The Three Bottom Lines
This is a guest post by David Seaman, Director, Three Lines Chartered Accountants
We are often asked why we called ourselves Three Lines. It is because we feel that when considering the financial performance of your business, no matter what it’s size, strategy or business stage there are Three Fundamental Accounting Bottom lines you must use to get to grips on the REAL financial performance of business. Each of these must be examined in detail and constantly cross-checked with other available financial business data.
Most people understand that businesses have to make a profit but often think this is the sole measure of how a business is performing. Remember the adage, “Turnover is vanity, Profit is sanity”.
If only there were one Bottom Line, it would be so simple!
Unfortunately, a good Profit does not necessarily alone imply a healthy quality business.
If you think about it, why do Profitable businesses run out of cash apparently without any warning?
Why do the directors of profitable businesses get sacked by shareholders because companies are underperforming? Or why do profitable companies get sold to others who then make changes, which quickly results in increased business performance?
Clearly, other factors are afoot. To get the full financial picture, there are Three Financial Bottom Lines, each connected, but each different, and each highlighting key financial business performance. Let’s look at each of these in greater detail.
Bottom Line 1 – Profit
The big advantage of the term the Profit Bottom Line is that everyone essentially understands what it means. You need to generate a Profit by ensuring that sales exceed business costs. Simple!
However, there are some potential fundamental drawbacks. For example, if your customers take longer to settle up each month, or your stock levels are out of control, the company may run out of cash and maybe forced to cease trading. The Profit line sadly does not highlight this problem.
Furthermore, the Profit Bottom Line is dependent on the accounting policies used to produce the accounts. An example here would be where there are identical companies with identical plant & machinery. However, each company may apply different depreciation accounting policies to write off plant costs, meaning each company now reports an entirely different Profit Bottom Line. This distortion to the Profit Bottom Line is unacceptable.
A further drawback is where the Profit Line has been deliberately manipulated with the result that very profitable companies overstate the reported Profit or even report a Profit when a Loss has actually occurred. It is highly unlikely that such disturbing instances would be solely picked from looking at the Profit & Loss account. The recent court cases of Tesco highlights this issue perfectly.
Bottom Line 2 – Operating Cash Flow
Remember the golden rules “Cash Flow. Cash Flow. Cash Flow” & “Cash is King.”
The Operating Cash Flow Bottom Line is so important and, in our view, it beautifully quantifies what is happening in business. The process here is that when a Profit is made, this Profit will be converted into cash when all your customers have paid and when you have paid all your creditors. If a £100k had been made in Profit, then the funds in your bank should increase by £100K. Simple!
What is even better is that by measuring Operating Cash Flow you are tracking the real day-to-day trading receipts and payments that go through the business bank account. The Operating Cash Flow generated from day to day trading should in essence always be higher than the reported Profit. This is because a Profit figure will always contain non-cash items, such as depreciation, which will by definition never hits the bank account. So, if a company’s annual Profits are £100k and there is a £20k annual depreciation charge included in the profit figure, then the cash flow generated that year should be £120k.
If the Operating Cash Flow Bottom Line is above the £120k as used in our example, then clearly the business is well managed. However, if the actual Operating Cash Flow is below this figure, then the business has an issue, which may be poor credit control or poor stock control for example which must be tracked down and sorted.
However, if the figure is consistently below the example of £120k, then the cause is either longstanding poor management or something more sinister such as figure manipulation. There are dubious steps that can be taken to improve Operating Cash Flow Lines which add credibility to a erroneous Profit figure, for example by delaying supplier settlements. This distortion may be picked up by using simple financial ratios such as tracking creditor days figure over time.
Bottom Line 3 – Return on Assets
The Return On Assets Bottom Line figure is simply obtained by dividing the Profit figure by the net business assets reported on the Balance Sheet Report. This figure can be simply viewed as the return your bank gives you on your bank account – a 1% return means you get £1 back on the £100 you invested.
The Return on Assets Line is best suited to larger businesses and not the typical SME. But it can be an incredibly useful measure of performance over time. If the Return On Assets figure goes down each year, the business is either making less profit each year or profits have increased despite considerable more investment being made into the business.
If the business cannot find opportunities to earn higher returns, the logical conclusion is sadly to close the business and take the funds elsewhere.
So, in essence, this is where our name Three Lines comes from!
Clearly the above is a lot to take in. But if you are serious about your business, please ensure you get prompt, meaningful and accurate monthly management accounts, which explain what the individual Three Bottom Lines of your business are. Ensure you get a Profit & Loss Account, a Balance Sheet and a Cash Flow Statement plus with KPIs, key data, and monthly commentary.
If you do not understand the accounts, do not believe them, or you are just simply worried something is not right, the golden rule here is do not hesitate. Get proactive and independent advice from a Part-Time Finance Director. This is by far the most efficient route to gaining financial expertise, in turn adding credibility to your business and maximising confidence.
If you have big ambitions for your business, you have concerns, or the business is in turmoil, the advice is the same. Do not waste a second. Get proactive & commercial advice from a Finance Director.
Finally, there is no point spending £1 getting the management accounts produced if the Board do not either use the Management Accounts to proactively manage the business or they are unwilling to face difficult decisions head-on.
For more info on Three Lines Chartered Accountants go here.