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Smoothing to Create More Meaningful Financial Statements

Financial statements can be very misleading when you are comparing months that contain different numbers of working days. The traditional approach presents numbers exactly as they appear from the financial records; producing meaningful financial statements calls for an entirely different way of presenting the information.

What I am going to show you here is how a “traditional” presentation will show that revenues are uneven and that profitability is declining while a set of well-organized management financials supported with effective Key Performance Indicators will show you that the real picture is almost the direct opposite.

In a company that uses a traditional approach, the monthly financials will be presented like this:

Month

1

2

3

 

Total

Revenues

$400,000

$375,000

$425,000

 

$1,200,000

Payroll

$245,000

$245,000

$306,250

 

$796,250

Overhead

$100,000

$100,000

$100,000

 

$300,000

Net Profit 

$55,000

$30,000

$18,750

 

$103,750

Net Profit %

13.75%

8.00%

4.41%

 

8.65%

In a progressive company that wants to use the financials as a tool to manage their business more effectively, the same information can be presented in a much more practical and meaningful way that matches expenses very precisely to the time period to which they relate:

Month

1

2

3

 

Total

Revenues

$400,000

$375,000

$425,000

 

$1,200,000

Smoothed  Payroll

$269,698

$231,169

$295,383

 

$796,250

Overhead

$100,000

$100,000

$100,000

 

$300,000

Net Profit 

$30,302

$43,831

$29,617

 

$103,750

Net Profit %

7.58%

11.69%

6.97%

 

8.65%

Revenues are uneven and under both approaches appear to have declined in month two. As far as profitability is concerned, the first presentation shows month one as the most profitable (13.75%) followed by month two (8%) and month three (4.41%). The second presentation shows a very different picture with month two the most profitable (11.69%). The difference here is in the treatment of payroll, and this is a telling example of how numbers can mislead.  

Much more than that, it is a compelling reason to reassess the management information that your systems are providing you and run your business more effectively by measuring what is really going on - not what the “traditional” numbers show.

After all….you can only manage what you measure.

The Timing Problem

The whole issue is a timing problem that is caused by months that contain different numbers of working days. It shows up most often and most significantly in the areas of revenue and payroll, and both can be smoothed to reveal the true underlying picture.

In businesses where the number of working days directly affects the amount of revenue generated, this can make a significant difference to the relevance of the numbers presented in the P&L. This is true to a greater or lesser extent for virtually all businesses, even those that operate under service contracts.   

The presentation of payroll expenses can also be misleading and there are two separate elements that can contribute to the confusion – the number of working days in each month and the frequency with which payroll is paid.

·         Working Days in the Month. This is a particular problem for businesses where production varies directly with the number of days worked. The number of days will directly impact the revenues booked during the month, and what looks like an increase can actually be a decrease purely because there are more working days in the month.  Obviously, different months have different numbers of days in them, but the number of working days also varies depending on where the weekends fall and the timing of Holidays.

·         Payroll Frequency. If you pay monthly or semi monthly then there is no problem as payroll matches financial periods, but the majority of businesses pay weekly or every two weeks, and this creates issues. If you pay every two weeks then there will be two months a year where you have three pay periods, and if you pay weekly then you will have four months each year where you have an extra payday. Unless you smooth them out, payroll expenses recorded in one month will really apply to the prior or following month and those months with an extra payroll will appear less profitable than they really are.

It important to look at your financials without this bias, and the best way to do that is to use an index where you look at everything that varies with the number of days in a month on a unit basis. In practice, that usually means revenues and payroll and it is easy to express them in terms of the number of business days in the month and that is often an appropriate measurement.

The starting point is to calculate the number of working days in the year, taking into account not only weekends but also holidays that affect workflow or the production schedule. Then calculate the number of working days in each month and you have the information you need to calculate daily revenues and daily payroll as Key Performance indicators to give you a much better snapshot of what is really going on in your business.

Example

I have a client who has a service business where his direct labor is about 66% of his revenues He pays the technicians weekly, and without smoothing, his P&L will look like this:

Month

1

2

3

 

Total

Revenues

$400,000

$375,000

$425,000

 

$1,200,000

Payroll

$245,000

$245,000

$306,250

 

$796,250

Overhead

$100,000

$100,000

$100,000

 

$300,000

Net Profit 

$55,000

$30,000

$18,750

 

$103,750

Net Profit %

13.75%

8.00%

4.41%

 

8.65%

This presentation makes it look as though revenues went down in month two and then up again in month three and that this affected profitability. In reality the picture of when profits were earned and how much they represented as a percentage of revenues is dramatically different because the number of working days in each month varied.

There are three areas that this business needs to look at in assessing its financial picture more accurately and effectively – Revenues, Payroll and Financial Statement Presentation.

Revenues

Instead of looking at gross revenues, the more meaningful measurement is to calculate daily revenues for each period, and this is a very effective Key Performance Indicator.

Smoothing the revenues to create this KPI simply involves dividing revenue billed by the number of days in the month to come up with a daily revenue number:     

Month

1

2

3

 

Total

Revenues

$400,000

$375,000

$425,000

 

$1,200,000

Working Days

21

18

23

 

62

Daily Revenues

$19,048

$20,833

$18,478

 

$19,355

This approach shows a very different revenue picture, with daily revenues actually increasing in month two and decreasing in month three, the exact opposite of what the unsmoothed financials showed.    

Used as a KPI and tracked monthly, this will provide you with a revenue measurement that is much more effective than the “traditional” approach delivers.   

Payroll

The profit picture is also distorted by payroll expenses. Payroll expense based on when it was paid does not directly correlate to the number of working days in any of the periods, and in addition March contains an extra payroll.

The more meaningful way to record and present this information is to calculate daily payroll.  This can be done quite easily by taking the annualized payroll at any given point and dividing it by the number of working days in the year.    

Annualized Payroll

$3,185,000

Working Days

248

Daily Payroll

$12,843

Once this daily number has been calculated, the smoothed payroll expense for each month can be established so that it can then be dropped into the financials. To calculate the smoothed payroll for the month, simply multiply the daily expense by the number of working days in the period:    

Month

1

2

3

 

Total

Daily Payroll

$12,843

$12,843

$12,843

 

$12,843

Working Days

21

18

23

 

62

Smoothed Payroll

$269,698

$231,169

$295,383

 

$796,250

This is another very useful KPI. Tracked monthly, it will provide you with a payroll trend analysis that is much more effective than anything the “traditional” approach can deliver.   

Financial Statements

More importantly, when the smoothed payroll is used in the financial statements it becomes really meaningful for the effective measurement of the business. You will notice that the payroll numbers, while different from what was actually paid in each month do equal the total for the quarter as the cycle catches up.

These smoothed payroll numbers can be easily dropped into the P&L, and a very different picture emerges:

Month

1

2

3

 

Total

Revenues

$400,000

$375,000

$425,000

 

$1,200,000

Smoothed  Payroll

$269,698

$231,169

$295,383

 

$796,250

Overhead

$100,000

$100,000

$100,000

 

$300,000

Net Profit 

$30,302

$43,831

$29,617

 

$103,750

Net Profit %

7.58%

11.69%

6.97%

 

8.65%

Instead of dramatic swings from month to month, the profit picture is much more consistent, and any trends or “blips” will show up much more quickly.    

If you have a business that is affected by the number of working days in a month, then this is a very important adjustment for you to make. It is an important step towards producing financial statements that help you run the business rather than just working for the Government and producing financial statements for compliance purposes.