Unintended Consequences

Business agility demands that a business be ready to react quickly to their environment in order to take advantage of change. However, there are times when a fast change results in unintended consequences. Many are the stories of plans gone awry, even when well researched and grounded in fact. All the more reason not to make snap decisions that can take your business in the wrong direction. Here are some questions that can help you discern the difference.

Are we equipped to handle the change? There are many companies that are the victim of their own success. Something that seems like a good idea turns out to be a great idea, to the point that the company is unable to keep up with demand. Before making a change or introducing a new product or service you need to ask several questions. The first is about volume, do you have the infrastructure to keep up demand? The second is about resources, do you have the people to keep up with the demand.

What would we do if demand was 2 times what you predict? 10 times? 100 times? Using hypothetical numbers allows you to analyze what effect different scenarios might have on your business. You may discover that up to a certain point, you can handle the new business or increased volume that a change may foster, but nothing beyond that point. If that is the case, you may want to introduce the change or new product to a smaller segment of your clients or the market.

Is the change based on fact or a hunch? It is true that there are those that can study a market and get a “gut-level” sense of what is going on. Generally speaking, I would not believe that of myself, and you should be skeptical as well. Is your hunch based on research and data, or is it based on anecdotal evidence but not supported by more extensive research? Getting to market with a new product or service includes doing a certain amount of research to back up the hunch.

Do you have a Plan B? If the new product or service does become successful beyond what you can handle, do you have a Plan B in place? Plan B can include outsourcing on a temporary basis, or using temporary staff to fill in. Be ready for success beyond what you predict.

These simple questions can help your business avoid unintended consequences on the road to success.

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!

Great Customer Service is No Accident

Nothing brings out the bulldog in me more quickly than poor customer service. Recently, the bulldog has had too many occasions to come out! In one case, a company website where I was trying to pay a bill was not working. The site was quite rudimentary for a $6 billion dollar company, with no help function at all. When I called the only number listed on the site, I went through the “pass you on” routine, with lots of hold time during which I was told how important I was to their company.  Finally, I reached the office of the right person to talk to, but she was on vacation. I sincerely hoped that she would make it back from vacation else I might never be able to pay my bill online (or anyone else, for that matter).

In another instance, a well-known delivery company left me a form to sign to have a package delivered on the second attempt. I even called the company to let them know that they could leave the package in the foyer and that I would sign the form. The next day, I found a second form next to the first. When I called this time, the customer service person could not tell me what happened and passed me on to the local terminal.

After a couple of tries, and more messages about how important I was, I reached the terminal manager. The manager explained to me that company regulations did not allow them to leave the package in the foyer of my condo. To put a quick end to the story, about fifteen minutes later when I removed my teeth from his leg (figuratively, of course), he agreed to have the package left as I had requested.

Customer service should be in the DNA of every company, and it does not happen by accident. Based on my experience, both as a customer and as a service provider, here are some guidelines to great customer service:

  1. Every employee of a company is potentially a customer service agent. Even amid the myriad choices in a company’s voice response system many people get through to one employee or another. Therefore, all employees must be trained and ready to handle customer service at a triage level, that is, be able to understand the problem and get the customer to the right place the first time.
  2. There should never be a circumstance where the only person who can solve the problem is not there. When there is a technical problem, multiple experts must be on hand. For a small company, this may mean having experts on call. With today’s technology, reaching a person who can solve a problem should not be a problem.
  3. Customer service representatives must be given reasonable authority to solve a problem. Repeating company policy is not a solution. Nor is saying, “My supervisor is not here right now, he will call you back.”
  4. At the very least, customer service representatives, supervisors and managers must learn how to ask questions and listen, not only to understand the problem, but ascertain what the solution is that the customer wants.

Finally, a suggestion to all companies: please stop using the “your call is important to us” routine!

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”!

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.

DuPont Analysis: The Numbers Don’t Lie

Over the years that I have been working with small businesses and entrepreneurs, I have discovered that there is no better way to judge the health of your company than through financial analysis. As the title of this blog states, the numbers don’t lie. A good financial analysis can lead you directly to the source of any 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.

In my experience, one of the best ways to analyze you business’ financials is based on a method developed early in the 20th century, the DuPont Method of ratio analysis. The method was created by F Donaldson Brown, an employee of the DuPont Company, as a way to manage General Motors . The DuPont Method was considered the standard until the 70’s, although I still find it a very useful tool.

The DuPont Method introduces a pyramid of ratios with Return on Equity at the apex (click here to download a file). At each level of the pyramid, the method deconstructs ratios into their constituent parts. For example, Return on Equity is composed of Return on Capital multiplied by Leverage. Return on Capital and Leverage are then decomposed into their constituent parts and so on.

The key highlight on financial ratio analysis is to see how financial operations drive value. Some finance people refer to this model as the value drivers model; others, as the financial levers model. The former see value drivers as the explanation of how an entity makes money and increases its value, hence the term “value driver.” The latter view financial ratio analysis as the method for identifying the triggers of financial results, hence the term “financial levers.”

There are three different types of ratios within a DuPont analysis: profitability ratios, activity ratios and solvency ratios. Profitability ratios analyze whether or not you are making money, and why. The question why is the most important part of that inquiry. Many are the occasions when an entrepreneur or small business owner will say to me, “According to my Profit and Loss statement, I am making money. Why is my bank account empty?” Profitability ratios will help to answer that question.

Activity ratios will help you understand how efficiently your business is operating. For example, if your business turns over its capital 3 times a year, but your competition does so 5 times a year, you could be at a competitive disadvantage. In other words you will find it harder to compete because the competition used its capital more efficiently.

Finally, solvency ratios will tell you whether or not you have the financial wherewithal to stay in business. There are many businesses that are the victim of their own success. A business that has a great product or service that others want to buy may expand so rapidly that they don’t have the capital resources (money) to keep up with the expansion. Solvency ratios will help you understand where you are in terms of capital resources and how fast you can grow.

So, tune in for the next three weeks as we take on the DuPont Method.

i Project Management Accounting, Callahan, Stetz & Brooks, John Wiley and Sons, Hoboken New Jersey, 2007
ii Ibid.

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”!