Managing the Four Bottom Lines

As a business owner, you have probably had conversations with other business owners, bankers or investors about your bottom line. Without question, the most common business "bottom line" measurement is net profit (net income). However, net profit is only one of four important bottom lines which indicate the true financial performance of a company; in fact, it's not even the most important of the four.

The four bottom lines that a business owner must fully understand and monitor are:

* Return on Invested Capital
* Net Profit
* Operating Cash Flow
* Profit Per Employee

Each of these measures a distinct aspect of the business. Any metric has inherent limitations and weaknesses, and these four are no exception. Considering them, as a complete package, however, provides a complete view of "bottom line performance" with which to evaluate the health of the business. Let's take a look at each of these bottom lines.

RETURN ON INVESTED CAPITAL

If forced to choose the most important of the four bottom lines, it would likely be return on invested capital. This measure demonstrates how successfully the business enterprise turns capital (resources) into profit. In other words, it measures how effectively the company uses its money (borrowed or owned). After all, the primary financial reason for a business to exist is to return profit to capital holders (investors and lenders). To be considered a strong performer, a business must at least yield a return higher than its cost of capital.

Return on invested capital is calculated by summing net profit, interest, and amortization, then dividing this quantity by total assets (excluding excess cash and non-interest-bearing current liabilities). The denominator of this formula is based on the balance sheet, but with net profit as the prime input of the numerator, this measure is equally affected by revenue and expenses.

Return on invested capital is very useful when comparing the financial performance of different businesses, whether within or across industries. Every company generates different revenue, profit, and cash flow levels, but return on invested capital provides an equalizing measure of how effectively companies produce profit from a given base of resources.

If return on invested capital is such a good measure, why is it not the sole bottom line metric of business performance? As noted previously, every metric has inherent limitations, so it's not wise to rely on only one. The limitations of return on invested capital include:

* It does not measure cash flow.
* It can be easily manipulated by accounting methods.
* It is more difficult to measure than the other three bottom line measurements.

NET PROFIT

Net profit measures the economic reality of a value proposition over time. In other words, is the customer willing to pay more for the product or service than it costs the business to produce and deliver it? If so, the business will generate a net profit. This metric is calculated by deducting all operating expenses from total revenue (sales). This metric is commonly presented in actual dollars as well as percent of revenue (e.g. $50,000 in profit or 6.8% of revenue for the month).

One must know the accrual basis and matching principle to fully understand net profit. Accrual basis net profit focuses on the promise and agreement aspect of a business transaction. This is different than recording the financial activity based on when the cash changes hands. The matching principle requires that the expenses associated with producing certain revenue be recognized in the same period. For example, if revenue from a particular sale is recognized this month, all expenses related to that particular sales event should be recognized this month as well. In addition, capital items that are expensed over time (as depreciation) must be separated from normal expenses.

The inherent limitations of net profit include:

* It does not reveal the real cash situation since it focuses on the promise and agreement part of a business transaction.
* It is an abstract measure because it comes from the income statement and can be manipulated with different accounting methods.

OPERATING CASH FLOW

Cash flow for a business is like fuel for a vehicle: it keeps the business running. A business can operate for awhile at a net loss, but it cannot operate one day without cash. Operating cash flow measures how much cash is generated by the operations of the business. This metric focuses on the cash settlement part of a transaction. Not included in operating cash flow are cash items related to capital investments (buildings, equipment, etc.), investors, or lenders. In general, operating cash flow should exceed net profit; however, net profit should ultimately be the largest component of operating cash flow. One exception would be in businesses in a continuous pattern of high growth where cash is needed to fund working capital, primarily accounts receivable and inventory.

The inherent limitations of operating cash flow include:

* Since it focuses on the settlement part of a business transaction, it can be manipulated by varied accounting practices and management decisions (such as paying vendors late, holding customer checks for deposit at a later date, etc.).
* It can be manipulated and increased at the expense of profit, as in the practice of factoring receivables (selling receivables up front for a discount).

PROFIT PER EMPLOYEE

Profit per employee measures the returns on talent in addition to capital. In today's knowledge-based economy, measuring the financial performance of intangibles is more important than ever. Intangibles might include process knowledge, brands, customer bases, or any other form of intellectual capital (specialized knowledge and relationships). Large profits can be produced by creating intangibles, as we see in the proliferation of technology, service, and web-based businesses. These businesses require little investment in traditional capital, but large amounts of investment in people talent. Profit per employee provides a metric indicating a company's success in converting its raw talent into profits. It is calculated by dividing the net profit by the number of full-time equivalent employees engaged in the business operations.

The inherent limitations of profit per employee, similar to those of its numerator, net profit, include:

* It does not reveal the real cash situation.
* It is an abstract measure because it comes from the income statement and focuses on the promise and agreement part of a business transaction.
* It can be manipulated through management decisions to use part-time or contract staff in place of full-time employees. Determining the number of full-time equivalent employees is an exercise in estimation.

MANAGING THE FOUR BOTTOM LINES

Effective financial management for business owners should take all four bottom lines into account. How good of a job is your organization doing? Do you have a good view and understanding of these measurements? The first place to begin is to organize a month-end financial score card that keeps all four of these bottom lines in view. An example of a simple monthly financial scorecard can be found in the pdf of this article at the website listed below.

While it's critical to understand these four bottom lines, we should note that all four are lagging indicators, measuring past performance. Past performance does not determine future success. Understanding the variables for each of these metrics can, however, help you as a business owner make decisions that will move all of these bottom lines in a positive direction.

SUMMARY

The four bottom lines discussed in this article represent different methods of viewing the performance of business operations. Certain businesses or industries may have different terms for them, but the underlying principle is universal: every business must make a profit, generate cash flow, and provide a financial return on its investment in both capital and talent. These four bottom lines should be used together rather than relying on just one or two, for each has inherent limitations which are complemented by the others. The full view will leave you better informed as a business owner.

Troy D. Schrock, CPA, is the developer of The ActionCFO Process, which provides a CFO system and part-time CFO to owners of midsize businesses who are looking for financial visibility and control without the cost of a full-time CFO. Most business owners are not even aware that full-time CFO expertise is unnecessary in most companies. ActionCFO advisors offer companies the expertise they need while implementing a fully customizable system to help business owners make better financial decisions. In short, business owners get the tools and CFO expertise in one package for less than 40% of what a full-time CFO would cost.

Learn more at http://www.actioncfo.com

Copyright 2009 Advisor Catalyst, Inc. Reprints permitted as long as the author information, website, and copyright statement are included.

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Managing the Four Bottom Lines