Mentor Development: Clues in the Financials

Read a case study about finding clues in the financial information from the mentee. Includes thought-provoking questions and best practice solutions.

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NOTE: To get maximum value from this case study you should know the following:

• Balance Sheet and Income Statement structure and purpose
• Basic financial ratios

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Finding Clues in the Financials – Case Overview

Tyrone has had a hectic year getting his business, called Clean Slate, launched. The business promise is that Clean Slate can help any family or small business get organized. Tyrone begins the process by completing a needs assessment review for his clients and then he implements a plan that involves clearing away clutter, organizing what remains and creating an approach the family or business can use to maintain the organization in the future. Tyrone is an expert at organizing and is already finding his skills very marketable.

Clean Slate is basically selling Tyrone’s services as an expert consultant but also includes the organization materials such as office supplies, totes and storage bins, and day planners in the overall cost to the customer. Tyrone’s hard work has definitely been worth it and people clearly need help getting organized because Tyrone has already built a strong client base in his market of Calgary, Alberta.

In the last mentoring meeting, Tyrone and Brianna discussed the upcoming Quarterly Report. When she learned that Tyrone is gathering the financial information on his new business to submit to Futurpreneur Canada, Brianna offered to look over the statements and provide some mentoring feedback.

In a recent email, Brianna received Tyrone’s financial statements. She is looking forward to reviewing the financials for Tyrone’s business particularly because this Quarterly Report falls at Clean Slate’s fiscal year-end. The next mentoring meeting is very important because following this discussion Tyrone will be updating his business plan and setting financial goals for next year.

While Brianna does not have a background in accounting, she feels like she should be able to ask questions that will add value to the discussion.

The financial information is attached below:

As at:	Current year			Next year
June 30, 20XX	Actual	Plan	Variance	Plan
Balance sheet
Cash	$326	$2,000	$(1,674)	$-
Inventory	$7,222	$5,000	$2,222	$-
Receivables	$3,638
Total current assets	$11,186	$ 7,000	$4,186	$-
Equipment	$2,238	$2,500	$ (262)	$-
Other assets
Total assets	$13,424	$ 9,500	$3,924	$-
Current liabilities	$3,687	$500	$3,187	$-
Long term liabilities	8,328	8,500	(172)
Equity	500	500
Total liabilities and equity	$ 12,515	$ 9,500	$ 3,015
Income statement
Income	$49,654	$ 45,000	$4,654
Cost of goods sold	7,289	4,500	(2,789)
Gross margin	42,365	40,500	1,865
Expenses
Salaries	25,000	25,000
Rent/premises
Travel	1,722	1,000	(722)
Office expenses	62	200	138
Interest/fees	2451	2250	(201)
Other expenses
Total expenses	29,235	28,450	(785)
Net income	$ 13,130	$ 12,050	$ 1,080
Net cash flow
Financial ratios
Gross margin	85.32%	90.00%
Are the products you are selling being adequately priced?
Net margin	26.44%	26.78%
Is your enterprise achieving an adequate level of profitability?
Receivable days	27
Are your revenues being collected in a timely fashion?
Quick ratio	107.5%	400.0%
Does your enterprise have adequate liquidity?
Inventory turnover	0.5	0.45
Is your inventory too high?

Questions:

• What omissions or errors are evident in the financial information that Brianna could ask Tyrone about in the meeting?
• What potential impact does the higher than anticipated inventory and receivables have on the business?
• Consider the Gross Margin of the business. If Tyrone had been able to meet his targeted margin of 90%, what would the impact on his profitability have been?
• What is the greatest short-term concern for Tyrone’s business? What are some possible solutions?
• What are three questions Brianna could ask during the discussion to promote dialogue around the financial information?

Finding Clues in the Financials – Best Practice Solutions

• The balance sheet presented does not balance as Total Assets are greater than Total Liabilities. Also, there is no information on net cash flow in the summary. If Tyrone is having difficulty preparing his own financial statements, this may be a subject for targeted self-development or perhaps an opportunity to work with another advisor (either paid or volunteer) who understands financial statements.
• Carrying higher levels of inventory and receivables reduce the cash flow of the business. A drain on cash flow will eventually rob funds from the operating budget and can cause fees, interest costs and an inability to weather a crisis. It appears by what was expensed as Cost of Goods Sold in the Income Statement, that the business has sufficient inventory (showing as an asset) to operate for an entire year. This seems excessive and Brianna may want to help Tyrone explore the potential consequences of carrying more goods than he originally planned.
• The gross margin is a measure of what portion of revenue is being spent on the goods and services. In Tyrone’s case, he had originally set his plan at 90% gross margin which reflects that the majority of his revenue is from his personal contribution with only a small amount of money being spent on organizational supplies and materials.If Tyrone had been able to meet the 90% target his Gross Profit would have been $44,689 ($49,654 income x .9 profit margin) which is an additional $2,324 in total profit.The original profit margin may have been set too high OR this may be an opportunity for Brianna to increase Tyrone’s focus on profitability. A discussion on how to improve the gross margin may result in ideas like negotiating a discount with the supplier of his materials or perhaps using a different quality of product being purchased.
• The greatest short-term concern for Tyrone is the lack of liquidity in the business. He has financed the higher levels of inventory and receivables using short term debt. This results in additional finance charges and, if left unchecked to continue building, could paralyze the business and prevent Clean Slate from continuing its pattern of growth. There are two obvious solutions to improve cash flow. The first is to lower the inventory levels back to forecasted levels (either through returning some of the items currently in inventory or through not replacing the inventory as quickly as it is used). The second solution is to examine the payment terms offered to clients to encourage lower levels of receivables. Based on the type of consulting services offered, Tyrone may not want to offer payment terms to his customers but rather collect payment at the time services are provided.Brianna may want to initiate this discussion by asking Tyrone to identify his greatest concerns and greatest successes that are reflected in the financial statements. This will help him to view the statements as a management tool in the future.
• Questions that promote dialogue are generally open and do not telegraph the answer to the entrepreneur. Some examples are below:
  • What are you most proud of that is represented in your financial reports?
  • What information surprised you most when you compiled the summary?
  • Where did the business perform differently than planned and why?
  • Based on the financial information, what is the most critical issue you need to address for the business?
  • How will you use what you’ve learned from your financial reports in your planning for next year?

Finding Clues in the Financials – Key Learning Points

• Reinforce the value of financial reporting. Many entrepreneurs have the misconception that financial reporting is administrative work. Demonstrate the value of financial information as a management tool by sharing the importance of it in your business, emphasizing what was learned during the financial review.
• Understanding Cash Flow is critical to a new business. Cash is king when it comes to the financial management of a growing company. The lag between the time the entrepreneur has to pay for goods and operating expenses and the time to collect from customers can either be a source of cash for the business or a use of cash. The solution is cash flow management. At its simplest, cash flow management means delaying outlays of cash as long as possible while encouraging anyone who owes you money to pay it as rapidly as possible.
• Explore the impact of action plans. After reviewing the financial information, your entrepreneur will likely create action plans based on what was learned. As a mentor, you can support the planning process by helping the entrepreneur examine the value of each idea in financial terms. What will a change in margin mean for the business? How will a new accounts receivable policy impact on cash flow?