HATTIE BRYANT: (In the Studio) Hi, I'm Hattie Bryant. Today you will meet Jim Schell. He started and sold four businesses and in his "retirement" he stays busy advising business owners. He is the author of six books and the co-author of Small Business for Dummies. His newest book, Understanding Your Financial Statements, is my favorite. (Voiceover) We'll also take you inside three very small companies that have a fully automated accounting system.

JIM: If you are, let's say a cabinet maker and you decide you can make the best cabinets in your community you open a business. Yet, you don't understand that cabinet making is a very small part of opening a business. Once you open that door and hang out your shingle, you are no longer a cabinet maker. You are a business owner who happens to make cabinets. It's part of the DNA of a small business owner or entrepreneur. Ask a small business owner, "So how's business." He will always tell you, "Sales are up." So how big is your business? He will always say, "A million dollars in sales." He will never say, "Made $100,000 dollars last year." Or, "I made a return on sales of 10%." Never hear that.

HATTIE: That's one of your goals then as a mentor, teacher, coach to small business and that is to get us to measure ourselves with more real numbers.

JIM: Yes, focus on return on sales for instance. How much are you making? When you sell a dollar do you make a nickel, a dime, fifteen cents? Focus on your current ratio which is your balance sheet figure. Focus on debt to equity to increase what you own. You have to pick something to focus on. And the reason you have to do it is because you talked, Hattie, about making a game out of it. A game is watching these numbers improve. And everybody understands it.

HATTIE: You've told me I need to close my books every month. When then do I need those numbers available to me?

JIM: Approximately right now is better than exactly right later on. What that means is that the fresher your figures are the more useful they are to you. The typical small business probably generates those numbers maybe 15 to 20 days after the end of the month. By then the numbers are cold. The knowledgeable small businesses will generate approximately right numbers 5 days after.

HATTIE: (voiceover) Now, let's meet Noel Hanson a 35-year veteran business owner who told us about his experience with new software.

NOEL: I don't have a CPA in this company. I don't ever want one. I don't need it. It's kind of like running a car. I just need to know how to turn it on and drive it. I don't need to know how it works. And I feel the same way about this software. I just want to be able to turn it on and use it and have it give me what I want.

HATTIE: (Voiceover) Located in Pasadena, California, Noel's business, Hanson and Company, provides consulting to non-profits with a team of four on the payroll.

NOEL: I'm actually going to set up a separate set of books which I can do with this. I can track it which is good for auditing purposes. I can give it to my accountants and they can perform the audit on it. And I can provide the audit to the city. This is a very, very useful tool for me.

HATTIE: (Voiceover) Chris Schatte and his wife Joni started their business, Texoma Lawn and Garden in 1994 and now have 5-10 employees depending upon the season. Located in Vernon, Texas, they recruited their son Michael to install new accounting software.

MICHAEL: It only took about an hour to get it all down. Then after that the wizards help you a lot. It's just fairly simple and they can do it without a kid like me.

HATTIE: One of the things I did read in the book is you made the comment that no consultant is worth their salt in working with small business unless the first thing they do is walk in the business and say, let me see your financials.

JIM: Right.

HATTIE: What if you say "Let me see your financials." And they say, "here's my sack of invoices and here's my sack of bills," it's a cash register mentality, what would you say to me?

JIM: This has happened. I guess I would figure out if I really wanted to help you or not and if I didn't I guess I would say I really can't help you without your financial statements.

HATTIE: What is FSU and who needs to go to FSU?

JIM: FSU is an acronym for Financial Statement University. Who needs to go there? Anyone, repeat, anyone who is in a position to consult with or help small businesses. The theory behind all this is you cannot help small businesses without first knowing how to read their financial statements.

HATTIE: (In the Studio) Jim reminds us that our financial statements have three parts. The Balance Sheet tells us where we stand today. The Profit and Loss tells us what we have done in the past and the Cash Flow Projections predict the future.

JIM: The balance sheet gives you the financial status of your business today. The left side basically shows you what you have, all of your assets and the right side shows who owns those assets. Part of them are liability; part of them are net worth. The liability part means somebody else owns them the net worth means you own them. If you have a million dollars in assets and your liabilities are $400,000 and maybe it's a bank loan or maybe it's your vendor's payables then the vendors and the bank own $400,000 or your million bucks and you own the other $600,000.

HATTIE: (Voiceover) Jim and I met at R. Wagner Arts in Portland, Oregon and owner Nani Waddoups gave us a tour. Her company specializes in custom finishes for interiors.

JIM: I am wondering if you use your financial statements regularly to manage your business.

NANI: I do. Primarily I use our Profit and Loss statements.

JIM: How about your balance sheet?

NANI: I don't use my balance sheet very much.

HATTIE: (Voiceover) Jim asked Nani what her gross margin is on most jobs.

NANI: Probably about 25%

JIM: Very low, right?

NANI: Very low.

JIM: What was it a year ago?

NANI: Couldn't tell you.

JIM: So you don't know your trend whether you're improving or not.

JIM: Everything is trend. So boil it down day to day. So yesterday if you sold $100, well its good if the day before you sold $50, right? Or, it's good if the same day the prior year you sold $50. So trend is everything in small business no matter whether you're looking at trying to sell your business, and then it's particularly true, or whether or not you're trying to make assumptions for budgeting purposes, for forecasting purpose, for whatever. Frequency establishes trend and trend determines so much. If you just took one balance sheet someone like me can look at it and tell how liquid the company is. But from your standpoint, if you compare a balance sheet today to one yesterday you can see how your company is changing -- trend.

HATTIE: How did you convince a banker to loan you the money to build this fabulous greenhouse?

CHRIS: We had to build a business plan through all of our previous experience. It was hard to get everything all (together).

HATTIE: Did you have to go back to old statements? Did you have to get an accountant to help you?

CHRIS: We didn't have an accountant at that time so we did it all on our own. Guess it worked out OK.

HATTIE: Because you got the loan.

CHRIS: That's right.

HATTIE: Now that you're using an integrated accounting system if you need another loan, is it going to be easier?

CHRIS: It was easier because we have already gotten a new loan under this new system.

JIM: Too many small business people think their financials are sacred. That nobody can see them. They are not that big a deal and they are particularly not that big a deal when you are dealing with someone, in the case of a large vendor, they will carry you for 30 days. They'll give you net 30 day terms which in effect, I'm going to loan you money for 30 days they should be allowed to see your financials.

HATTIE: (Voiceover) Lacy Marlette has been Noel Hanson's CPA for over 10 years.

LACY MARLETTE: From their listing of cash receipts and cash disbursements, which has some detail in it, we are able to produce for them a balance sheet and a P & L and that's of some importance to them. What's more important is from that we can begin projecting out from a tax planning status where they are what they need to do in regard to salaries whether they're going to have a tax liability whether they are not how they can best plan for the year, whether they should do a pension plan.

HATTIE: (Voiceover) But now Noel can produce a balance sheet anytime.

NOEL: The coolest thing about this program is the fact that I can see on the front company page everything I need to know about the health of my business right now. I don't have to think any further than that. I can move on and do what I like to do best which is working directly one on one with my clients solving their problems.

HATTIE: If someone comes to an advocate, a CPA or a banker, they ought to come with their financials if they are asking for help, right?

JIM: Absolutely. Let's go back to a basic tenet here. You cannot impact the profitability of your company without doing one of three things: increasing sales, increasing gross margin, decreasing expenses. How do you know where the leverage is? What needs to be done unless you can see the figures that give you the relationship between all those figures?

JIM: What's the ratio of your current assets to your current liabilities? Do you know that number?

NANI: I don't.

JIM: You need to understand your balance sheet just as much as your P & L. It's more important than your P & L.

JIM: The P & L tells us what the results of our operations have been for the period covered. Financial statements should be monthly. So if this is March the 10th, we are going to kick out financials that show us what we did in the month of February. So a P & L says how much we sold, that's sales. The gross margin part of it is how much we made off of those sales. Then the expenses are what it cost us to provide all of the administration. Then there's bottom line -- which is where everybody goes -- they do know that figure. We all know if we go to the bottom line we say, "There's our net income, that's our profitability -- that figure there."

CHRIS: Profit's what we're in business for. Usually on the P & L I'm looking at labor costs or cost of goods. Especially on P & L you can see where all of your money goes. The only way to increase your profitability is decrease your costs and sell more products. That will increase your profit.

JIM: That figure, the bottom line on our P& L is a figure that's used to pay taxes on.

HATTIE: So depressing.

JIM: Hopefully we'll talk about cash flow. It is not cash. It is just a figure that we pay taxes on. But, it is important because taxes are important. But going back to the whole trend thing, it shows how we did in February compared to January and hopefully it also shows what we did compared to a year ago in February.

HATTIE: (Voiceover) The P & L gives us many numbers including cost of labor. Nance Yale is the office manager at Hanson and Company and she is happy to have new payroll tools.

NANCE: Every month I sent a payroll summary to an outside consultant who figures the taxes and sends it back to me and tells me how to fill out my little forms and I send it on. There are mistakes sometimes. Now I am able to do the process myself. I save the monthly expense and keep control in the office where I know it is being done right.

JIM: Your gross margin's too low at 25%. You know that.

NANI: Yes.

JIM: There's only two ways to improve it. Number one is be more efficient at the manufacturing part and the second is to increase your prices. Where's the leverage for you? Which one of the two is the direction you need to go?

NANI: In our case, fortunately, we really don't have very much competition so we have raised our prices.

JIM: If you're only making a 25% gross margin you have to raise your prices.

NANI: We created a bid sheet. We put in the estimated cost of labor and estimated cost of materials. We have a formula that we created with our CPA for approximately how much more we need to add to that to cover our overhead and taxes and things like that.

JIM: My guess is that as you do those quotes you generally plug in more than 25% profit.

NANI: Yes.

JIM: But in the end it isn't there so something is wrong in the job costing, right?

NANI: Well, yes it has been.

JIM: The gross margin right now is 25%. What should it be?

NANI: I don't know. I only know that the bottom line sure needs to be a lot higher than it is.

HATTIE: (Voiceover) At Small Business School.org there is self-help study for people who want to start a business and for those who want to grow the business they have. To learn more about this episode choose the overview. You can read every word you're hearing today when you choose the transcript. And, go deeper with the case study. There's streaming video and access to interactive study guides throughout the site.

HATTIE: (In the Studio) Cash is king for us business owners and it's the cash flow projection part of our financial statement that forecasts our cash needs.

JIM: We talked about profitability now we're talking about cash. Someone once said, profits are what you pay taxes on and cash is what you take home. Cash measures what's in your bank account and savings account. And which is more important, what you pay taxes on or what's in your bank account? So we need to track that.

HATTIE: Help us understand the factors that play into the cash flow statement information.

JIM: First there's the profitability of your business which in turn will translate to cash. Are you turning your accounts receivable? Are you turning your inventory? How much are you spending on equipment, furniture and fixtures and what have you and how often do you pay your bills? Your accounts payable? Are you paying on time? A lot of the cash transactions are not on the P & L. For example, if you buy equipment it goes to the balance sheet but it doesn't go to the P & L. When you buy inventory it doesn't go in the P & L, it goes on the balance sheet. It all sucks up cash. The cash flow statement measures what the P & L doesn't which is the inflow and outflow of cash.

HATTIE: How did you project cash flow before and how are you doing it now?

CHRIS: It was a two part system.

HATTIE: It was bulky and maybe you just didn't bother to do it.

CHRIS: We did it, it just took a lot of extra time.

CHRIS: We can take our employees' time and materials and create an invoice directly in the software. This seems like it has made us more efficient and cut out a few steps on the way we did it before. Now with our integrated system our efficiency level has gone way up which has benefited our bottom line, for sure.

JIM: When someone like me goes into a business we'll ask, "I'd like to see your accounts receivable aging -- how quickly are you being paid by your customers-- and then let's go to your accounts payable aging -- how quickly are you paying the folks that you depend upon for their product? Hopefully you generate an accounts receivable aging. This will show you what your receivables are for 1-30 days, what they are from 30 to 60 and 60-90. You get that report and you focus on keeping the percentage of receivables over -- you pick a date -- generally most companies it will be 60 days. One of the first things you ask when someone has a cash flow problem is, how much of your receivables are over 60 days? If they say "I don't know," then you know that the problem is they are not generating the correct reports. If they say my receivables over 60 days are 25% then you know what the problem is. If they say they are 1% that tells you something too. We have to go some place else.

HATTIE: (In the Studio) Jim teaches business owners to develop what he calls key indicators. He has 11 generic key indicators that work for every business but he also has each owner come up with ones that are specific to their business.

JIM: Each month you're going to generate a cash flow statement a P & L balance sheet and a key indicator report. What is a key indicator report? It's just what it says. You're going to pick anywhere from 8 on up key indicators that are peculiar to your business. When I say 8 on up, the key indicator report is a living breathing document. The key indicators may change as you grow and different things happen. So first remember a key indicator is not generic and it's different for your business than it is for anybody else's. Basically what it does is capture the key percentages, ratios and relationship of the numbers that come out of your P & L, balance sheet and cash flow statements.

HATTIE: (Voiceover) This is Jim's generic list of key indicators. From Your P & L you get...

1. Profit for the Month

2. Profit Year To Date

3. Sales for the Month

4. Sales Year to date

5. Return on Sales Year To Date

6. Salaries and Wages as a Percentage of Sales

From Your Balance Sheet you get...

7. Current Ratio

8. Debt to Equity

9. Inventory

10. Accounts Receivable

11. Percentage of Receivables over 60 days

HATTIE: Chris, what do you consider to be your key indicators? What numbers tell you if you're doing good or bad?

CHRIS: The way inventory is selling versus the previous year. Accounts receivable for sure. The collection on that.

HATTIE: So accounts receivables. Inventory. What about sales?

CHRIS: Definitely sales. Daily sales through the register and the way our employees are scheduled. What work we can get to. People come in and schedule us.

HATTIE: How often with the new system you've installed do you look at your key indicators?

CHRIS: We look usually, if not daily, depending upon my work load,at least once a week.

JIM: The key indicator report has two purposes. Number one it will make your management job easier. It allows you quick access to the important things in your business and it shows you the trend and the direction in which you are going. But an even more important use of the key indicator report is to engage your key employees in the management of the business. If you were to hand them a P & L, balance sheet and cash flow statement, you have trouble reading them, right? What do you expect of your employees?

HATTIE: Their eyes cross and they say no wonder I'm not the owner. I don't even want to fool with this.

JIM: Right. Let's say you have your bookkeeper and you've got on your key indicator report the percentage of receivables over 60 days. And if 6 months ago your percentage of receivables over 60 days was 10% and now they're 5%. Everybody in this meeting knows that your bookkeeper is improving at collecting your receivables.

HATTIE: (Voiceover) Jim points out that Nani needs a specific key indicator to watch.

JIM: I want to go back to the 25% gross margin. If I were your consultant, I would say this is your number one problem in this company. You should create a key indicator report and the top item should be gross margin. You should do everything you can do to focus on increasing that 25% to 30%, 35% whatever, in a reasonable timeframe. In the first place, you need to go back to that job costing form, redo the job costing form, redo the logic with which you estimate jobs. It is too low, something is wrong here. My guess would be in your industry that the gross margin should be up in the 35% to 40% range.

HATTIE: (Voiceover) Creating financial reports and tracking key indicators would be hard without software but now it's easy.

NOEL: We're able for the first time to get quality information back right now on where we are and what we're doing. That is something I have never had in the history of the company. I now know what my receivables are. I now know what my payables are. I now know that my accounting for payroll is going to be right.

JIM: When a business owner gets to the point where his favorite day is the day his financials some out, or even better than that, his favorite day of the month is the day he can push the button on his software and out will kick a preliminary P & L -- when that's the favorite day of the month-- then you know you've arrived at the point where financial statements are meaningful to you. Where you know that you get it. That it's all about numbers.

HATTIE: (In the Studio) We think Jim Schell's book, Understanding Your Financial Statements, should be required reading for every business owner who wants to grow. (Voiceover) And these business owners are smiling because they're watching their numbers and the numbers tell them they are growing in the right direction. (In the Studio) I'm Hattie Bryant for Small Business School.

The Closing of the Show

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