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.

Chief Twitter Officer?

The headline to an article published recently in India Real Time (WSJ.com) read, “Can Chief Twit be far behind?” The reference was to the possibility that the Chief Twitter Officer may already be in existence. The article also mentions officers such as Chief Monster at Monster.com, Chief Internet Evangelist at Google and Chief Belief Officer at Future Group. Your humble blogger, who is known as the Chief Bulldog at the The COO’s Bulldog certainly is in good company.

Then there is the Chief Human Capital Officer at the US Department of Energy. I don’t know; I think I would rather be a person than capital, what do you think? Not to be outdone, another government agency has a Chief FOIA Officer. (Would that be pronounced “foya” or “foeea”?) It turns out that the Chief FOIA Officer works for the FCA, or the Farm Credit Agency, processing Freedom of Information Act (FOIA) requests that come to the agency. I wonder if the federal government has a Chief Acronyms Officer to make all of these up.

In an article on Greenbiz.com Ellen Weintraub complained that while she had seen plenty of Vice Presidents of Sustainability and Directors of Sustainability, she had yet to see a Chief Officer of Sustainability. Perhaps there is not enough work to keep that person busy, this making them more of a Chief Unsustainability Officer. When I looked up the definition of sustainable, I came across the words “carry on”. The Chief Carry On Officer would either be in charge of company parties or loading people on airplanes these days!

Then there is the Chief Green Officer; is the word green a noun denoting the person’s responsibilities or an adjective describing their color? Or is the Chief Green Officer simply another name for the CFO? It has gotten so bad that Steve Tobak, in his BNET column, The Corner Office, opines that we should no longer say C-Suite, but should rather use the term C-Tent!

Getting back to the Chief Twit; I worked for him a number of years ago, but fortunately did not stay long at that company!

What is the Role of the COO?

Recently, I came across an article (see the reference below) that supports the idea that in general, the role of the COO is misunderstood. The authors of the article contend that the role of the COO depended largely on the CEO and posited 7 different potential roles for a COO (or any operating executive) depending on the CEO and his skills, abilities and personality.

I found this interesting, as a colleague had posited a different idea, that the Role of the COO was dependent on the nature of the business and in particular, on the ultimate responsibility of the COO for the overall operations of the company. The member pointed out that while the COO often had direct reports that were in charge of different aspects of operations, since the COO was ultimately responsible for those operations, that fact would shape the role of the COO.

The basic theory of the article mentioned above is that there are 7 potential roles for the COO:

1. To implement the CEO’s strategy;
2. To lead a particular initiative, such as a turnaround;
3. To mentor a young, inexperienced CEO;
4. To complement the strengths or make up for the weaknesses of the CEO;
5. To provide a partner to the CEO;
6. To test out a possible successor;
7. To stave off the defection of a highly valuable executive, particularly to a rival.

Since the premise of the article is that the role of the COO depends on the CEO, it should not be surprising that that only role 1 and 2 above seem to relate directly to operating a company. The article itself points out that many of the COOs and other operating executives that they interviewed did not always focus on the day to day operations of the company, but often had other significant tasks to pursue.

On the other hand, as my colleague pointed out, the type of business and the operational realities would also seem to weigh heavily on what the COO must undertake in his or her role. The day to day operations of a manufacturer, distributor or service company differ greatly. The size of a company would have a major impact on what a COO is doing on a daily basis. In a smaller company, the COO is more likely to be a, dare I say “hands on” manager than in a larger.

In either case, Bennett and Miles do point out that in their research, the success of the COO depends to an extraordinary degree on how well the CEO and the COO develop a sense of trust, using the metaphor of “having each others back”. The relationship of mutual trust is often difficult to attain for various reasons both internal to the relationship as well as what the authors refer to as “Those seeking to drive wedges” between the two.

Personally, I believe that both the authors of this article and my colleague have uncovered different aspects of the COO’s role in the modern corporation. On the one hand, the relationship of trust between the CEO and the COO is vital to the COO’s success, but we cannot minimize the how the nature of the responsibilities of the COO will also color the role to a great extent. We will look at both aspects of the COO’s role in future postings.

In the meantime, I would be very interested to hear from the COO’s and other Operating Executives in the audience: what is your experience in your role as Chief Operating Officer?

Second in Command, The Misunderstood Role of the Chief Operating Officer, Nathan Bennett and Stephen A. Miles, Harvard Business Review, May 2006.

Not Another Meeting!

I shudder to think of how many meetings I have attended during the last decade. Late in the afternoon, when I review my schedule for the next day I am tempted to ask the question, “Am I working tomorrow or going to meetings?” Many of the meetings I have attended in recent years included people on multiple continents and varying time zones. I have come to believe that the meeting may very well be the bane of modern business.

On the other hand, I must profess guilt at having been the instigator of many of those meetings. Running a business in a collaborative manner demands meetings. If this is to be so, it is imperative that meetings be well run and productive. Here are 4 tips that will help improve your meetings.

Have an objective: An old saying says it all, “If you don’t know where you are going, that’s likely where you will end up!” In order to avoid meetings that wander all over the place and never really come to a conclusion, have a clear objective for your meeting. Be sure that every person coming to the meeting knows the objective, and is prepared in advance to achieve the objective.

Have an agenda: A meeting without an objective will go nowhere. A meeting without an agenda will meander along the way, whether or not there is an objective. An agenda of precise topics that meeting attendees are prepared to take up will help maintain the group’s focus and promote productive conversations. Meeting attendees should be expected to be well prepared in advance. Nothing kills a meeting quicker than a group that is not prepared.

Have a timetable: The meeting should have a set beginning time and ending time, and these should be adhered to. Start the meeting at the appointed time, no matter how many attendees are missing. End the meeting on time as well. Attendees will lose any enthusiasm they may have for the meeting if they know in advance that the meeting will drag on forever. Attendees should have an idea of how long they may speak to any topic so that a “run-on” participant does not hijack the meeting. In addition, don’t be afraid to end a meeting early if all the work has been accomplished.

Have a moderator: It is often difficult to chair a meeting and be an active participant at the same time. Consider having a neutral moderator whose purpose is to keep to the agenda, direct traffic among participants and generally keep order. In small companies, it may be hard to find the extra person who is not actively involved the subject at hand, but for the more important meetings it can be a great help. For mission critical meetings, you may even want to consider hiring a moderator from outside the company. Of course, it then becomes essential to brief the moderator in advance of the session.

Small Business and the Unemployed

For several years I have been presenting seminars at Career Place in Barrington, Illinois, working with numerous unemployed. Many of these people had developed a one-page handout that contained highlights of their qualifications and experience. Often, a list of targeted companies was also on the one-pager.

The problem is that most of the companies targeted on these handouts were Fortune 500 and other large companies. Unfortunately, many of the large companies have not been doing a lot of hiring lately. I counseled these people to look at small businesses, because when you consider companies with $500 million annually in revenue and less, there are several thousand in the greater Chicagoland area. I am sure that this is true in many other metropolitan areas as well.

For the unemployed there are two questions to ask: why seek out small business and how to do so?

Why the unemployed should seek out small business.

Most entrepreneurs that start businesses have great experience…in something other than business. The entrepreneur focuses on doing whatever is necessary to get the business going. In particular they are focused on their customers, how to find them and how to get the customers to buy.

During startup, entrepreneurs are usually less interested in business practices than in their fundamental expertise. And for them, this is the correct attitude to start with. However, if the entrepreneur’s idea gets traction and the business starts to grow, there are a host of business pitfalls that need to be avoided. In the past, I have written articles on the importance of tracking cash flow, in particular incoming cash as a basic and often ignored process. In other cases, entrepreneurs have never done a “break even” analysis that would show them whether or not they are profitable.

Many unemployed have the skills necessary to help these small businesses grow and thrive. On the other hand, often small business owners don’t even know what they need. There have been times when I was discussing different aspects of business with entrepreneurs only to have them discover that I had information and skills they needed; they just didn’t know that they needed them!

In other cases, small businesses are seeking the proper people to help them, but the positions they are trying to fill don’t show up on Monster or in ads. This brings us to the second question.

How to find and reach out to small businesses.

Since many small businesses do not know what help they actually need, or have limited resources to find people, it is up to the unemployed (or employed looking for a change) to find the small business and reach out to them.

There are many resources on the Internet and in libraries that can aid the research. A good example is the Business Affiliations Database from Lexis Nexis, available in many libraries. You are able to search for companies by many different variables. First, to find the kind of company that you would like to work for determine the SIC or NAIC codes (industry classifications) using an online database, easily found in a search for NAIC or SIC. Once you find the classification of the company’s industry, you can use that as part of you search. In addition, you can search by company revenues and geographic area.
Now you have a list of companies to approach, but what to do next? Corporate Affiliations will list, for most companies, the owners and officers.

My suggestion is to write a letter to a person at the company explaining that you are interested in possibly working in their industry and are conducting research. Who should you choose to write to? That will take a bit of creativity, but here is an example: supposing that you are an experienced marketing person, and you notice that the company does not have a marketing director listed. Your best bet is to contact the person that would most likely have a marketing director reporting to them, perhaps the CEO or COO. Then write your letter.

Several days after your letter has been sent, follow up with a phone call requesting a short meeting (15 to 20 minutes) where you could ask questions and conduct your research. If you find a gate-keeper, try to enlist their help; explain the research that you are doing and ask for their help in setting up an appointment. Be sure never to say you are looking for a job.

Once you have an appointment scheduled, be prepared not only to ask good questions, based on industry research that you will do before the appointment, but also be ready to talk about what you do and how it is applied. Often, you will be surprised at the interest the person you are meeting will have in what you do. Even more so, you will frequently be directed to other people to contact, both within the company as well as at other companies.

Small businesses need a variety of experienced business professionals in order to thrive. Use the information in this article to take the initiative and find a niche for yourself in small business.