Finance For Managers and How To Use OKR
In many organizations, managers of different departments are not familiar enough about the concept of finances. For example, a sales or marketing manager might assume that it is redundant to know anything about finances, because it is completely irrelevant to their jobs and what they have been asked for. But in today's era it is vitally important to have a stack of skills to expand your capabilities and being able to overcome the future challenges that you might face. In this article I am going to discuss about the basic rules of finances and how to read the balance sheet, income statement and cash flow.
Sales & Revenue:?
The difficulty about revenue or sales is that when should revenue be recorded or recognized the answer is when the product or service is delivered that's the time that the revenue should be recorded on income statement.?
First we are going to break down all the financial statements into three parts. The first part is the income statement, the second part is the balance sheet and the third part is the cash flow statement.?
The income statement shows revenues, expenses and profit for a period of time (month,quarter or year) also called a P&L statement. The bottom line of an income statement is net profit or net income or net earnings. In some nonprofit organizations the profit line is called surplus or deficit. In order to figure out what is really important to a company you can compare the biggest numbers to the sales of a company, for example, after sales or revenue the second line is usually cost of goods sold or COGS and if this number is high and is close to sales then it means management pays a close attention to this line.
We are having a formula of percentage of expenses relative to sales and this is a magnitude of an expense number relative to our sales or revenue so the formula is the following:
% of Sales Expenses = (divide your expenses in a particular period / total sales ) x 100
Footnotes: A typical income statement may or may not have food notes but if they do, just make sure you read them carefully, because sometimes they might be overlooked by people and you don't realize properly enough the real relationship between the numbers. For example, a typical footnote that might be at the bottom of the income statement might be numbers are in millions or in billions or in thousands so these types of things are very important to comprehend the real meaning of every single number.
Something that I highly highly recommend and I really emphasize on is to know that income statement is mostly a prediction and reflects an estimate and assumptions and it may or may not be true so assumptions by nature means something that you predict and something that you're not pretty much sure about and that's why when you see income statement and try to analyze it you have to keep in mind that the numbers are predictions and assumptions and you don't have to heavily rely on them, we will talk about this later on.
Backlog and bookings: Backlogs are not considered as sales yet and in some cases you should pretty much ask yourself what a particular trend in backlog or bookings mean because they are completely different and they have different meanings. For example, a typical growth in backlog means or might need the increase in sales or problem with production or when the backlog is decreasing and diminishing it can be an indicator of a decline in sales or probably you have a greater production capacity and that's why it's decreasing and plummeting. One metric that can be really helpful in order to determine whether your backlog is in a healthy status or not is by assessing the company and how much of the backlog will convert into sales in a given period of time, for example a company might say that they are expecting around 75% of their backlog to turn into sales in the next 6 months. Backlog can have two meanings: it might mean that you cannot meet the demand of the products that you're selling, that's why the number is too high and is increasing or it might be because you have a huge backlog or if it's decreasing it may need that you have improvement in terms of working efficiently.?
Deferred revenue: Imagine you buy tickets from an airline to go from Paris to London so once you buy the ticket you pay the whole amount of money but the airline has not provided the service yet and that's why this type of payment that companies receive doesn't go under sales in income statement but rather it goes to the liability section in the balance sheet, because the company owes you money for providing the service.
Cost and expenses: In a typical Service Company the cogs or cost of goods sold is called differently and it's called cos or cost of services. The idea of cogs is to measure exactly all the costs that are associated directly with making that particular product or service.
The concept of above and below the line:? above the line means sales and cost of goods sold and below the line are associated with operating expenses, interest and taxes. The difference between these two lines is that items that are listed above the line are having a natural tendency to vary from time to time or for a short-term period compared to the numbers that are below the line, therefore managers will tend to check above the line meticulously.
One thing to make sure the accountants keep doing consistently is that if they consider the expenses that they have taken into account for this month they should do the same thing in the next month and the following months as well because if there is lack of consistency in accounting then the financial department will be in trouble by lack of consistency and the auditor might assume that they are trying to cook the books.?
Operating expenses; this category is considered the major category of expenses. It also includes all costs that are not directly related to making the product or delivering a service. Such as rent utilities, telephone bills, research and marketing, management, staff salaries, HR accounting, etc. Plus anything that is pretty much not related to the cost of goods sold. Think of operating expenses like a doctor or surgeon that is having a knife in their hand so with that knife they can kill or they can treat their patients and this is the same in your company as well operating expenses can be both good and bad. For example, if you hire bad people in your company that can be really detrimental to your company and it can even lead to bankruptcy but on the other hand if you hire good people in your company chances are good that you can have grow and succeed in your industry. There is one exception in this category and that is the cost of sales and marketing. This section Includes a significant portion of operating expenses and that's why some companies such as Microsoft put sales and marketing in a different line and not under operating expenses.
Sometimes there are some expenses that are called non-cash expenses. Non-cash expenses are something that is relating to the expenses that you actually don't pay with your cash at all and it will be deducted from your company because of the time and depreciation. For example, if you buy a truck for your company that is worth $50,000 that value will be depreciated in one, two or three years and your truck is no longer worth the same anymore.
Gross profit margin: Gross profit margin is calculated by subtracting cost of goods sold from sales. To determine whether the gross profit margin is in a healthy place or not you should compare yourself to the other companies in the same industries that have the same size as yours. Or you can also look at the year to year trends and examine whether your gross profit is headed down or heading up (Warren Buffett recommends a 10 year bracket). If it's heading down you should ask yourself why it's happening? And what’s the root cause of diminishing gross profit margin?
Operating profits; this line is another important line that plays a significant role in determining whether you're having a healthy income statement or not and it is calculated by subtracting operating costs (or SG&A) from gross profit. Operating expenses include rent, equipment, inventory cost, marketing, payroll, insurance step costs, all funds that are allocated for research and development, depreciation and amortization, all of them are under the category of operating expenses which is also known for EBIT (Earning Before Interest and Taxes).?
Taxes have nothing to do with how well you're running your business and it's pretty much irrelevant in terms of your business efficiency and also the interest expenses are depend on how much money you borrow from banks or other financial institutions in order to run your business and how much you're relying on their help to run the business but at the end of the day neither of them account for how well you are running the business.
One-time charges; in business sometimes CEOs are forced to apply some changes in the business that are going to be done for just one-time only and then afterwards in the next following months it will no longer be applicable anymore. For example, sometimes companies are forced to pay severance expenses to laid off former employees, that's how it's called one-time charges.
EBITDA; Some people assume that EBITDA (Earning Before Interest Tax Depreciation Amortization) is a better measurement to determine the health of the income statement of a typical company because it ignores the depreciation or non-cash charges.?
Net profit; net profit is the bottom line of every single income statement and it is determined by subtracting all the expenses from the sales and how much profit are you able to make from the business you are in.
Three solutions for low profitability:
1) Can be increasing the profitable cells which can potentially take time because you have to find more customers or prospects in order to convert them and sell them something, in other words you have to find new market to sell more of your service or product
2) The second one is reducing the cost of goods sold and how to run more efficiently and productively in order to reduce the cost that are associated with the product or service that you're selling and to do that you have to find inefficiencies and apply some changes during the process of making the product to reduce costs.?
3) Cutting or reducing the operating expenses which is usually reducing the head count or the number of employees that are working for you.
From the top three solutions the most ideal one would be to increase sales or find more customers and the other two for example reducing the head count is not very ideal for a typical company unless you're really spending money on something that is unnecessary.
Contribution margin; There are two ways to take a look at the contribution margin: the first one is to cover the fixed cost and the second one is sales minus variable cost which determines how much contribution margin or how much profit is left over to cover your fixed costs. Contribution margin contributes to pay off the fixed costs and the formula is:
Balance sheet; balance sheet is a statement of what a business owns and owes at a particular period of time.?
Equity = What a company owns - What a company owes or in other words:
Asset = Liability + Shareholder’s equity
The main target of companies is to increase their profitability and Equity together and they have a positive correlation with each other, meaning if the company's profits increase the shareholders Equity increase as well and vice versa.?
The best way to elaborate exactly what the difference between profitability and Equity (or book value) is like the Grades and GPA that we used to get at school. Profitability is like the grades such as -A, B, C+ and etc that you used to receive in a particular course but Equity though is more like your overall grade point average or GPA that you would receive at the end of a semester.
Accounting professionals, pretty much the same as an income statement, have to make some estimations to figure out what the number of some lines are.?
?What is the fiscal year in accounting? Any 12 month period that the company utilizes in order to account for their accounting purposes is called a fiscal year. Majority of companies use calendar year in order to determine their fiscal year but some other companies use another method, for example a period of first of October 2023 to 30th of September 2024 or some retailers use a specific weekend, for example the last Sunday of the year to mark the end of their fiscal year. You always must know when the fiscal year of your company is to know and understand How recent your data is.
*Important point: If companies have some unorthodox items or lines on their balance sheet it will be described and explained in the footnotes of the balance sheet itself so I highly recommend paying attention to that and reading it carefully.
Assets
Assets are broken down into various parts and they are included by cash and cash equivalents, accounts receivable, inventory, investments, PPE or property plant and equipment, vehicles, furniture, patents or intangible assets.
Cash is basically the money that you have in the bank. Accounts receivable is the money that customers owe you and it's like a loan that company gives to customers and it expects to receive it back later on. Both cash and account receivable are called current assets because they are expected to be used within one year. But on the other hand PPE, technology, patents, or trademarks are not expected to be used within one year and that's why they’re called non current assets.
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Smooth earning; This concept relates to the fact that companies should grow steadily and predictably and a company that spikes and grows all of a sudden is not very reliable and professional investors are not really interested in investing in such companies.
Allowance for bad debt: This concept is usually used when some customer do not pay their bills and have a bad history on their payments. Accountants usually use this in order to estimate and be more accurate in terms of the “account receivable” line and allowance for bad debt is subtracted from accounts receivable.
One way to increase the cash of the company; one of the best ways to increase your cash is by decreasing the inventories of your company and other things being equal with that way the company's cash will be risen and a typical company should always keep their inventory as low as possible, provided that they have enough materials to make the product to deliver it, once the customer places the order.?
Important note: Companies look at the value of their assets based on the purchasing price and not the present value of properties. For example, if a company bought a typical property for $5 M eight years ago, chances are good that the property is appreciated due to inflation. The point here is that sometimes investors hope for finding such undervalued assets on the balance sheet which is encouraging for them to invest, because apparently the actual value of the company is more than what’s mentioned on the balance sheet.?
A company can magically go from unprofitable to profitable just by changing the way it depreciates its assets. That art of the finance magic extends to the balance sheet as well. If the company decides it's trucks can last 6 years rather than three it'll record a 50% smaller charge on its income statement year after year. That means less accumulated depreciation on the balance sheet, a higher figure for net PPE and thus more assets. More assets by the fundamental accounting equation, translates into more owners equity in the form of retained earnings.?
Goodwill: A corporation can magically go from unprofitable to profitable simply by modifying how it depreciates its assets. The art of finance wizardry also extends to the balance sheet. If the company decides that its trucks can survive six years rather than three, it will record a 50% lower charge on its income statement each year. This results in less accumulated depreciation on the balance sheet, a greater figure for net PPE, and hence more assets. According to the fundamental accounting principle, greater assets equals more owner equity in the form of retained earnings.?
Amortization: Amortization pertains to intangible (non-physical) assets, whereas depreciation applies to tangible (physical) assets. Intellectual property such as patents, goodwill, trademarks, and so on can all be considered intangible assets. Most intangibles must be amortized over a 15-year period for tax reasons.
Consider renting a bike manufacturing facility for $60,000 per year. You put $5,000 for rent on your income statement, but where does the remaining $55,000 go? You should keep track of it someplace. Prepaid rent is one type of prepaid asset. When you buy something, you hold the rights to that space for a year, making it an asset, which you track on the balance sheet. Every month, shift $5,000 from the balance sheet's prepaid asset line and record it as a rent expenditure on the income statement. That is known as an accrual, and the account on the balance sheet that reflects what has not yet been expensed is termed an accrued asset account.?
What is MTM (Mark To Market)? Most of the assets that companies have are calculated by asset purchase price minus accumulated depreciation, there is one exception to this method and that's called Mark to Market (MTM) rule. MTM involves changing the value of an item to match what the market thinks it is worth right now. For instance, if a business bought an office building ten years ago for $1M and it's now worth $3M, the historical cost principle says that the asset's value should be listed at $1M, which is what it cost to buy in the first place, however the MTM concept would say that the building is worth $3M now.?
Liabilities
Liabilities are always divided by two parts: short-term liability and long-term liability. Short-term liabilities refer to the liabilities that should be paid off in less than a year. The most common examples of it include accounts payable, current taxes due for payment, short-term loans, salaries or employee’s wages, lease and payments. Long-term liabilities are the ones that are due more than one year such as mortgage loans, bonds payable, deferred bonuses, deferred taxes, pension liabilities and other long-term leases or loans. The caveat for long-term liabilities is that if the number is substantial it has to be watched very closely.?
Current portion of long-term debt: If your company owes $100,000 to the bank on a long-term loan, maybe $10,000 is due this year. So that's the amount that shows up in the current liabilities section of the balance sheet. The line will be labeled as the current portion of long-term debt. Then the other $90,000 shows up under long-term liabilities therefore this is how you can calculate and understand the main difference between short-term and long-term debt.
Accrued Expenses: When an expense is recorded on the books before it has been paid, it is called an accrued cost or accrued liabilities. A company pays its employees' salaries on the first day of the next month for services rendered in the previous month. Employees who worked all of November will receive payment in December. If the company's income statement on December 31 solely includes the salary payments made, the incurred expenses from the employees' services for December will be excluded.
Deferred Revenue: This one? refers to the product or service where the money and the payment has only been received but the service or product has not been delivered yet. So initially the payment will be recorded as an obligation on the balance sheet but once the product or service is delivered it is taken off from the balance sheet and it will be recorded on the sales line on the income statement. The most common industry that deferred revenue is widespread is the airline industry because you pay the flight ticket but the service has not been provided yet so it is a liability to them until they let you to fly. Or project-based businesses when you pay a down payment prior to the start of the work.?
Equity: It's the money that investors put in and the income that the business keeps over time.
Capital: It has different meanings, for instance, physical capital is plant, equipment, vehicles. Financial capital however, from an investor’s point of view is the stocks and bonds he holds. From a company's point of view it is shareholders equity investment plus whatever funds the company has borrowed. Source of capital is an annual report showing where the company got its money from. “Uses of capital” show how the company used its money.
Owner’s Equity
Preferred Shares: Also known as preference stock or shares are a specific type of stock. Preferential shareholders usually get dividends on their investments before normal stockholders do. The price of preferred shares, on the other hand, doesn't change as much as the price of common shares, because they usually pay a set dividend. People who own preferred shares might not be able to fully gain from the value growth of a company. When a business issues preferred shares, it sells them to buyers at a set price at first.The value shown on the balance sheet reflects that price.
Common shares or Common stock: Most shares do not have any voting rights but common shares or stock do. The ones who hold such shares have the right to vote for members of the board of directors (mostly one share one vote). Common shares might or might not pay dividends and the value that is shown on the balance sheet is according to the issuing price of the shares that is shown as par value and paid in capital.?
Dividends; People who own shares in a company get money from their wealth in the form of dividends. Distribution of such dividends usually happens at the end of a quarter or year.
Retained earnings; This is the profits that have been reinvested in the business instead of being paid out in dividends. The number depicts how much money the business has kept or put back into business over its lifetime.
Remember the famous formula of balance sheet which is Assets = Liability + Owner’s equity? In most of the transactions the owner's Equity remains unchanged and that is because the owner's equity changes whenever the company takes in funds from its owners or pays out some money to its owners or records the profit or loss. This is exactly how the owner's equity section on a balance sheet gets changed. But at the end of the day as long as you understand that whatever transaction happens affects both sides of the equation you will be good. For example, if there's a transaction for $25 and the company has sold something for $25 this increases the sales in the asset section and also increases the owner's equity as well for the same amount.?
Cash Flow
Cash flow is one of the secrets of Warren Buffett's success. (only cash flow and debt balances are facts) It is not something as similar as profit because the profit is something that the accounting department assumes how much a company is going to receive from customers, but if you study cash flow, it shows you exactly whether the company is capable of paying its own bills, payrolls or investing in the equipment or not. Cash flow is quite different from an income statement or balance sheet because both of them are based on assumptions and estimations but when you take a look at the cash flow statement you kind of check the company's bank account.?
Unfortunately there's a lot of managers that underrate the importance of cash flow and they assume that profit is something that they have to take a look at and care more about but as I mentioned already profit is just an assumption and you don't know whether it's true or not. But cash flow is something that shows exactly how much money does exist at this very moment and that's why it's very important to take a close look at.
Cash is not the same as profit and one reason is that, that cash might have come from loans financial institutions or Banks and won't show up in the income statement at all and even operating cash flow is not the same as net profit.?
One reason is revenue is booked at sale once the company delivers a product a sale is recorded and profit is recorded by subtracting costs from that Revenue, but no money has actually been exchanged yet in cash flow. However, the story is totally different and it's recorded whenever a transaction is made. The 2nd? reason is that expenses that we have on the income statement, some of it may have been paid earlier like rent 3 months in advance. Most expenses will be paid for later when vendors’ bills come due. So the expenses on the income statement do not reflect cash going out. The cash flow statement however, always measures cash in and out the door during a particular time period.?
The third reason is that Capital expenditures don't count against profit. a capital expenditure doesn't appear on the income statement when it occurs, only as the item depreciates is its cost charged against revenue. So a company can buy trucks, machinery, computer systems and so on and the expense will appear on the income statement only gradually over the useful life of cash item. cash is another story, all those items are paid before they have been fully depreciated, and the cash used to pay for them will be reflected in the cash flow statement.
Now you might say that at the end of the day the profit and cash flow will be pretty much equal after all accounts receivable are collected or after all accounts payable are paid and that's very true especially for well-managed firms. But there's always a chance that you cannot receive the payments from customers on time or you cannot pay your bills on time either and that's why we avoid thinking that profit and cash flow are the same.
Profit without cash: This concept is one of the main reasons that companies go bankrupt and ultimately go out of business. Imagine a company has to pay a vendor within a month but the account receivables are due two months. As a result the company does not have enough cash to pay its vendors and they cannot continue operating anymore.
Important note*: Comprehending the main difference between profit and cash flow is extremely important for managers and CEOs and it’s the foundation of financial intelligence. The ultimate lesson about profit and cash is that a healthy company needs to have enough of both of them at the same time.?
Finding the right kind of expertise; sometimes there must be huge differences between companies and between profits and cash flow for example if a company is profitable but it is short in terms of the cash did Denny's needs Financial expertise for example someone who is capable of lining up additional finances financing. On the other hand if a company has enough cash but is not profitable then it needs operational expertise, someone who is capable of decreasing cost or generating additional revenue without adding costs. To put it in the nutshell I would say financial statements tell you exactly what kind of expertise you need to hire in your company to be able to grow or cut the costs of your company to be able to survive.
Making good decisions about timing: Sometimes you need to be decisive in terms of timing to be able to boost your company’s effectiveness. For example, say in the first quarter of a year you have a lot of profit leftover and you have to buy components for the company then the best decision for timing would be to buy those products in the second quarter of the year, when you have enough cash to pay for those components.?
Language of cash flow: There's always a cash inflow and cash outflows in the business and they are broken down into three parts:
1: The cash that is used for operating activities such as making a product or service to deliver to customers' places. And it also includes the cash that has been received from the customers when they pay their bills. and also the cash that the company pays out in salaries or vendors and landlords along with everything they should pay to have the doors open.
2: Cash that is paid for investing activities;? this part refers to investment made by the company and not by its owners. Cash spent on capital investment is a key subcategory in any business. That is the purchase of an asset. If a company buys a truck or machine the cash it pays out shows up on this part of the statement. On the other hand, if a company sells a truck or machine or any other assets the cash it receives shows up here for anything that involves buying or selling company assets.
3: Cash from or utilized in financial activities: Financing is generally about borrowing money and paying back loans on one hand and transactions that happen between a company and its shareholders on the other. Therefore, if a firm receives a loan then the proceeds show up in this category. If a corporation receives an equity investment from a shareholder, that shows up here as well. Also if a company pays off the principles of its loans or buys back its own stock or pays dividends to its shareholders those spendings will show up in this category.?
*Important note: One of the signs of having a healthy business is to have a healthy operating cash flow. A healthy operating cash flow is an indicator of the fact that the company is doing a great job to turn the profits into cash and also it means that it can finance its own growth internally rather than borrowing money from or selling its stock.?
The relationship between cash flow categories
The second category of cash flow statement is related to how much does the company is willing to invest for the future. if the number is low compared to the size of the business then it means that the company is not investing a lot at all conversely if the business is spending a lot of money then it means that? management has high hopes for the future of the company. Generally speaking, what counts as high or low totally depends on the size of the company. Usually service companies invest less in assets than a company that is a manufacturer.?
The third category shows how much the company depends on outsiders to receive financial aid for the company.? If you look at this category over time you will realize whether the company is a net borrower (borrowing more than it is paying off) or not. You can also observe whether the company is selling new shares to outside investors or even buying back its own stock or not.?
Financial analyst or investors usually take a real close look at cash flow statement because there is way less room for manipulation compared to income statement or balance sheet. Also they look at this statement to figure out whether the company is able to turn profit into cash or not the other thing that is extremely important is that just because there is less room for manipulation in the cash flow statement doesn't mean that there isn't any room for manipulation at all. For example, some companies delay to pay their bills to the vendors or outsourcing companies or they delay to pay employees bonuses to show that the cash flow looks high within a quarter. But usually companies cannot do that over and over because eventually vendors will stop providing services to the company and that's how they will no longer be able to show a high cash flow statement.?
Reconciliation;? It means that the cash line on a company's balance sheet should match the cash that the company actually has in the bank. It's kind of like keeping your cheque book in order, but on a bigger scale.
Ratios
Ratios indicate the relationship of one number to another. To figure out a ratio you should divide one number by another and then reveal the outcome as a decimal or percentage. For example, when banks want to figure out if a company is able to pay off their loan or not they use the debt to equity ratio to get an idea of that. Senior managers watch ratios such as a gross margin, which makes them understand rising cost or inappropriate discounting.?
Potential and current shareholders look at ratios such as price to earnings, which helps them decide whether a company is valued high or low by comparison with other stocks and with its own value in previous years. When ratios get out of a range that's the time that you should pay attention to. Because chances are there's something going wrong within a process and that's why you have to be really meticulous when that happens.?
There are four main ratios that managers and stakeholders utilize to judge companies' performance. 1. Profitability 2. Leverage 3. Liquidity 4. Efficiency
Generally speaking whenever you take a look at the ratios you should appraise the overall value of numbers. For instance, if a company like Walmart is consistently earning a 3% profit margin on an annual sales of more than 400 billion dollars that's a lot more money compared to a company that is making 30% profit margin on a business that has an annual sales of 50 million dollars.?
Gross profit margin = Gross profit / Revenue
The result will be expressed as a percentage. If a firm is making a gross profit of $1,933 and the amount of revenue that they make equals to $8,689, then the percentage is 22.2%. Gross profit depicts the fundamental profitability of goods or services before overhead and expenses are deducted. To elaborate? 22.2% more deeply I would say that 77.8% is the cost of goods sold so you should always ensure that gross profit margin is well beyond the COGS, so you'll be able to advocate the company from a financial perspective and stay in business.?
Operating profit margin percentage; Operating profit or EBIT is calculated by subtracting the operating expenses from the gross profits? and it describes how well a corporation is running its entire business from an operational point of view.
Operating margin = Operating profit (EBIT) / Revenue = $652 / $8689 = 7.5%
Operating margin is a good indicator of how great managers as a team are doing their jobs. A downtrend and plummeting line in operating margin should be a caveat and it shows that costs and expenses are rising and increasing faster than sales which is apparently a bad sign for the business. Also operating margin is a crucial indicator and they are capable of having a control over it but not on taxes or interests.?
Net profit margin percentage; This ratio indicates how much out of every sales dollar it receives to retain after everything else and all the expenses are paid for such as people,lenders, government etc it is also known as ROS or return on sales.
Say a company is having a net profit of $248 and is making a revenue of $8,689, the the calculation looks like this:?
Net profit margin = Net profit / Revenue = $248 / $8,689 = 2.8%
Net margins are different from industry to industry for example in retail stores it is really low. The best point for comparison is a firm's performance in previous time periods and its performance relative to similar companies in the similar industry.
All the ratios that were mentioned and covered above are driven from income statements. Now let's take a look at the ratios that are driven from both income statements and balance sheets.
First we going to start with return on assets; return on assets or Roa shows what percentage of every single dollar that is invested in business was returned back to you as a profit. ROA indicates how constructive the firm is at using assets to make profits. The formula is calculated as below:
?Return on assets = Net profit / Total assets??
Sometimes ROA has a strange meaning. If it's too high compared to the other competitors in the same industry then it means that the company avoids investing in renewing its own machines and equipment. Therefore having a really high number doesn’t necessarily mean that the company is doing well. Another tricky point about ROA is that executives play with numbers and try to decrease the assets to make the ROA look high.?
Return on equity; assets apparently refers to what the company owns, and Equity refers to its net worth as determined by accounting rules. the formula of return on Equity or Roe is the following:
ROE = Net Profit / Shareholder’s Equity
From an investors point of view ROE is a very important ratio and if someone wants to invest in a company they want to see a substantial amount of ROE.?
Leverage Ratios
Leverage ratios are very practical ratios for evaluating companies’ performance and it shows you how much the company's relying on banks money or other people's money and etc generally whatever that is not owning it. Leverage is the financial analyst's word for debt and is defined in two different ways in business and in companies. First is operating leverage and the second is financial leverage.?
Operation Leverage is the ratio between fixed costs and variable costs. increasing and boosting your operating leverage means adding to fixed cost with the objective and intention of diminishing the variable costs. As an example a retailer and manufacturer that is expanding and getting bigger are more productive factories and they are increasing their fixed cost but they are trying to lower the variable costs.?
Financial leverage though means the extent to which a firms asset base is financed by debt. In financial leverage we will focus on just two ratios; debt to equity and interest coverage.?
Debt to equity ratio explains how much debt a firm has for every dollar of shareholders equity.
And the formula is the following;
?Debt to equity ratio = Total liabilities / Shareholder’s equity
This ratio is not usually depicted as a percentage term and one of the functionalities of this ratio is that bankers utilize the debt to equity ratio to decide whether or not to offer a loan to a firm.?
Interest coverage; This ratio is another favorite one of bankers and it shows how much interest bankers have to pay every year relative to how much it’s actually making and the formula is as below:?
Interest Coverage = Operating profit / Annual interest charges = $652 / $191 = 3.41
To put it another way, I would say that this ratio is the best approach to reveal companies’ capabilities to pay their interest. If a ratio gets really close to 1, then that’s a bad sign. Majority of companies’ profits are going to be paid off with interest. Conversely, a high ratio is an indicator that the firm can afford to take more debt or at least to make the payments and at the end of the day senior managers should concentrate on paying off the debt.?
Debt to equity ratio = Total liabilities / Shareholder’s equity
Suppose the total liabilities of a typical company is $2736 and the shareholder’s equity equals to $2457 then the debt to equity will equal 1.11. This ratio is not in percentage and in the majority of organizations the number is more than 1 which means that the company has more debt than equity.?
Liquidity ratio; Explains about the companies’ capability to meet their financial liabilities such as payroll, debt, payment to vendors, taxes, etc. Basically, there are 2 common liability ratios, current ratio and quick ratio.?
Current ratio consists of accounts payable as well as short-term loans and the formula is the following:
Current ratio = Current assets / Current liabilities
Quick ratio which is also called as an acid test is calculated as: (Current assets - Inventory) / Current liabilities
The usefulness of quick ratio is that it explains how easy a company can meet its short-term liabilities without the need of selling-off inventory or converting it into commodities. Any company that owns a lot of inventory, needs to know that lenders and buyers will be looking at their quick ratio and (most of the time) they expect it to be well above 1.??
The OKR method
OKR which stands for objective key results, is one of the greatest strategies that giant companies such as Google or Intel have been using to grow their business with. I break OKRs down into 2 parts and will explain each of them.
Real application of OKR
Suppose you have an online store and you are selling fashion products. You have various types of goods such as sneakers, t-shirts, pants, shorts etc. Your objective is to make $10 million by the end of 2024 and you have various types of channels to sell your products to your target audience like social media, phone calls, in-person selling, google ads, website conversion, referrals, word of mouth, billboard ads and advertising on 3rd party companies or influencers.
Objective: Making $10 million and we have 6 different channels to sell our products to. If we reverse engineer we can see that in order to hit that amount we should calculate how much we need to make each month. So 10 m / 12 would be $834 k per month. Then $834 k / 30 days will be $27,800 a day. Now that’s more clear and now we can calculate how much we need to make per hour to achieve our goal, which is $27,800 / 24 h which will be around $1,159 per hour.?
So assuming the average profit margin that we have is $30 then we need to calculate how many sales we have to make from each channel to hit our daily goal. The answer is the following:
6 channels x 155 sales a day = 930 units of sales per day
930 units x $30 profit margin = $27,900
Now, apparently in business there are always ups and downs and you cannot make the same amount of money from each channel everyday. For example, if you are selling on Amazon and Social media both you might be able to make more sales on those platforms rather than phone calls or in-person selling.?
Therefore this leads us to the concept of ratios again. Ratios as have already been discussed show the relationship of one number to another. Here I would like to show you how you can determine which marketing channel you should devote more attention to.?
For example, imagine that the revenue that have been achieved by the company in a day is as following:?
As can be seen in the above chart the amount of money made from each channel is phone calls ($2,000), Social media ($12,000), in-person ($1,000), Google & website ($5,000), referrals ($5,000), publicity ($2,900). So the total amount of income that the company was able to make is $27,900. Now in the following ratio calculation we want to see how much percentage each marketing channel is able to make for the company per se:
Phone calls = $2,000 / $27,900 = 7.1%
Social media = $12,000 / 27,900 = 43%
In-person = $1,000 / $27,900 = 3.5%
Google & website = $5,000 / $27,900 = 17.9%
Referrals = $5,000 / $27,900 = 17.9%
Publicity = $2,900 / $27,900 = 10.3%
So the ratios above show exactly how much percentage each channel is contributing to make sales. Social media is at the top by 43% sales and google, website and referrals with 17.9% are the ones that the company is driving the most sales from.?
The Golden Question; In business there is one question that you can ask which helps you to determine your company’s financial growth. That question is the following:
“How likely are you to refer our service to your family, friends or colleague? ”
You should ask your customers to give you the score on a likert scale from 1-10.?
The people who give you the score of 0-6 are the ones who are called detractors and the likelihood of referring your business is too low.?
The people who score 7 or 8 are passively satisfied with you and are likely to refer you to the people they know.?
And ultimately the people who give you 9 or 10 are called promoters and you will have a strong chance of getting referred by them. The calculation of Net Score Promoter looks like this:
Net Score Promoter = Promoters - Detractors?
The best companies are the ones that typically get a score of 75 to 80 percent.?