Financial truth often lies behind the numbers

Financial truth often lies behind the numbers

Matt Davies, lecturer in finance and accounting at Aston Business School, dispels four common myths about financial management.

After 25 years as an accountant, trainer, university lecturer and consultant working with a wide variety of organisations, I’ve realised there are some common myths on the subject of financial management. Dispelling these myths is an important part of developing financial literacy. My recommendation is that business owners and managers invest the time and effort to ‘unlearn’ these misconceptions, in order to develop key financial skills and knowledge.

Anyone involved in business can benefit from being able to communicate financial concepts more confidently and, ultimately, manage more effectively. So here’s the truth about four of the most widely held misconceptions:

Myth 1: ‘The balance sheet provides a reliable measure of the value of a business.’

False. The balance sheet (or statement of financial position as it is now referred to) provides information about your financial state of the business, not its value. 

Many valuable assets (such as people and internally generated brands) are not recorded on the balance sheet, and those that are recorded are generally shown at their original cost (and for longer term assets, depreciation is then deducted).  

Value is determined by the future performance potential of the business, whereas the balance sheet is only based on past transactions and events. Generally, therefore, a balance sheet can significantly understate the true worth of your business.

Myth 2: ‘Profit is a reliable measure of financial performance.’

False. It’s important to recognise that profit is merely an ‘opinion’ on the business’ financial performance and should never be regarded as an entirely reliable measure. 
There are several choices and judgements involved in the measurement of accounting numbers. Examples include depreciation, accruals and provisions, none of which can be measured with 100% accuracy.

Myth 3: ‘Profit is the same as cash flow.’

False. It’s perfectly possible to have positive profits and negative cash flows. The reasons why there is a difference between profit and cash flow include:
Sales made on credit are recorded in the income statement when the sale is made, not when the cash is received.
Expenses are recorded as they are ‘consumed’, not when they are paid for.
The cost of inventory is only recorded as an expense when inventory is sold, not when it is bought or manufactured.
Cash spent on capital expenditure is not recorded in the income statement, whereas depreciation (a non-cash expense) is.

Myth 4: ‘It’s possible to measure the true cost of a product or service.’

False. Many of you may be placing far too much faith in your accountant’s measure
of ‘cost’. 

Whilst some costs (‘direct costs’ such as materials and labour) can be accurately related to a product, there are many costs (‘overheads’) which are far more difficult to deal with. 
Many businesses use very arbitrary systems for sharing the overheads across the product range.  These systems might appear to be reasonable but they don’t necessarily provide a guide to a product’s ‘true cost’. 

You therefore need to take care when making pricing and product mix decisions using cost information which is not always very reliable.

Matt Davies teaches on programmes for the Centre for Executive Development (CED) at Aston Business School. CED works closely with clients to create tailored programmes that deliver measurable returns on investment.

Impact assessments are built into all its programmes to demonstrate and quantify
how intended results have been achieved. The programmes blend new, research-based thinking with relevant, proven tools to help executives think more clearly and creatively to meet strategic goals.

Find out more at www.aston.ac.ukaston-business-school