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!

Filling the Entrepreneur’s Skill Gap

In a past Blog, I have written about making sure that you surround yourself with a team that covers any areas that are not your strong point. As an entrepreneur, you have many skills and the drive to succeed, but rarely do you have it all. Therefore, is crucial to find people to help you with those areas. Many entrepreneurs find this difficult, for different reasons. One reason that is often cited is lack of funds to hire employees.

The reality is that you do not need full time employees to do everything that has to be done, and hiring contractors for critical elements of your business process can work, and often are less expensive than you might think. While it might be a challenge to come up with funds to pay the contractors, it is well worth the effort when you see the outcome.

For example, I am engaging in a sales campaign for another enterprise in which I am involved. We are doing it the old fashioned way, sending out letters with a real ink signature and following up with a telephone call. I do not engage a full time person to do sales for this particular company, at least not yet. How did I find my sales caller? In this case, I used the site Elance and found a person that had the skills that I needed. I then interviewed her by phone (a great test of someone’s phone skills), and finally had her do a few test calls. Based on the results, she has been making sales calls for 9 months now.

Another example would be using a service to make your work look professional. Last year, I conducted a survey in the same industry as the company mentioned above. The results were significant and very interesting, but the resulting white paper looked kind of blah. I then used a graphic artist who took the content and formatted it with typesetting and graphics that brought immediate attention to crucial information and conclusions of the report. I never could have done that on my own.

The lesson taken is that an entrepreneur/small business owner will never have the skills to do it all, so don’t be afraid to hire a contractor to fill in those skill gaps.

Question: do you have any examples of how you used outside help fill in skill gaps. Also, do you have any suggestions on where to find the help you need?

Be Thankful for What We Have

Several days ago, my wife was sworn in as an U.S. citizen in a ceremony in Chicago. Having dealt with the government bureaucracy throughout, we did not have high hopes for the occasion, but were pleasantly surprised by the ceremony that took place. Along with the 140 other new citizens and several hundred friends and families, we sang the national anthem and recited the pledge of allegiance. We watched a video about immigrants and also a music video with the song, “Proud to be an American”. The new citizens recited the oath to their new country.

For me, the highpoint of the ceremony was when the new citizens came forward to receive their certificate of naturalization. Of course, this is the digital age, so there were several new citizens taking selfie-videos of themselves receiving the certificate.

The person that impressed me the most was a gentleman in his 60’s, who really looked the part of an immigrant; neatly dressed but somewhat grizzled, with the rough hands of one who had done manual labor for many years. When he received his certificate, he held it aloft in both hands as high as he could reach to show it to friends and family across the room, and then began jumping up and down in a dance of sheer joy, a wide smile on his face. This was an important moment in this man’s life!

Of course, bureaucracy was on display that day as well. It took longer to check in the 141 prospective citizens than the actual ceremony. The Bulldog noted several quick changes in process that could have cut the time in less than half, but I kept my peace that day.

Afterwards, my wife told me about a comment that one of the bureaucrats made during the checking in lineup. Seeing the long line waiting to check in, she asked how many were there. When she was told that it was 141, she said, “Wow, why so many? Are they giving something away for free? I want some!” My wife had the right thought, but she did not verbalize at the time. I will now, “Ma’am, you’ve already got it, and you don’t even know!”

What the bureaucrat had was the liberty and blessings of being an American citizen. Unfortunately, at least at that moment, she seemed to have forgotten that fact. Many do, including myself from time to time. The freedom to live as I would like, to be an entrepreneur and build a business that supports my family and my community. The freedom to express myself and my ideas. We often take these things for granted, and often it is immigrants who remind about these freedoms.

To quote Churchill, “”Democracy is the worst form of government, except for all those other forms that have been tried from time to time.” (From a House of Commons speech on Nov. 11, 1947).

 

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.

 

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.

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.