By Donald R. Pinkleton, CPA
We all suffer from information overload. On a personal level, it’s merely annoying. But when it comes to running a business, it can be deadly. If you spend all day plowing through a sea of “information”, you won’t get anything else done. So, to survive the onslaught, we all develop our own filtering methods. I call them “information survival skills.”
Reactions to information overload range from “ignore it” (hope it’ll go away) to “beat it to death” (the paralysis of analysis.) In my accounting career, I’ve seen the full spectrum.
I’ve seen firsthand how financial reports have been viewed as information overload. There are highly successful entrepreneurs whose eyes glaze over when shown their financial statements (and tax returns!) Their response often boils down to “I know how to make money
– I don’t need to look at all this, that’s what I pay you to handle.”
This echoes a popular definition of an accountant: “Someone who solves a problem you didn’t know you had, in a way that you don’t understand.”
I like to depart from that definition whenever possible. I try to help business owners to understand the problems on their own, so they can work out the solutions that are best for them. Yes, there are those who don’t want or need such help – they truly have the Midas touch (at least until it stops working.) This article is for the rest of us. Because financial information contains feedback we need to manage our businesses. But how do we separate the wheat from the chaff?
We can take a clue from the “I know how to make money” entrepreneur: he has grasped the ability to focus on key metrics, and to ignore the noise of “too much information.” I have known successful entrepreneurs who have run their businesses on the “Three W’s”
Model: “What do I have, What’s coming in, and What’s going out?” Are they unsophisticated? Not at all — they’re focused like a laser on the controllable factors that determine success or failure.
And that’s the focus of this article: what makes you money? Or, more precisely, what loses money? The key to managing any enterprise is in managing information. But how do we do that?
All information management systems require Gatekeepers. Anything you’re actually going to spend time on should be able to satisfactorily answer these three questions:
What do I do with this information?Where’s the action item?How do I make money — or save money — with this information?
What do I do with this information?
If someone tells you the building is on fire, the answer to that question is fairly obvious. Otherwise, we need to determine if the information is relevant to our business objectives. In other words, “Is there something here that can move me closer to my goals?” Does this information convey a threat, an opportunity, or a distraction? It’s not always easy to determine which it is. Once identified, distractions can be discarded, leaving only threats and opportunities to evaluate. (“Oh, is that all? Just threats and opportunities? I can take the rest of the day off.”) Financial information is not exempt from this test: we should be able to look at a report and ask, “What is this telling me?” That leads us to the next question:
Where’s the action item?
The goal of financial reporting is to provide information for decision making. Period.
The business owner needs to identify which pieces of the puzzle are on track, and which areas require corrective action. Standard financial ratios are a common tool used to evaluate operating results – gross margin %, net margin %, inventory turnover, receivables turnover, etc. These tools serve as “flags” to alert business owners that an area critical to success needs their attention, and that corrective action may be required.
Gross margin is critical to business success, because that represents the amount of money I have to pay all other expenses and to generate a profit. If the income statement shows me that the gross margin percentage (defined as [Sales minus Cost of sales] divided by Sales) is shrinking, I need to find out why, and take corrective action if necessary and possible. In other words:
How do I make money — or save money — with this information?
Continuing our example, I may need to investigate further to find out what’s causing the decline in the gross margin percentage.
- Is the product or service I sell viewed as a commodity, indistinguishable from what my competitors offer?
- Is market pressure reducing the price that my customers are willing to pay for products like mine?
- What is the average gross margin percentage for similar firms in my industry?
- Is there a way I can add value to my product, so that it’s not seen as a commodity?
- Or is the cost of producing and delivering my product rising?
- Is that also due to market pressure, or has my production and delivery process become less efficient?
- Whatever the issue is, what do I do about it?
Sometimes I’ll change nothing, because this is actually good news! Maybe I’m selling larger quantities to my customers: the volume discounts are eating into my gross margin percentage, but the gross margin dollar total is actually increasing! And my other expenses have not increased. Oh joy, oh rapture – it’s time to give myself a raise!
The previous example is a simple case that would not normally require extensive investigation. Most real-life issues are not so obvious. In addition to the numerous standard financial ratios that can be used to analyze the results of operations, there are some ingenious tools that are unique to certain industries. For example, a restaurateur I know looks at food sales vs. food reorder costs: if the ratio is less than 2 to 1, he knows he has a problem. The key point remains in knowing what information to focus on.
The strategies we implement to achieve our goals tend to be complicated by numerous complementary and contradictory factors. And some of those factors may be beyond our control. But all successful strategies must be focused, proactive and reactive. There must be a clear objective, a plan to get there, and a plan B for when plan A fails. Remember the old military adage: “No plan survives contact with the enemy.”
That’s why financial information should be part of your critical feedback loop that converts information into action. There is a wealth of information in the financials, if we know what we’re looking for and how to extract it. One of a CPA’s primary objectives is to help the business owner understand the story that the numbers are telling, and what numbers one should be focusing on. And to further understand that the numbers will tell different stories to different readers. The same numbers may mean very different things to an owner, a tax preparer, a loan officer, or a prospective purchaser of the business.
But that’s a topic for another day. I don’t want to burden you with information overload.
Just always keep in mind the fundamental law of the universe: “If your outgo exceeds your income, then your upkeep will be your downfall.”