Essential Finance – Compare and contrast

Arts organisations operate in an environment where a range of questions is asked of them by a wide variety of stakeholders. One of the richest sources of information that an organisation can use to provide information to its stakeholders is its financial statements. The primary financial statements produced by arts organisations are the income statement, balance sheet and the cash-flow statement. The selective use and meaningful interpretation of aspects of these is a powerful management tool that can be used to monitor and analyse performance.

Important measures

Ratios tend to be relative measures: they measure one number in relation to another. For example, the income generated by fundraising or sponsorship could be measured against the costs involved. However, ratios should be selected that give an insight into the major areas of concern to stakeholders – namely risk and liquidity, effectiveness and efficiency. Typically, the key ratios for arts organisations would be:

• risk, measured by the extent of reliance on grant income
• liquidity, measured by levels of debt and cash reserves, and how long it takes an organisation to collect the money that it is owed – longer periods indicate that there will be pressure placed on the cash reserves
• efficiency, which could be measured by looking at the level of costs in relation to the level of income. This would tell us how much of the income is being used to meet operating costs and in meeting client needs. Increases in costs needs to be interpreted in the context of inflation and price increases.

Ratio analysis is a skill and technique that is developed over time. It is very tempting to begin calculating figures immediately; the problem is, however, that unless you identify the important areas of the organisation from the requisite stakeholders’ perspective then you could be calculating ratios that are irrelevant. Ratios and numbers by themselves are of no practical use, it is essential that they are compared with something, e.g. last year, the budget, or ‘competitors’. We also need to make sure that we are comparing like with like.

Step by step

The initial stage is to give the information a thorough ‘look’ and to cast a layperson’s eye over the financial statements without the use of a calculator. All you need to do is to get a feel for what the organisation’s position is. Look for significant figures, trends and comparisons – for example, what is the comparative level of self-generated income and staff costs? What are major costs? What are the figures for debtors and creditors and cash balances? Once you have read the financial statements, you will have a very good idea where the interesting and problematic areas are.

Proceed through the income statement looking at the type of income generated – grants, donations, ticket sales, sponsorship. How does it compare with previous years and expectations? Calculate the overall composition and relative increase or decrease. It is useful to examine the proportion of income taken up by major expenses, for example, artists’ fees, salaries, promotion and publicity.

Expenses compared to income indicate efficiency: if income increases year-on-year by (say) 20%, expenses should not necessarily rise in line and one should generally see ‘economies of scale’. The reason for this is due to the nature and type of cost incurred; costs being predominantly fixed or variable. Fixed costs typically include expenses for items such as rent and paying staff salaries. These costs will not change (within reason) with levels of activity, for example, a theatre or dance company that does one or thirty performances will not incur additional salary costs, a gallery that extends opening hours does not incur additional rent costs. Variable costs are those that will fluctuate with the level of activity that an organisation carries out.

Cash is key

The examination of the balance sheet follows the examination of the income statement; this will show the level of short-term and long-term debt, debtors, and cash resources. Cash is effectively the lifeblood of all organisations: lack of cash or the inability to access cash will spell the end for all organisations. A number of financial statements will not include a cash flow but it is possible to construct a basic statement that shows how much cash was generated during the year and where it all went. Take the surplus or deficit for the year (income statement) and add items included in the income statement that have not involved cash payments, the most common example being depreciation. Look at the balance sheet and calculate the differences between this year’s and last year’s stock, debtors and creditors – an increase in stock and debtors reflects cash going out, an increase indicates cash coming in. Added together, this will give the total cash generated in the year from day-to-day operations. Other cash flows relate to investing activities, for example purchases and disposals of equipment. (Look at the balance sheet to check increases or decreases in fixed assets.)

Some caution has to be exercised when calculating and evaluating ratios, for example the accounts that will be used will be past information and not necessarily indicative of the current situation. Comparisons must be made but they need to be truly comparable – artistic programmes may be fundamentally different, client groups may be different, different accounting judgements may have been made last year.

Ratios will never provide a definitive insight into what has happened; what they can do is to focus our attention on the areas of concern and interest. Further information will usually be required to clarify our understanding – for example, management accounts, and booking diaries (to calculate occupancy for venues). The ratios calculated must be driven by the needs and requirements of the stakeholder.

Mahmood Reza is Proprietor of the Accountancy Practice Pro Active Accounting.
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