Even within the sign and digital graphics industry, there are hundreds of different types of businesses. Some specialize in high-volume contract work while others’ forte is one-of-a-kind signage... and everything in between. But there’s one thing every sign business needs to do: earn a profit.

 

In order to earn that profit, every company must engage in four basic business practices:

• Secure necessary financial capital;

• Develop product offerings and an operating facility;

• Skillfully manage and control its business activities; and

• Take the resulting profit and either reinvest it back into the business or return it to the investors.

 

Unfortunately, businesses communicate the effects of their activities in a very peculiar language, best understood by those remarkable people with little green visors and pocket protectors: the bean counters. The rest of us, though—owners, managers and employees alike—make decisions every day, however seemingly insignificant, that affect the profitability of a business.

 

Those decisions are captured in our profit-and-loss statements, balance sheets and cash-flow statements. Let’s focus on the last one this month, and see if we can make it simpler to digest. Doing so will enable you to extract valuable insights about the health of your business.

 

Basic definitions

Learning “finance-speak” is an important first step for anyone who wants to align his or her performance and personal goals to the business’s goals, strategies and policies. For the employee, such alignment often provides opportunities for challenging assignments and advancement within an organization. For the business owner, it could accelerate the desired progress for growth and success.

 

To begin, trace the flow of money as it flows through your business. It may be trite to say, but cash is truly the lifeblood of any business. Without cash, a business cannot survive. By analyzing the cash-flow statement, you can paint a mental picture of the financial activities that took place in your business during a given time period.

 

For the remainder of this discussion, I’ll refer to the cash-flow statement of the hypothetical company, Olde Towne Sign Factory. Notice that the statement is divided into four fundamental activities: operating, investing, financing and returning. These activities define how cash flows in and out of a business.

 

• Operating activities are uses of cash to produce goods and services and acquiring cash by selling those goods and services to customers. Therefore, cash can flow in or out through operating activities. For any business, sources of cash are any transactions that increase the cash balance. The four most common sources are shareholders, lenders, customers and suppliers. Conversely, the use of cash is any transaction that decreases the cash balance.

 

Some examples are paying dividends, repaying loans, paying for operating expenses and investing in assets.

• Financing activities can only bring money into the business via owners’ investment (equity) or bank loans (debt).

• Investing activities use cash to acquire permanent assets—normally defined as assets lasting more than one year—such as land and buildings, property and equipment needed by the business to run and grow.

• Finally, returning activities are the use of cash to repay lenders, reward investors and—if you are lucky enough to turn a profit—pay taxes to the government.

 

Get off on the right foot

A cash-flow statement works much like the check register of a personal checking account. The top line is the starting balance—which is zero for businesses like Olde Towne, in their first year—or the ending balance from the prior year’s statement.

 

With one glance at the cash-flow statement, we can see that the Olde Towne Sign Factory acquired some “seed money”—from investors by means of a stock sale, and from a bank loan. Later, if it needs more money, it can issue more equity or take on more debt. Although financing activities are undertaken for the same reason—to bring capital into the business—they can be distinctly different in their appeal to investors and lending institutions.

 

Investors are not given a promise to be repaid like banks are—as illustrated by the interest rate, loan conditions and payment schedule. However, if shareholders do not see a regular and attractive return on their investment, over time, they will cease to invest. Remember that shareholders are part owners, which means they share control of the business by their vote of the board of directors. Equity owners have come to expect a return greater than what they could fetch if they just placed their money in a bank account.

 

A great company... on paper

When Olde Towne Sign Factory bought new equipment and computers, it was investing in its future. Those transactions are recorded as investing activities because Olde Towne acquired fixed assets that are expected to last over one year. See the $100,000 and $500,000 on the cash-flow statement for computers and equipment, respectively.

 

While cash fuels most business activities, the operating activities are key to the year-to-year success of any enterprise. Paying the salaries of your production workers, procuring raw materials and overhead—often grouped together as working capital—are good examples of operating activities. Marketing expenses, such as advertising and sales commissions, are also recorded as operating activities on the cash-flow statement.

 

When a sale is made, goods and services are exchanged for cash or a promise to pay. In Olde Towne’s case, they collected $1.5 million in sales revenue on $950,000 cost of goods sold. That translates into a 37 percent gross margin—considered healthy for most American businesses but on the low side for a custom sign and digital graphics company. The cash provided by operating expenses was $350,000, when $200,000 for Selling, General & Administrative costs were subtracted from the profit of the sale of goods and services. Finally, accounts payable ($175,000) overshadowed the accounts receivable ($75,000) by $100,000, and thus reduced cash provided by operating activities to $250,000.

 

Let’s assume an average tax rate of 40 percent. That explains the $100,000 ($250,000 × 0.4) for income tax expense under returning activities. And, since the interest rate on the bank loan was six percent, an additional $60,000 was subtracted for interest income as a returning activity.

 

So, did we make any money?

By the fact that Olde Towne Sign Factory started with nothing and, at the end of its first year of operation, now has an ending cash balance of $1.45 million is a good indicator. But does that tell the entire story about the health of a business? 

 

It is worth noting that no dividend was paid to shareholders this year. That may be allowable for the first year, but investors can be fickle and their collective patience grows short unless you keep them inspired to maintain ownership.

 

Much like a competent doctor would not determine the health of a patient from a blood test alone, you cannot determine your company’s life expectancy from just the cash-flow statement. But by evaluating the profit-and-loss statement and balance sheet side-by-side with the cash-flow statement, you should be able to predict its likely future and make decisions to improve that health.

 

The profit-and-loss statement (more formally known as the Consolidated Income Statement) can and should be used to draft a sound operating budget and design a profitable pricing strategy. Time and space does not permit me to elaborate further, but stay tuned to future columns for more on this topic.

 

Boils down to a simple fact

In general, if the cash coming in exceeds the cash going out, the business is achieving its basic purpose for existing—that is, earning a profit. Nothing like stating the obvious, I suppose. Take time out to study your company’s financial statements that you receive from your bookkeeper, CPA, or accounting software program to do your own analysis.

 

For the same reason your doctor runs many of the same tests during every annual physical, compare results from the three financial statements from year to year. You are looking for trends that either indicate you are progressing toward achieving your business goals or heading down a dangerous path to ruin. Despite what the hapless owners may express or believe, businesses rarely go “belly up” overnight, without some warning of trouble. Heed the signs and take preventive action. Believe me, you’ll feel better in the long run. Good luck!