, saving £1 is equal to making an extra £10! Which is easier?
Building the scoreboard
Your scoreboard has three bottom lines:
Effectiveness: Revenue / Assets
Efficiency: Profits / Revenue
Productivity: Operating cash flow / Assets
For any financial statement to be useful, you need multiple points of comparison. This is how you can tell whether you’re getting better or worse over time: the trend is your friend.
So rather than looking at just the income statement for the current period on its own, look at it alongside the last 3-6 (or more) previous periods to see the direction of the trend.
If the trends are getting worse, you need to think about what activities are causing the numbers and make some changes.
To have meaningful reports, you need to match costs and revenue to the same time period so you know what costs were necessary to produce which revenue.
For example, if you pay £12,000 of rent in January for the whole year, it would be unhelpful to set the entire year’s rent against just January’s sales. Instead, you should record £1,000 against each month.
If you’ve made a big sale and you give the customer 60 days to pay, record the sale when it’s made and not when the cash is received.
This is called accrual accounting. The alternative is cash accounting.
KPIs and critical drivers
A KPI is an effect. For example, Effectiveness (revenue / assets) is a KPI
It’s useful, but it only tells you what’s happened after the fact – like bathroom scales will tell you how much you weigh, but not what’s caused to you to lose or put on weight.
There will always be something driving the KPI. If the KPI is your scales, the driver is your diet.
Any business will only have 3-5 of these critical drivers.
To find them, ask yourself:
When I have a bad month financially, what happened that shouldn’t have happened or didn’t happen that should have done?
Your job is to:
- Identify the critical drivers
- Develop the performance standards (benchmarks) for each critical driver
- Communicate those critical drivers to your team
- Set the rewards and consequences around their achievement
- Measure, report and correct the critical driver execution on a daily basis