The DuPont Method: Profitability Ratios

As I first mentioned in this Blog two weeks ago, a good financial analysis can lead you directly to the source of most problems within your business. Yet, many small business owners and entrepreneurs don’t spend a lot of time on financial analysis, or only do so superficially. The series of Blog posts on the DuPont Method of analyzing financial performance will give the small business owner and entrepreneur an excellent set of tools to begin doing financial analysis on their business. For a diagram of the DuPoint Method, click here.

Net profit is a good thing, although it should never be confused with positive cash flow (see the Blog It’s Cash That Counts).  When your net profit is not where you want it to be, digging deeper into the profitability ratios can help you understand why.  Let’s start with Net Profit Margin which shows the percentage of each dollar of sales remaining after all costs and taxes are paid. The Net Profit Margin formula is pretty straightforward:

Net Profit
Sales

The key to remember here is that the Net Profit Margin is an indicator of how your business is doing, financially, but it does not tell us much about the details. Underneath Net profit Margin are two other ratios that can lead you to understand why you have the net profit that you do. On the one hand, you have direct expenses that your business incurs to create the product or service that you sell, and on the other hand you have operating expenses that your company incurs to support the production of that product or service. If either one is out of line your bottom line will be affected.

Examples of direct expense could be the cost of materials in manufacturing, or the wholesale price of a product that a company distributes. For a service company, the cost of consultants or other employees that create and provide the service is often the largest direct expense. Operating expense might be rent, utilities, and internal company services such as human resources or accounting. Now, there are eternal arguments on what constitutes a direct or operating expense; I am not going to take that up here because it is really the topic for a dozen other Blog postings!

When we decompose Net Profit Margin into its’ constituent parts we are able to see two things clearly, how well the business is operating and how much tax is paid to the government:

Operating Profit Margin X Tax Rate

I will leave it to the lawyers and accountants to take up tax rates, but Operating Profit Margin is the key to understanding how profitable your company is. The constituent parts of this ratio will reveal to you how well your company is doing both with direct expense and operating expense with this formula:

Operating Profit Margin = Gross Profit Margin X Operating Expense Margin

Gross Profit Margin represents the percentage of each dollar amount that remains after paying for the direct expenses. Its formula is:

Gross Profit
Sales

Gross Profit Margin represents the percentage of each dollar of sales that remains after paying  direct costs for providing goods and services. This ratio will tell you how efficiently your company is at creating products and/or services. Knowing the history of this ratio will be helpful, but even more important is the comparison to you industry. If your company cannot provide equivalent products and services at a similar cost, you will have difficulty competing in the marketplace.

Operating Expense Ratio (sometimes called Selling, General and Administrative expenses, or SG&A) represents the percentage of sales that go to the general operations of the company. The Operating Expense Ratio is calculated as follows:

SG&A
Sales

In effect, there are two areas of a company that drive profitability, the cost of the product or service that the company sells and the cost of general operations to run the company. If either one is larger than it should be company profitability will suffer. Some companies have problems with one or the other, and at times some companies have trouble with both.

Next week, we will introduce activity ratios, and the week after, have a complete example of a financial analyisis, including an spreadsheet that you will be able to use as a model for you own company.

DuPont Analysis: Capital, Debt and Equity

Capital equals debt plus equity. We hear this phrase, but do we really understand what it means? The best explanation that I ever head was also the simplest. Capital represents all of the assets of the company. Debt and equity represent who owns those assets.

As an example, if a company has $1,000 in capital assets, and $400 in debt, then equity is equal to $600. The bank, or whoever holds the company’s debt, owns 40% of the capital, and the owner(s) of the company own 60%. The proportion of debt and equity to capital is also known as the company’s capital structure.

We should also note that, although we express these relationships in dollars, we may not be talking about cash in the bank, but about other types of assets that could include buildings or other real estate, equipment, inventory as well as other intangible assets, such as good will (which is another topic completely!).

You will recall from last week that return on equity (ROE) was the ratio at the top of the DuPont pyramid (for an image of the pyramid click here), so let’s start there. ROE represents the earnings that a company makes on each dollar of invested equity. In other words, it is a sign of how each dollar of equity is contributing to the bottom line. The calculation for return on equity is:

Net Income
Equity

So, if a company had net income of $12,000 and equity of $100,000, then ROE would be 12% (ratios are usually expressed as a percentage). In other words, for every dollar of equity, the company returned $.12. One way that the ratio can be useful is to compare it to previous years. For example, if the previous years’ ROE was 8%, you could infer progress.

On the other hand, if the previous year was 16%, you could infer the opposite. Another way to use ROE would be to compare it to your industry’s average. If the industry’s average was 20%, for example, your company could be at a competitive disadvantage.

As we work down the DuPont pyramid, we see that ROE can be broken down into two constituent parts, Return on Capital (ROC) and Leverage. ROC is similar to ROE, in that it expresses the return on each dollar of capital in the company. Its’ formula is:

Net Income
Capital

If the same company as above had $150,000 in capital, then the ROC would be 8% or a return of $.08 on each dollar of capital. As in the previous example, you could compare the ROC to previous years, or to company expectations for this year, or you could compare it to the industry ROC. All would be useful in understanding how your company is performing.

At this point you might exclaim, “Wait a minute, how can ROC be less than ROE!” The answer to the question reveals the power of leverage, as well as the usefulness of the DuPont Analysis. To explain the power of leverage, let’s look at the capital structure of the company, that is, the ratio of Capital, Debt and Equity.

Let’s start out by assuming in a first example, that the company actually had no debt. If that was the case, then there would be no difference between the account of capital (debt + equity) and the amount of equity. Therefore ROE would be $12,000/150,000 = 8% and ROC would also be $12,000/$150,000 = 8%.

In reality, we said that the company had $150,000 of capital. If equity is $100,000 then based on the formula capital equals debt plus equity, then the company has $50,000 in debt. Let’s now look at the formula for Leverage:

Capital
Equity

Based on the formula, our example company has leverage of 150,000/100.000 = 150%., or simply expressed, 1.5 When we apply the principles of the DuPont Analysis, this becomes clear.

Ratios at each level of the DuPont Analysis are equal to the ratio above. So, another formula for ROE is:

ROC x Leverage = ROE

In this case 8% (ROC) x 1.5 (Leverage) = 12%. By using debt to increase the amount of invested equity, the company was able to get a better return. If the company had no debt, they actually would not have had as good a net profit.

We can see then that by deconstructing the top ratio, ROE in to ROC and Leverage, we have a better understanding of the company’s financial structure and why they have made the returns that they have. Next week, we will continue to delve deeper into the DuPont pyramid.

It’s Cash That Counts

Next week I will begin a series about a financial anlysis tool known as the Dupont Analysis. To set the foundation, I am repeating this Blog about cashflow, because it introduces the capital blance sheet, which is integral to a Dupont Analysis.

I was working with an entrepreneur in startup mode, and was once again reminded of the difference between profits and cash. Particularly in startups, but also in more mature companies that achieve a breakthrough of some sort, mistaking profits reported on an income and expense statement with cash in the bank could be a crucial error. How do people make this mistake?

They do so by not taking into account the timing of cash flows. Remember, an income and expense sheet is reporting sales and expenses as they are booked for accounting reasons, but the cash flows that accompany the sales often do not happen at the same time.

For example, unless they are in retail, most companies do work on a credit basis (when retail accepts a credit card payment, they deposit slips like cash, so there is no extended term). You may not think about that way, but terms like Net 30 or Net 60 are nothing more than extending credit to your clients. In other words, your company is financing your customers’ purchases. The longer that it takes to be paid by your customer, the larger the debt that you finance.

Every company has a cash cycle, and depending on the business that you are in, there are more or less components to that cash cycle. Let’s take a company that distributes materials to other businesses. Here is a view of their cash cycle:

1. Purchase materials on credit terms (Net 30, 60, etc.) from suppliers
2. Hold in inventory
3.Repackage and sell to customers on credit terms (Net, 30, 60, etc)
4. Paid by customers
5. Pay suppliers

Now, this is a simplified cash cycle, but you get the idea. Obviously, if your customers are slow to pay you and you must pay your suppliers, you could be in for a shortfall of cash. Actually, one of the greatest risks to a startup or small company that is trying to grow is running out of cash while the business is expanding quickly. We should also note that there are other expenses (salaries, benefits, office space or utilities) that must be paid even if your customers are not quick paying you.

That brings us to the concept of Working Capital. Working Capital is the amount of cash that your company needs to have available in order to keep the cash cycle going or better put, to keep the company going. Working Capital is usually tracked in a type of spreadsheet known as a Capital Balance Sheet (which is a bit different than a Balance Sheet).

In a regular balance sheet, capital is kept above and debt below. In a capital balance sheet, a certain portion of debt is brought above. Here is the outline of a how to calculate Working Capital in a simple capital balance sheet:

Receivables (what your customers owe you)
+ Inventory
+ Current Assets
– Payables (what you owe your suppliers)
= Working Capital

Working capital represents the cash that a company needs to keep on hand to operate with receivables, inventory and payables. Receivables represent the cash that you have invested in materials and financing your clients. Payables are what your suppliers have invested in your company.

If the company sells $10,000 worth of materials in a month, 50% at Net 30 and 50% at Net 60, it means that they will not collect any cash for at least 30 days (if the customer pays on time!), and some of it not for 60. Even so, after expenses they might show a net profit of $1,500. There’s the rub, the net profit is not cash in the bank! If the company has bills to pay this month (or salaries) they must use the cash flow from previous sales to pay.

A startup company, in particular, will have problems if as they grow they do not have adequate cash in the bank to pay for expenses while waiting for cash to flow from sales. Often, a portion of the original investment capital in a new company is put aside for Working Capital; other means of having working capital at the ready could include a line of credit.

This is precisely what is meant by being adequately capitalized. Working with investors, bankers and others, the company’s executives must ensure that they have the cash in the bank to operate or they will literally be “out of business”!

What is a Consulting Executive’s Time Worth?

Quite often, when I am working with an owner or executive of a small consulting company, I find that the person I am working with is hard put to tell me what they are worth. In some cases, the owner or executive is worth everything, as they are doing everything. But even those who are doing everything cannot answer my question because they don’t know.

The fact is, every hour that an owner/executive works is worth something, but the real question is, is the company capturing the value that the owner/executive is creating with every hour of work? Unfortunately, the answer is often no; here is why.

An owner or executive of a consulting company often has 2 roles; the first as a consultant working with clients and secondly as an owner/executive running a company. The consultant is billing hours to the client for work done, but the executive is not, as the client work they are doing is either selling or pre-sales, and the internal company work is simply not billable.

Yet, all of the work that the owner/executive performs creates value for the company. If the owner cannot find a way to monetize that value, the company is losing out on an important revenue stream. The answer on how to capture that value is overhead; bringing us to a discussion on how overhead is handled in many small companies.

When considering the P & L of small consulting company, look at where the cost of providing consulting services is placed; often under General and Administrative Expenses as part of salaries, even if the consultants are contractors paid on an hourly basis. The cost of providing consulting services more properly belongs at the top of the
P & L, under the Cost of Providing Goods and Services, it reflects the direct cost of providing the consulting services.

Any non-billable time then belongs under General and Administrative Services. The key reason for differentiating here is to be able to understand what part of the consultant’s time belongs in overhead. This applies in particular to the non-billable hours of the owner/executive, as including these hours in overhead is the only way to monetize non-billable hours.

Let’s take this one step further. In many small consulting companies, the owner/executive may not even paid a regular salary, simply paying themselves what the company can afford at the end of each month. However, if the owner/executive is truly worth their billing rate, then every hour that they work should be calculated at a cost that is the same as their billable rate. As a result, when the company’s overhead is calculated and added on to the billable rate of each consultant, the true value of the owner/executive will be captured.

As you can see, the value of an owner/executive of a consulting company is worth a lot, but only if that value is properly captured.

It’s Cash That Counts

I was working with an entrepreneur in startup mode recently, and was once again reminded of the difference between profits and cash. Particularly in startups, but also in more mature companies that achieve a breakthrough of some sort, mistaking profits reported on an income and expense statement with cash in the bank could be a crucial error. How do people make this mistake?

They do so by not taking into account the timing of cash flows. Remember, an income and expense sheet is reporting sales and expenses as they are booked for accounting reasons, but the cash flows that accompany the sales often do not happen at the same time.

For example, unless they are in retail, most companies do work on a credit basis (when retail accepts a credit card payment, they deposit slips like cash, so there is no extended term). You may not think about that way, but terms like Net 30 or Net 60 are nothing more than extending credit to your clients. In other words, your company is financing your customers’ purchases. The longer that it takes to be paid by your customer, the larger the debt that you finance.

Every company has a cash cycle, and depending on the business that you are in, there are more or less components to that cash cycle. Let’s take a company that distributes materials to other businesses. Here is a view of their cash cycle:

1. Purchase materials on credit terms (Net 30, 60, etc.) from suppliers
2. Hold in inventory
3.Repackage and sell to customers on credit terms (Net, 30, 60, etc)
4. Paid by customers
5. Pay suppliers

Now, this is a simplified cash cycle, but you get the idea. Obviously, if your customers are slow to pay you and you must pay your suppliers, you could be in for a shortfall of cash. Actually, one of the greatest risks to a startup or small company that is trying to grow is running out of cash while the business is expanding quickly. We should also note that there are other expenses (salaries, benefits, office space or utilities) that must be paid even if your customers are not quick paying you.

That brings us to the concept of Working Capital. Working Capital is the amount of cash that your company needs to have available in order to keep the cash cycle going or better put, to keep the company going. Working Capital is usually tracked in a type of spreadsheet known as a Capital Balance Sheet (which is a bit different than a Balance Sheet).

In a regular balance sheet, capital is kept above and debt below. In a capital balance sheet, a certain portion of debt is brought above. Here is the outline of a how to calculate Working Capital in a simple capital balance sheet:

Receivables (what your customers owe you)
+ Inventory
+ Current Assets
– Payables (what you owe your suppliers)
= Working Capital

Working capital represents the cash that a company needs to keep on hand to operate with receivables, inventory and payables. Receivables represent the cash that you have invested in materials and financing your clients. Payables are what your suppliers have invested in your company.

If the company sells $10,000 worth of materials in a month, 50% at Net 30 and 50% at Net 60, it means that they will not collect any cash for at least 30 days (if the customer pays on time!), and some of it not for 60. Even so, after expenses they might show a net profit of $1,500. There’s the rub, the net profit is not cash in the bank! If the company has bills to pay this month (or salaries) they must use the cash flow from previous sales to pay.

A startup company, in particular, will have problems if as they grow they do not have adequate cash in the bank to pay for expenses while waiting for cash to flow from sales. Often, a portion of the original investment capital in a new company is put aside for Working Capital; other means of having working capital at the ready could include a line of credit.

This is precisely what is meant by being adequately capitalized. Working with investors, bankers and others, the company’s executives must ensure that they have the cash in the bank to operate or they will literally be “out of business”!

Strategy, Finance and Project Management

I have heard it said on many occasions, “But we don’t do any projects!” Of course, the company executive who has said this really means it. And, in a certain sense, he is correct. His company more than likely does no client projects. The reality is that if the company has a strategy, and renews that strategy periodically, then the company has projects. The fundamentally projects are about change, any change. And the reality is that without proper project management that links together strategy and finance, many attempts at renewing strategy are futile.

Proper project initiation and planning asks a series of fundamental questions that set a performance baseline that can be integrated into pro forma financial statements. Once integrated, the pro forma statements enable a company to review a range of possible financial outcomes in order to decide whether or not the project meets the company’s criteria for being undertaken. The baseline also permits the company to make intelligent decisions at markers along the way, called Phase Gates, as to whether or not the project should continue.

Here are questions that will help a company get the project right the first time around:

What is the project; what will it deliver? Fundamental question – often ignored. This is like taking off on a trip without ever determining where you are going. Now, the answer to the question may not be readily apparent when it is first asked. The company may have an idea of the business objective that they want delivered by the project, without understanding exactly how it will be accomplished. A crucial part of planning is determining, in more detail, what the end objective will be?

Who are the stakeholders? As with the first question, this one is frequently unanswered, in particular with strategic projects. As I mentioned in a previous blog posting, A Simple Strategy, identifying each of strategic stakeholder and what their stake is can be the difference between success and failure. Stakeholders can be both internal and external to the company, but most often it is employee stakeholders that are missed.

What is success and how is it defined? You would think that this is a question that would never be missed. Not so! When defining success for a strategy project, each area of the company needs to have their particular element define, and how that element is linked to success measures. The link needs to be concrete and measurable.

What is the work, who will do it and how much is there to do? Defining the actual work to be done to a level of detail that guides competent team members is foundational. This work will lead to the creation of a project schedule, cash flow statement and budget. Of course, the previous questions set the stage for these last three, whose answers become the baseline mentioned above.

Once all of the information about schedule, budget and cash flow are integrated into forward looking pro forma financial statements, the company has information for good decision making.

A Simple Tool to Calculate and Track Cash Flow

Last week, in the posting It’s Cash That Counts, I wrote about the difference between net profit in a Profit and Loss Statement and the reality of cash in the bank. Business owners get into trouble when they really on Net Profit to understand where their cash is. This month, I would like to present you with a simple tool to help you calculate future cash flows as well as to track current cash flows.

To better follow this posting, I have created an Excel spreadsheet, which can be seen in Google Docs by clicking here. (You may want to open the spreadsheet in a separate window or tab. Not only will the spreadsheet help you with this explanation, it can also be extended to a full year to use in your business.

On the left hand side of the spreadsheet, you will see a summary of the January Profit and Loss Statement, indicating a profit before taxes of $750. The business owner may look at this and scratch his head, asking, “My bank account is overdrawn, what gives?” The reality is that due to the timing of cash flows, he will only have incoming cash of $3,000, based on the percentage of cash sales along with collections of his accounts that pay in Net 30, 60, 90 and more.

When the business owner calculates cash flow out, first for Cost of Sales, it turns out to be $6,250 because not only does he pay some of his accounts in cash, but he also has payables of Net, 30, 60, 90 and more. In addition, he has his regular expenses, or overhead, that cost him $3,950 a month.

Therefore, the business owner’s total cash outflow is calculated by adding together Cost of Sales Cash Out and Total Expenses, which equals $10,200. Since his Total Cash in equals only $3,000, the owner has a Net Cash Flow of -$7,200. As you look across the months sales gradually increases to the point where cash flow is no longer negative. However, if the business owner does not have either an equity investment or a loan to cover the shortfall, he may be out of business in 3 months.

Below, you will find detailed instruction on how to gather information to calculate your cash flow. Using this same tool, you can also forecast your cash flow into the future. Forecasting is a useful exercise that will help you understand in advance when you will need the working capital to stay afloat.

Calculate Cash Inflow

The first task is to calculate your actual cash inflow. Follow these steps.

Cash Inflow for the Month
o Using the Income and Expense statement for the current month, and any other available information (invoices or contracts) to calculate cash inflow for the current month
o Using the Income and Expense statement for the previous month, and any other available information to calculate Net 30 cash inflow for the previous month
o Using the Income and Expense statement for the month before last, and any other available information to calculate Net 60 cash inflow for the previous month
o Using the Income and Expense statement for months prior to month before last, and any other available information to calculate Net 90+ cash inflow. All income that is more than Net 60 is usually added together into Net 90.
o Total Cash Inflow = Cash + Net 30 + Net 60 + Net 90

Cash Outflow for Cost of Goods Sold in the Month
o Using the Income and Expense statement for the current month, and any other available information (invoices or contracts) to calculate cash outflow for the current month, calculate Cost of Goods Cash outflow for the month.
o Using the Income and Expense statement for the previous month, and any other available information to calculate Net 30 cash outflow for the previous month.
o Using the Income and Expense statement for the month before last, and any other available information to calculate Net 60 cash outflow for the previous month.
o Using the Income and Expense statement for months prior to month before last, and any other available information to calculate Net 90+ cash outflow. All income that is more than Net 60 is usually added together into Net 90+.
o Cash Outflow for Cost of Goods Sold the month =
Cash + Net 30 + Net 60 + Net 90+

Monthly Expenses
Use the total of monthly expenses from the Income and Expense Statement

Total Cash Outflow:
To calculate the total cash outflow for the month, add cash outflow for cost of goods to monthly expenses.
Total Cash Outflow = Cost of Goods Cash Outflow + Expenses Outflow

Calculate Net Cash Flow:
Subtract cash outflow for the month from cash inflow for the month to calculate Net Cash Flow.
Net Cash Flow = Cash Inflow – Cash Outflow (could be negative number)

• Add the beginning cash balance to the monthly net cash flow to determine current cash.
Current Cash balance = Beginning Cash Balance + Net Cashflow (could be negative number)