July 15, 2011

For years I have reviewed budgets, and financial statements prepared at the end of each month, quarter and year. Often when I scan these in the presence of a peer, a client, or an associate, they wonder how I reach some of my conclusions so quickly. I have no specific magic, nor any unusual skill. If anything, I have an accumulation of experience gained from looking at so many of them.

First, I look for things that stick out like a sort thumb. Is something on the income statement way out of line? If sales revenue is way up and gross profits are not, that sticks out. Somewhere along the way, profit margins took some kind of a hit. This is usually caused by increases in costs, reductions in prices, a shift in the mix of what was sold, or to whom it was sold, from higher profit products (services) to lower profit ones.

Next, I dig a bit deeper and look for the root cause. Then look for the answers to these questions: Was this caused by a one-time event? Is it the start of a trend, and if so, how long will that trend last? What can be done to reverse it? Can it be reversed and the lost profits recovered?

You can use this same approach if sales revenue is up and gross margins are up a comparable percentage, but operating profit or net profit is not. Then the problem must be in selling, general, and administrative expenses, or some period expense (a variance, and unusual charge), or interest expense (due to elevated inventory, slow collections, lower payables, or a large capital expenditure). All of these will increase working capital and since that is usually borrowed money, interest costs go up with it.

The final questions I ask, and perhaps the most important ones, are these:

• Are these out-of-the-ordinary results are going to continue for a longer period of time?

• How long has it been developing and how long will it continue?

• Can they be remedied and the lost sales and earnings recovered in this fiscal year?

• How? And who’s going to get on that right away?

• And most important of all: Does it or will it impact the bottom line of the company by a tenth or more? (A tenth means 0.1 percent of net sales.)

In most companies, financial statement results, where expressed in percentages of net sales, are rounded to the nearest tenth of a percent. Thus any adverse result—variance to budget/plan or to last year, or to latest forecast—that equals 0.1 percent is greater than the rounding, and shows up on the bottom line.

That makes a tenth a meaningful amount. Accumulate a few tenths and pretty soon, you have a serious financial impact on any company. (Note that I look at things in terms of the percentage of net sales.) Obviously, a $10 billion revenue company might view a $100,000 miss differently than a $100 million company. It is less meaningful in the larger company’s results. I am not sure it should be viewed that way, since $100,000 is still a large amount of money and something (or somebody) went wrong. But in the larger setting, it is relatively not as serious, with a better chance to make up for it elsewhere.

Now you know the first secret of quickly identifying what to look for in financial statements that reveal issues, problems or mistakes made. I have seen companies ignore misses of a tenth until there were 2, 3, or even 6 or 7 of them. If you have a 0.6 or 0.7 percent miss, when the top financial summaries are rounded up to whole percentages in reporting, alarm bells will go off. Why? Because 0.6 or 0.7 percent miss rounds up to a whole percentage point, and that is big in any size company.

In the future I’ll write more about how to find a point that will recover those several tenths you lost, and maybe even find more than a whole point. But for now, just look for those tenths and fix them. You’ll be happy you did, and so will your boss—and your shareholders.

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