Part 1: Understanding the Foundation of Financial Reporting

Welcome to our 4-part series on leveraging your financials to measure and enhance business performance. Throughout this series, we will delve into financial fundamentals, key metrics for analysis, diverse performance measurement techniques, and strategies for prioritizing investments to drive growth.

In Part 1, let’s begin by establishing a common language through an exploration of the basics of financial reporting. We’ll focus on crucial elements that must be in place to ensure accurate and consistent financial information for analysis.

Organizing Your Financials:

To gain a clear understanding of your cost centers, it’s essential to have a well-structured Chart of Accounts within your accounting system. Your P&L and Balance Sheet need to be properly labeled and organized in a way that you can clearly understand your cost centers. For example, are your Sales and Marketing expenses grouped together, including a subtotal? Structuring your P&L by cost centers enables effective budgeting, variance analysis, and the creation of performance metrics. Additionally, ensure your Balance Sheet items are correctly categorized into short-term and long-term accounts, as well as by account type. Furthermore, consider utilizing fields in your accounting system to generate detailed reports that provide revenue and Cost of Goods Sold (COGs) breakdowns by product. Incorporating such features into your accounting system streamlines tracking and reporting for your metrics.

The Importance of Accrual-Based Financials:

I cannot emphasize enough how important it is to have accrual-based financials. While cash may be king, cash basis financials fail to illustrate your company’s performance on a period-to-period basis. The Generally Accepted Accounting Principles (GAAP) matching principle dictates that revenue and expenses should be recognized in the period they are earned and/or used. For instance, if you are on a cash basis and receive a $100,000 payment in one month, that revenue is likely for the prior month or months. And many of the expenses associated with that revenue would be recorded in those prior months, therefore creating a mismatch of revenue and expenses. Another example involves annual subscriptions: cash basis accounting would record the entire expense in one month, whereas an accrual basis would distribute it over the 12 months of usage. Cash basis financials often exhibit irregularities, with fluctuating margins and net income, while accrual-basis financials will reflect a more even and consistent performance.

Accurately Measuring Costs of Goods or Services Sold (COGs/COS) and Gross Profit:

To obtain an accurate reflection of your gross profit and gross margin, it is crucial to properly measure the direct costs of producing your goods and services. The key is that only “direct” costs should be included in COGs. Some common mistakes include omitting customer support costs or neglecting software and data costs. Sales and marketing costs should never be included in COGs. In Part 2 of this series, we will explore various approaches to analyzing gross profit, allowing you to gain a comprehensive understanding of your business’s performance.

Review all 3 Financials Statements:

When reviewing your financials, make sure you are reviewing all three statements;: the Balance Sheet, Profit and Loss (P&L), and Statement of Cash Flows. Financial performance is not solely reflected in the P&L statement; valuable insights about the health of your business can be gleaned from both the balance sheet and cash flow statement.

In our next blog post, we will delve into the metrics and data required to effectively measure performance across your organization. Subsequent articles will explore consistent performance measurement practices and guide you in making informed decisions to optimize your business growth.

Stay tuned for Part 2: Metrics and Data Needed to Measure Performance