Finance Does Not Live In Isolation

Finance does not live in isolation, an interesting concept. There are two important ramifications to that concept, first, you cannot look at your company’s numbers just for now, or just for this year. As a matter of fact, not even just for this year and last (unless, of course, you just started last year). Rather, you need to look back at least three years. You do so in order to see the trend lines of how you arrived where you are now. Are you improving or declining? If for example, your cash cycle is 145 days, what was it three years ago, better or worse? If better, work to understand what you have done right. If worse, dig down to find out what is going wrong.

The second ramification of the opening statement above is a question: what is your competition or industry doing? You need to know how you compare to your competition, whether you are a local or national player, dig out information about the rest of the industry. From the example above, what if the industries cash cycle average is 95 days? Can you see how you may have trouble competing in an industry that is far more efficient than you in keeping cash flowing through your organization? A longer cash cycle will mean that you must tie up more cash in working capital, rather than investing in other ways to improve business.

There are any number of online researchers that can provide you with industry information for you to use in viewing how your business stacks up against the competition. I prefer Bizminer, an online research company, because they break down their research in ways that are very useful for a small business. For example, you can do research on a statewide basis, and many of their reports are narrowed down to a small area, such as a county. In addition, their reports are broken out into different revenue categories, allowing you to narrow down your comparative information to your industry sector.

A last word, when comparing your company to your industry, do the comparison over the same timeframe that you are using for your company review. That is, if you are going back three years to see what your trends are, it is important to look at industry trends for the same period, to see if you are trending in the same way. This can give you another important clue on how your financial picture is shaping up.

Never leave your numbers all by themselves!

More Efficient and Productive

There are many small businesses that start out producing a product, and of necessity, sell their product in small quantities directly to consumers. This is the bootstrapping phase of a (hopefully) growing business. If the product catches on, there is a phase where growth is rapid, and the business may begin to acquire customers that want larger quantities, or even better, want to distribute the product themselves.

The small business may struggle to keep up with providing the product to all that want it. In particular, if the product is at all customized, it may be difficult to keep up with all the customizations that need to be made for individual customers while trying to ramp up larger scale production for large customers and redistributors. The question is, how do you decide where to put your energies and capital as you expand?

What some small businesses fail to do is consider the finances of the situation in order make a better, more informed decision. Other small businesses cannot consider the finances of a situation, because they do not adequately track cost properly. If you fall in to the latter group, you may want to look at a Blog that I wrote concerning cost, by clicking here.

For those that are tracking costs sufficiently, one way to consider the situation is by reviewing capital turnover. Capital turnover is calculated as sales divided by total capital. Capital Turnover is an activity ratio that will tell you how well you are utilizing your capital. For example, if a company had $100,000 in assets and $200,000 in sales, the calculation is:

$200,000/$100,000 = 2

In other words, 1 dollar of capital produced 2 dollars in sales. To use the vocabulary of the ratio, every dollar of capital was “turned” 2 times.

Once the company has established their overall capital turnover, they can use their knowledge of their costs to make an estimate of what portion of their capital is involved in the sales to different customers. Let’s say that they believe that roughly half of their resources are dedicated to each segment of the customers, small customers and large customers. However, the ratio of sales to each segment is not, with $150,000 going to the large customers and redistributors and $50,000 to the others. We could then do 2 calculations:

$150,000/$50,000 = 3
$50,000/$50,000 = 1

In this case, the large customer and redistributor segment is “turning” dollars at three times the rate of the small customers, therefore is using capital more efficiently. Now, this seems pretty obvious in this example, and working out the numbers is often more complex than this example.

In this case, the small business needs to consider ways to move towards putting more resources into the large customer segment and away from the small. Now, that brings up m=other questions, such as how to do so without alienating one set of customers. That would be the topic of another Blog. The important conclusion here is that having made this analysis, the small business now knows how well they are using resources and where they need to change to become more efficient and productive.

Sustaining Growth – A Practical Example

In last week‘s posting (Sustaining Growth), I introduced a model that would allow a small business owner to understand how fast their company may grow without external financial inputs. In other words, how quickly can your business grow without running out of cash and without infusing new cash from equity or loans. In addition, the model also allows a small business owner to see how other changes and improvements might

The Allowable Growth Rate model that I introduced last week is:

AGR = Net Profit Margin x Rate of Retention x Asset Turnover x Leverage

Let’s take a look at an example: a small business has sales of $900,000, with Cost of Goods Sold (COGS) of $350,000, Sales and General Administration (SG&A) costs of $400,000 for a Net Profit of $150,000. In addition, the company’ owner pays a dividends $100,000 to investors. The business has Capital of $450,000, of which $300,000 is debt and the rest equity.

 AGR   =   16.7%    x    33.3%   x   2   x   2   =  22.2%

AGR     =     $900,000     x     22.2%     =     $200,000

Simply put, with retained earnings of $50,000 (after dividends), the company turns assets over 2 times a year, and has leverage of 2, meaning that internal operations will allow the company to turn the $50,000 of retained earnings into $200,000 of new sales without external funds.

Supposing, however, that the product or service that the company sells has made a hit in the marketplace, and sales could grow much more quickly than that. If the company expands more rapidly, they will be pinched by a lack of capital to sustain the growth.

If it is possible to make improvements internally, you should try. For example, if the company can decrease Cost of Goods Sold, Sales or General Administration Expenses, each dollar saved would be another dollar to be reinvested into the business, all things being equal. For example, a decrease in COGS and SG&A of just 5% would increase Net Profit and AGR as follows

AGR   =   20.8%   x   46.7%   x   2   x   2   =   38.9%

AGR     =     $900,000     x     38.9%     =     $350,000

You could also analyze other operations. What if the company could use its assets more efficiently, thus increasing capital turnover? This would allow them to create more sales with the same assets, thus increasing AGR, again without external financial inputs. The following example assumes that the company is able to increase asset turnover from 2 to 3, increasing revenue to $1,350,000. We also assume that COGS and SG&A will increase by roughly 1/3, as would dividends. The resulting equation for AGR is

AGR   =   27.8%   x   65.3%    x   3   x   2   =   108.9%

AGR     =     $900,000     x     108.9%     =     $1,470,000

Of course, not every company is simply going to increase asset turnover by 50%, but this illustrates how internal change can have a significant effect on financial performance. In reality, you would always want to look at improvement in internal operations as a way to increase AGR, before looking at external financial inputs, such as debt or equity. If you were to seek external financing, a good investor or bank partner is going to want to look at improvements anyway.

 

Sustaining Growth

Every business owner wants to be successful; or at least all of the business owners I know do. However, there are a significant number of businesses that do not succeed in the long term because of how well they succeed in the short run. Most often, this is because the business grows more quickly than their cash flow allows (see Its Cash That Counts and A Simple Tool to Calculate and Track Cash Flow). Adequate cash flow is vital to the success of any business, and it is possible to analyze your company’s financials in order to predict the rate of growth that your cash flow allows.

Allowable Growth Rate will tell you how fast your company may grow without changing any external financial inputs, such as increasing equity financing or loans. The lesson here is to know what your company’s allowable growth rate is without such financial adjustments and then be ready to apply the adjustments when needed. Negotiate the additional equity or loan before you need it!

This posting will look at the Allowable Growth Rate Formula, and next week will follow with a practical example. Here is the formula for Allowable Growth Rate:

AGR = Net Profit Margin  X  Rate of Retention  X  Asset Turnover  X  Leverage

Net Profit Margin: The first term of the formula is simply the percentage of your net profit, which is Net Income divided by Revenues. The formula presumes that the first source of operating cash is your company’s profits. Recall that I mentioned above that this formula addresses the allowable growth rate without external financial inputs. If your company does not yet have net profit, you will automatically need external financial inputs in order to operate at all, let alone grow.

Retention Rate: Retention rate refers to the amount of Net Profit that is retained within the company. For example, the company may be obligated to pay a dividend out of profits, or as the owner, you do not take any personal salary until after all other expenses are met. The retention rate is calculated by dividing the amount of profit retained in the company by the total of net profit.

Asset Turnover: Asset turnover refers to the number of times in a year that your company uses a dollar to move its operations forward. It is calculated by dividing the company’s Total Assets from the Balance Sheet by Revenues. Asset Turnover is a way of looking at how efficient your company is with its resources. This is important for determining your company’s growth rate: the more efficient that your company uses its resources, the greater the allowable growth rate.

Leverage: Although not everyone agrees with me when I state it like this, but Leverage basically tells us who owns what in a company (see DuPont Analysis: Capital, Debt and Equity). If the total capital in a company is $150,000, and the owner’s equity is $100,000, then that means that there is also $50,000 in debt (belonging to the bank or other individual or entity). In this case, capital divided by equity equals 1.5. Debt is used as a lever to increase the amount of capital available to operate the company. In many small companies, there is no leverage because the company has not taken on debt.

Next week, a practical application of the formula.

Resolve to Follow Your Cash Flow

I saw an interesting saying on a sign the other day, “New Year’s Resolutions, they go in one year and out the next.” That is my philosophy as well when it comes to New Year’s Resolutions. Yet, as a business owner, there is one resolution that ought to be made for the coming year: pay attention to your cash flow.

Most small business owners review their Profit and Loss Statement (hereafter P&L) more or less regularly, but often forget that the bottom line of a P&L is an accounting number. That is, the net profit on a P&L does not take into consideration the timing of cash flows. The business owner will look at the P&L and see a great number, then look at their bank account and say, “Where’s the money?” There are a number of reasons why those numbers may be different.

First, take into account the credit you extend to your customers, also known as receivables. If you have booked sales in a given month, but the actual payment is coming 30, 60 or 90 days in the future, your bank account will not reflect that fact. If you picture your sales as coins flowing into a bucket, any sale made on credit actually has an IOU on it instead of a dollar sign.

Secondly, take into account the credit your suppliers and vendors extend to you, also known as payables. For example, If you look at a P&L that contains cash that will not be paid until 30, 60 or 90 days into the future and do not take that into account, your cash on hand will be inflated beyond what it really is. If you spend those committed dollars on something else, such as payroll, and then have a problem with cash inflow, you might not be able to meet those supplier and vendor obligations when they come around.

The best way to avoid this problem is with a Cash Flow document that takes into account the timing of cash flows. The cash flow document will not register sales for a given month, but the actual cash inflow. The document will not register purchases of goods or services, but the actual cash outflow in a given month. The Cash Flow document should also show the recurring monthly cash outflows for payroll, rent and other expenses. By creating a cash flow document that moves into the future at least 6 months, you will be much better able to predict what cash you will need in any given month in order to cover all of the cash outflows.

Resolving to follow your cash flow in 2013 is one resolution that you can’t afford not to make!

DuPont Analysis: A Practical Example

The previous Blogs in this series introduced you to the DuPont Analysis; this offering will take up a practical example of how a DuPont Analysis can help you understand the state of a business. The subject of the analysis is a small company that manufactures medical devices of different sorts.  This study uses financials from 2011, at which time the company was about a $1.6 million company. To view or download the DuPont pyramid with pertinent numbers go to this  LINK.

I have discovered that people often feel that financial analysis must be quite complex. Well, yes and no. Large companies with complex business structures can be time consuming to analyze. However, in my experience, small business analysis does not need to be complex at all. As a matter of fact, the problems that a small company may be experiencing are not usually very difficult to pinpoint through financial analysis. The example that follows should give you a feel for the relative simplicity of analysis. Of course, if the numbers themselves are off, so will the analysis, but for the sake of example, the numbers presented in this analysis are accurate.

At the top of the pyramid we have a Return on Equity of 25%. In other words, for every $100 of equity invested in the company, there is a return of $25. Now, how are we to interpret that? There are several aspects to consider. If the company was expecting a 15% return, they are doing quite well. On the other hand, if they were expecting 35%, not so well. The previous year Return on Equity was 26%, which gives you one clue, meaning that the current year is down just a bit. However, the current year’s revenues are up by 16%, so there may be something amiss.

In order to understand better we must go deeper into the pyramid. Return on Capital is 23% with leverage at 1.09, meaning that the small load of debt that the company is carrying is actually improving return on equity (23% X 1.09 = 25%). So the problem is not that the company is over leveraged. As we continue down the left hand side, Net Profit Margin at 23%, Operating Profit margin at 30% and Gross Profit Margin at 72% all seem to indicate that the company has cost under control. On the other hand, perhaps the company could boost returns by increasing leverage. Using debt to increase capital for the purpose of increasing investment might be an option.

When we look at the Total Asset Turnover Ratio (also known as Capital Turnover Ratio), we begin to see the tip of an iceberg peaking above the water. The 1.0 indicates that the company is probably not using capital efficiently. At 1.0, the company is turning each dollar of capital over once a year. So, before the company goes looking for increased debt, they must discover why their use of capital is not more efficient.

We can see that Working Capital Turnover is just over 2, which could be an indication of where the rest of the iceberg is hiding. Working Capital is the amount of investment that is used to keep the company operating. It includes inventory, payables and receivables. Another way that this is expressed is in the Cash Cycle, how many days does it take to circulate a dollar in the process of creating a product, collecting that dollar from clients and paying to vendors.

As we can see, in the pyramid, this company’s cash cycle is 613 days long. Of that cycle, inventory is 554 days. This means that  it takes the company 555 days to circulate a dollar in their production and sales process, including both raw materials and parts purchased from vendors, work in process materials that are unfinished products and inventory both on the company’s shelves waiting to go out  or already on a distributor’s shelf waiting to be sold.

The real problem facing the company is that they are tying up capital in their inventory, making it difficult to deploy that capital for other reasons. For example, if their sales were to create a breakthrough, and they required additional manufacturing capacity, it would be difficult to do without taking on additional loans. But, would they want to take on increased debt when their use of that debt is so inefficient.

The real key is how to shorten their production and sales cycle, so as not to tie up large amounts of capital. The solutions could be improved manufacturing methods such as the use of Just in Time, better forecasting the marketplace for demand and paying closer attention to the inventory on distributor’s shelves. The company would do well to fix this problem before it became an even greater challenge, impeding future growth. In addition to fixing the problem, the company needs to monitor the level of both inventory and working capital closely, to guard against future reoccurrence.

As you can see, understanding the way that financial reports give a vision into the state of a company is not all that difficult. Using the tried and true DuPont Method will afford you that vision into the state of your company, and is well worth the time spent to produce the numbers that “don’t lie”!

The DuPont Method: Activity Ratios

In our last Blog entry, we discussed Profitability Ratios, which can show you how well you are doing at making a profit. As a component of the DuPont pyramid, profitability ratios show you how well you are using your capital to generate sales (click here for an image of the pyramid).

The other component of Return on Capital consists of the activity ratios, which measure how well your company is using capital to support operations. It is often said, “It takes money to make money” and the activity ratios illustrate how well your company is using that money to operate. We should mention, first off, that although we use dollars to calculate ratios, often those dollars refer to non-monetary assets, such as equipment, plants and inventory. The dollar amounts may also denote credit and debt, which we will explain a bit later.

The top activity ratio in the DuPont pyramid is total asset turnover ratio. This ratio tells us how many times a business turns a dollar over during the time period studied. Another way to describe this ratio is to say how many times a dollar’s worth of assets creates a dollar’s worth of sales. The ratio is calculated as follows:

Sales
Average Total Assets

Average total assets is determined by dividing the sum of total assets at the beginning of the time period studied with total assets at the end of the period, divided by two. If a company had total average assets of $100,000 and had sales of $200,000, the Total Asset Turnover Ratio would be 2. In other words, each dollar of assets was “turned” 2 times during the time period. The more times that a dollar of assets is turned, the more efficiently you are using your capital.

Fixed Asset Turnover is especially important to those that have large investments in fixed assets such as plants, machines, trucks and other equipment. The Fixed Asset turnover ratio will tell you how well your company is using these assets. It is calculated:

Sales
Average Fixed Assets

If your company has $50,000 in fixed assets and $200,000 in sales, your Fixed Asset ratio would be 4. In other words each dollar of these assets was turned 4 times. The importance of this ratio is not only in how well you use your assets internally, but also in comparison to your competition. If your ratio is 4, and your competition is at 8, then you are much less efficient, and will find it hard to compete. If your competition is that much more efficient, they could lower prices to be more competitive.

The final activity ratio that we will look at is Working Capital Turnover. As you may recall, working capital represents the assets and cash that you need to keep your company operating. In previous Blog entries, I have often explained that a fast-growing company that is not well financed may run of cash and go out of business, despite success at selling a product or service. This ratio is also referred to as the cash cycle, in other words, how long does it take for a dollar to be create a product or service, and then be received back as payment.

Monitoring Working Capital Turnover will help you avoid that pitfall. There are three components to this ratio:

  • Inventory Days: the number of days it would take to sell the inventory that you have on hand at your current sales rate.
  • Receivable Days: the number of days, on average, that it takes you to collect a dollar of receivables. In essence, this ratio lets you know how much “interest free” credit you extend to your clients.
  • Payable Days: The number of days, on average, that you take to pay a dollar of payables, the interest free credit that your vendors extend you.

The ratio is calculated:

Inventory Days X Receivable Days X Payable Days

If for example, your Working Capital ratio was 45, meaning that it takes 45 days to use a dollar to create a product or service (including paying for suppliers) and collect that dollar back in receivables. Many manufacturers and distributors keep too much capital tied up in inventory. Small manufacturers’ that find themselves in a cash crunch need to look at inventory, including Work In Progress, to be sure that they do not have too much on hand.

All businesses need to pay attention to receivables and payables, which are nothing more than credit that businesses extend to each other. Many a small business has gotten in trouble by purchasing goods and services at Net 60 and selling at Net 90. You must keep payables and receivable in balance in order not to have large amounts of cash tied up in this type of “loan” to your customers.

Now that we have covered the basics of a DuPont Analysis, the next Blog posting will be a practical application of a DuPont Analysis.