engineering management
financial measurement
If you own your own business, you need to understand some basic instruments that track fiscal soundness.
By Daniel Koenig
So
you want to be your own boss. You want to run your own company. Great!
But don't fall into the trap of ignoring the financial tools that can
help you track your bottom line.
Volumes have been written about financial management. My purpose here
is to introduce you, the engineer soon to be entrepreneur, to the fundamental
financial measurement and management tools you'll need to run your
business. As one who worked in operations, I want to assure you that you
can use financial measurement tools to benefit your businesses. They're
not an unpleasant appendage or a necessary evil.
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Understanding basic financial principles will aid and abet your dream
of bringing a good idea to fruition: your very own business. Financial
tools, coupled with an understanding of how to use them, give you the
ability to navigate your business to success. Without this understanding
and without a dedicated commitment to using financial tools, you greatly
reduce your chance of making a business success from that outstanding
idea. But if you understand and use financial tools to gain and control
capital, you'll realize your dream to commercialize your idea.
Entrepreneurs don't need to be expert financial analysts to succeed.
But they do need to know how to safely pass through the twisted and often
perilous path of business finance. Businesses keep score with financial
reports. So, in order to learn whether you have a good or bad score, you
need to understand and interpret the rules.
Measuring Financial Health
No matter how advanced your idea for a new product is, your better-mousetrap
business will be judged by the classic financial measures. They are the
balance sheet, the profit or loss statement, and the cash-flow statement.
Why are they important? The flip answer is "because the business
world uses them to determine how well a company is doing." If you
don't plan to discuss the financial status of your company, then
you don't need to bother with them. But if you decide to get a
bank loan or a line of credit, if you want to evaluate a potential vendor
or customer, if you file business income tax, you'll find the bank,
the vendor, and the IRS speak the language of these common financial measurements.
These tools are rational financial measuring methods that really do spell
out the financial viability of a company. They describe how much the company
is worth, whether it will be profitable in the near future, and whether
it'll be able to pay its bills when the invoices arrive.
The business world uses these three ways of measuring the financial health
of a business because no one measurement can tell the whole story.
The balance sheet gives a snapshot of the company's financial strength
at any particular time—usually at the end of a significant measurement
period, such as the end of a calendar quarter or a year. It plays a company's
assets against its liabilities. It shows what the company would be worth
if it were liquidated at that point in time. A balance sheet is an equation:
Liabilities+Equity=Assets.
The profit or loss statement shows whether the company made money or lost
money over the reporting period. It usually represents the same period
as the balance sheet.
The method and format of a profit or loss statement is the same as for
a budget, which operational people are familiar with. It reports gross
and net earnings, and so becomes two equations:
Sales-Cost of Goods Sold=Gross Profit;
Gross Profit-Operating Expenses=Net Profit.
The cash-flow statement measures the company's up-to-the-minute
cash receipts and disbursements. It's akin to a general ledger
or to the balance in a checking account. Just like a personal checking
account, the cash-flow statement portrays company status up to the last
entry of the period. It shows how money came in and how the money was
spent. The main strength of the cash-flow statement is in showing you
whether or not you have enough money to pay your current bills.
You need all three measurements to detail the financial state of your
company. The balance sheet tells you how much your company is worth; the
profit or loss statement tells you whether it's currently profitable;
and the cash-flow statement tells you the rate at which money comes into
and out of the bank accounts. A healthy company would have a significant
net worth, be profitable, and be able to pay its bills.
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While we like to think of finance as being very objective and unemotional,
it really isn't. Balance sheets and profit or loss statements are
very subjective. They're at the mercy of the observer, who says
whether or not they're satisfactory.
Likewise, being able to pay your bills with your sufficient cash flow
may be a laudable accomplishment, but at what price? Does it mean you
have no cash reserve for emergencies? Or do you have more than sufficient
funds to pay all bills, but your company is being shortsighted by not
investing more money in labor, material, and associated overhead?
So we see that each of these measurements—though they portray an
objective state of the company—needs to be evaluated based on standards
set by the owner and by those with interests in the company.
Are there guidelines for interpreting these financial measurements? Sure.
Are they important? They probably are, but only in a transitory way—when
they're used to further a specific goal you have, such as obtaining
a line of credit.
Rather than listing various goals for each of the three measurements,
I think it's more important that you, as a business owner, feel
comfortable with the values portrayed by each measurement. For instance,
I feel comfortable when a start-up company has a net worth at least 10
percent higher than its initial investment capital, when it consistently
makes a profit greater than its savings-account interest, and when its
cash flow can pay its bills—including salaries—within the
common 30-day grace period. All of these will allow you to buy on credit.
Understanding the big three—balance sheet, profit or loss statement,
and cash-flow statement—will whet your appetite to learn more.
That understanding will lead to your strategic uses of credit. When you
have to make choices, you'll soon be tying operational activities
to the best use of funds. And, of course, that understanding will lead
to much more.
The fundamental financial measurements we discussed are tools. Just as
you know how to make and deliver your product and you know your rate of
production, you should know these financial tools. They become additional
arrows in your quiver and help you make better decisions because you better
understand business functions. My advice is to embrace them and use them
as you would any other means that helps you be successful in achieving
the dream of owning your own successful business.
Daniel Koenig is an ASME Fellow and the author of
The Engineering Entrepreneur and
of Fundamentals of Shop Operations Management: Work Station Dynamics,
both published by ASME Press. He was 1995-96 president of the Society.