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Don't be fooled by bottom line profit

Posted in Nigel Milton - The Accountant February , 2013  7 Comments  Add your comment ›

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Nigel Milton, Partner at BDO

Managers and business owners must understand what drives the misleading bottom line, what measures (or metrics) should be used to manage the business and how to use those metrics to improve business performance and forecasting.

The lessons of the past 18 months are as valid as ever despite recovery mode, especially when it comes to the temptation of struggling business to continue production even when there is no immediate market.

Continuing to produce certainly keeps staff busy, but eventually you’ll end up with a lot of product and no cash flow.  Your bottom line profit has killed off your business.

The key for managers in these situations is in understanding what drives the misleading bottom line, what measures (or metrics) should be used to manage the business and how to use those metrics to improve business performance and forecasting.

We all know profit is usually made when inventory is sold.  Profit is also made when inventory is produced, as a proportion of fixed overhead expense is removed from the profit and loss and put on the balance sheet as inventory.  Managerial focus can then turn to production as a means to increase the bottom line.  At the same time that the bottom line is telling managers that everything is OK – while sales are not being made, cash is being lost and debt is being incurred.

The key is to focus on cash and use metrics that will help drive cash out of the business.  However not all the problems can be tracked immediately to the bank account.  Build-up of profit – making inventory on the balance sheet can be partially offset with increasing creditors.  One way around this is to measure operating cash flow calculated from financial statements.  But I believe a deeper analysis is required.

For me the goal is to concentrate on the levers that drive sustainable operational cash out of the business.  These are sales volumes, the contribution margin of those sales (sales after variable costs), sales mix, supporting overhead and inventory levels and values.  On a business by business basis the starting point is to find the ever changing optimum mix of these often competing ingredients.  Opportunities to improve cash flow may even present themselves after this analysis.  At the very least this analysis should lead to a good understanding of the business’s cost structure, development of supporting measures and a more robust forecasting process.

At this point the detailed work of driving out the harder to reach cash can begin.  This will likely involve a number of discrete initiatives.  Big corporates will often use a structured programme to do this.  You may have heard of some of them – Lean Manufacturing, TPM, The Toyota Way and Six Sigma.  Not having the cash to invest in a structured programme shouldn’t stop a smaller business from implementing some of their own initiatives – and many are doing so.

Looking at the wrong measures – even bottom line performance – can lead to fatal decision making.  Measuring cash drivers will reduce the risk of business distress, help develop and understanding of the business’s cost structure and provide a platform for robust forecasting and cash management.

Nigel Milton

Partner, BDO

nigel.milton@bdo.co.nz

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