Focus on your P&L? Nah. Not here.
There are circumstances where the P&L tells you next to nothing about the health of the business and where it is headed. Further, the P&L can sometimes be misleading for decision-making purposes. In a world where we rely more and more on data, we have to silence the noise and focus on the right data when we make important decisions and plot the way forward.
Don’t misunderstand, ignoring your P&L does not mean not caring about your financial health. You can be driven by value creation, deeply care about employees and investors, and still pay no attention to something that any business class would have at the top of the syllabus. So if not the P&L, what else do we focus on? Here are a few examples of how non-P&L financial presentations can help you keep a finger on the pulse, assess performance, and pivot when necessary.
Run-Rate Profitability – Silence The Noise in Health Assessments
When we start a financial health assessment, we focus on go-forward profitability (aka pro-forma or run-rate) including recurring annual revenues and the embedded cost base. This is our best proxy for whether the business will satisfy its debt service obligations, pay its people, and generate additional earnings for reinvestment. It also tells us our ‘go-get’; if we are short and need to close the gap. The run-rate does not include lumpy one-off revenue – these amounts can be unpredictable, are not contracted, and we’d rather treat them as upside to our health assessment.
Here, run-rate profitability is a superior metric to the P&L because it incorporates the knowledge we have today and the decisions we’ve made, without the noise of how past performance differs. For example, if you hire somebody at the beginning of the month, the impact of his/her cost doesn’t show in last month’s financials. However, in the run-rate, we pick up the full annual cost of that addition. We build the run-rate manually from a bottoms-up analysis of revenue and expenses, and bridge from the run-rate back to recent performance to sanity check our assumptions.
Liquidity Runway – Cash Is Lifeblood. Make Sure You Have It!
Cash is king. Falling short creates a myriad of problems. Missing debt payments leads to antsy lenders (at best), and employee retention is near impossible if there’s any hint you’ll miss payroll. In businesses with high operating leverage (where fixed costs represent the bulk of the cost structure, and changes to revenue up or down flow almost entirely to the bottom line) and some lumpy revenues, keeping tabs on the liquidity outlook is critical.
If you combine this business profile with growth initiatives that require capital investments and significant ramp up time, it’s easy to see how quickly cash can get sideways. Here, you can utilize a rolling weekly and monthly cash forecast to keep tabs on the runway. If we think we may be pulling an Icarus, we have the tools and process to be proactive and make the necessary adjustments.
Know the difference between profitability and cash flow. Your accrual accounting may not reflect the monthly cash inflows/outflows of the business, and your profitability metrics aren’t going to pick up non-P&L items like capital expenditures or R&D investments. The cash forecast will also reflect the timing of non-recurring expenses and large single outflows like debt maturities or annual bonus payments.
Initiative ROI Tracking – Are Our Ideas Working?
“You’ve got to spend money to make money” is a common mantra, but one word is way off. We never spend money in a business, we invest. While I believe the invest mentality should be applied to every single expenditure, in this example I refer specifically to the return on investment (ROI) of new growth initiatives.
When new products or offerings take time to gain traction, we need to isolate the capital investments and new revenues and expenses apart from the base business. This ensures we maintain a clear view of the base (run-rate profitability) while allowing us to constantly take stock and test assumptions on new opportunities. Costing more than we expected? Taking longer? Are these execution issues or did we misread the market? Any liquidity constraints as a result? Better revisit that liquidity runway!
Keep in mind that ROI is not just a financial exercise based on the direct cash in and cash out of the initiative (such as revenue and margin targets). Synergies with other offerings (like increased marketability), opportunity cost vs. other initiatives, and the impact on the liquidity runway should all factor into your assessment of progress. Be sure to apply a wide lens across your business as a whole before you go deeper down a rabbit hole.