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!

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: 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”!

Customer Service Personified

Last Saturday, my wife and I were on Navy Pier waiting for the fireworks when I ran into my good friend Joseph, who I believe to be the personification of Customer Service. The lessons he teaches by his actions are worth reviewing, so here is a repeat of that Blog from last year.

This past week, I took my wife for lunch at the Union League Club in Chicago. While I was there, I saw my good friend Joseph. Actually, he saw me first, as Joseph is a member of the wait staff at the club. By the time I had my soup from the buffet Joseph had placed my favorite soft drink at a table in the corner that he knew I preferred. As I approached, he caught my eye, flashed his signature smile and held out his hand to greet me, saying as he always does, “It’s good to see you!” My wife shares my opinion that Joseph personifies customer service.

Now, the award winning Union League Club in Chicago has many outstanding employees who give great service all the time so that it is easy to say that the club administration is doing all the right things to encourage their employees. Many of their employees have been on staff for years, indicating that they enjoy working at the club, and it shows! All the same, there is something special about Joseph; you can’t just teach somebody to be the way he is, although others could learn from his example. After thinking it over for a while, I concluded that there are four qualities that Joseph personifies: pride of ownership, personal warmth, attention to detail and enthusiasm.

Pride of ownership: It does not matter in which of the clubs restaurants you see Joseph; he always acts as if he owns the place. I mean this in a good sense, that he wants people to enjoy his restaurant and he will do everything possible to see that you do.

Personal Warmth: I believe that there are few people who can go to one of the club’s restaurants more than a couple of times that don’t know Joseph and consider him a friend. He consciously works at getting to know you and what you like. His efforts include more than just food and drink; in his unobtrusive way, Joseph gets to know about you as a person and remembers what he learns.

Attention to Detail: Joseph is always moving, seeing what is going on and who needs something. He is able to anticipate what you need next almost before you know it. As I mentioned above, my favorite soft drink will appear on the table before I get there with my food. Grab a dessert and he will be there with a fork before you sit down.

Enthusiasm: It is obvious that Joseph loves what he does. His underlying enthusiasm for his work shines through as he surveys the room and does whatever needs to be done. At the same time, Joseph has a great sense of timing, knowing how to take care of something without becoming the focus.

Recently, I took my granddaughters to the club for lunch for the first time. They were in Chicago, and I felt were ready for the experience. I was sorry that Joseph was not there that day, as I had prepared them in advance to watch him as an example of how to approach life with a great attitude and the spirit of great customer service that anyone in business should possess.

Worn Down by Your Business? Beat a drum!

I am writing this on Sunday morning of the first vacation I have taken in 2 years. There is so much to do that I don’t know how I can take a vacation right now. I am sure that many if not most entrepreneurs and small business owners often feel this way. Yet, if I allow myself to be completely burned out, my business will suffer. So, here is an idea to help you sustain yourself during busy times. Beat a drum!

Well, maybe not literally, although in my case I do mean so. Several years ago I attended a fund-raiser for a friend’s dance company (Chicago Dance Inc., if you are in or near Chicago, it would be well worth it to catch a performance). I bought tickets for a raffle, and won a free class at the Old Town School of Folk Music. Being of Irish descent, I have long been interested in Irish and in particular the bodhran, a Celtic drum. I enjoyed the class and took another. After the second class, I decided to try my hand drumming at an Irish music session in a pub, where I met my current teacher, John Williams.

I now spend a half an hour practicing every day and 3 hours on Sundays playing the bodhran at a pub. The physical exertion of playing the drum has helped to reduce my stress levels and be more relaxed. The camaraderie of the other members of the music “session” and our common love of Irish music has given me an outlet for conversation that has nothing to do with business, so that I am able to focus on something completely different. As well, playing music in a session is just plain fun! How many of us small business owners and entrepreneurs ever do something just for fun?

Now, I don’t think that every entrepreneur in the world needs to play a drum, but taking up a hobby of some sort, even for a few minutes a day, will help you increase your energy and clear your mind so that when you return to your business you will do so with new enthusiasm. My Irish mother in law used to have a saying, “A change is as good as a break!”, meaning that it can be just as restful to do something different as to do nothing at all. I highly recommend it.

If by chance, you would like to hear some great Irish music, stop by Tommy Nevins Pub in Evanston, Illinois any Sunday between 3:00 and 6:00 PM. You might even spy the Bulldog beating on a drum!

Here is a quick update to my Blog last week “Beat a Drum”, last week I participated in a great bodhran seminar with Mairtin de Cogain at Milwaukee Irish Fest. Mairtin is a well known Irish musician who is currently using Kickstarter to finance a DVD project including video, lyrics and music about the County of Cork, Ireland. Check it out!

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.