Lagging indicators –Using Financial Statements to unearth dysfunction

Unfortunately financial statements being a record of the past may or may not represent the future. As such we refer to financials and their related interpretation measures as lagging indicators.

On the other hand we can create a set of financial statements that represents a future that we wish to perform to. Some call it a budget.

The failure with “the budget” is not in the final product but more in the preparation process. Budgets are usually not the most favorite pastime for those who are involved in the preparation. Normally it takes a lot of work WITH VERY LITTLE FEEDABCK except for the not acceptable stuff people get from senior management.

More critical are the situations where senior management believes that their design of the budget process is highly participatory and they have as many people involved in the process as possible. Only in very few instances do people actually participate (apart from doing what they have to do) normally there is nothing in it for them except more work. Management even solicits proposals but they go nowhere and at the end of the day it becomes a spread sheet nightmare with a whole lot of number crunching and very little thinking

Once again we will be controversial. The budget is very important but the effort is not in the numbers it is in the thinking. Preparing the numbers should be about 5% of the total effort. In fact we will prove that a summarized income statement, balance sheet and cash statements at the very macro level are as effective if not more effective as the mass detailed line by line outputs.

We bet a $1 that when a detailed budget is reviewed against actual and there is a reasonable variation between the budget amount and the actual amount that the standard reaction is

      The budget was wrong

      We accounted for that in another area or it does not matter as that category is intact.

      It’s a timing difference (the amount will correct itself in the future)

      There is a good reason for this difference we had no real other choice alternatives

      And so on

 Next time please observe how these detailed line items are managed if we are wrong the $1 is yours.

Our philosophy is based on getting the foundation in place. The base of this foundation is the knowledge of the fundamentals.

Fundamental	Change agent
1. Where did we do well	What decisions combined with good execution produced the expected result.
2. Where we did well, can we do more of it	How sustainable and replicateable are the superior performance activities. Can we convert their activities in core competencies?
3. Where is the opportunity	As defined by our gross potential
4. Where  are we sub par	Is it worth while investing to change

These fundamentals become the basis for our lagging indicators. These lagging indicators in turn become the driver to our leading indicators or core competencies

Let’s use our financials to assist in defining these fundamentals

Figure 8 some examples that are revealed by the financial statements that have a direct connection to the way we do business

A greater understanding of these dysfunctions will be gained in the next part 3 of our blog – The 5 chapters of financial statement communication.

Remember a dysfunction can also be a superior value added function if this is the case it would fit under fundamental 1 and possibly be part of fundamental 2.

For example fundamental 1 is about where we did well. If EBIT (operational profit growth percentage) growth % was 10% and revenue growth % was 8% we have a dysfunction although be it in the right direction. I realize this sounds crazy but it is quiet often under this circumstance that I ask the question “what did you do to get this result or outcome”. What would you suspect the 6/10 answers are!

“We not exactly sure… we increased prices on certain services, we focused on some defined segments and we made some dramatic people changes but at the same time input costs increased and we also had to drop our pants to keep 2 key customers”

Great so what’s in there is a core competency that we can replicate and what was due to a couple of stars that happen to be in alignment at the time.

 The moral is that we often look over the signals that could give us superior performance.  It’s amazing how our numbers can give us these signals all we have to do is know what we did that created the result and then replicated like crazy.

We are now ready to start the budgeting process. Our budgets are prepared on a macro level at least at the first run stage. The budget will be driven by the 4 fundamentals. For those environments where only fundamental 1 applies we will be most conservative with our projections. Where fundamental 1 and 2 applies we will be very aggressive with big performance improvements expected. Fundamental 3 is the tricky one as the ability to extract large amounts of value here requires a lot of good thinking, the right decisions, good execution and an excellent feedback system. In other words the management focus here must be pristine.

Create the budget clearly showing which fundamentals are implanted where. Prepare the income statement balance sheet and cash flow statement at the minimum of 4 90 day or quarterly cycles.

Now comes the fun part connecting these lagging indicators to the leading indicators or core competencies. Before we do so let’s make sure we have a foundation in what these leading indicators are and how important it is to identify and describe them appropriately

Global Financial Bridge is a great tool to identify these areas of dysfunction simply by looking at about 30 numbers in your One page scorecard.