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Research Triangle Business Advisors

June 2013 Newsletter

Looking at your bank account balance is not the best way to measure your company’s financial health. CEOs and business owners often seem like they don’t want to understand or focus on the financials. There’s the “Who wants to explore those complicated financial statements.” Or, the “Isn’t that what I have an accountant for?” Successful, growing businesses use a combination of financial and operational metrics to manage the business. This month, let’s look at what YOU should consider doing to manage your business based on the financials.

Bob De Contreras

919-280-1307

Bob@rt-ba.com

www.rt-ba.com

Managing Your Business Based on the Financials

Yes, you should have a competent CPA to help you organize the financial details of your business. But that doesn't let you off the hook as the CEO or business owner. YOU have the responsibility to make sure your company is headed in the right direction. The good news is that you don't have to fully immerse yourself in those financial statements to set direction and guide your company.

Top business leaders look at a combination of both financial and operational metrics. Then, they use these metrics to benchmark the company's current performance against the competition and their own past results. To get started you should consider the following tips on metrics and how to use them to manage your business.

Continuously Evaluate Your Cash Position

A financially well-run business will have an improving cash position at the end of each and every month. Said another way, a healthy company generates a positive cash flow, meaning the money coming in exceeds the money flowing out. Keeping a running tally of your cash position month-to-month is the best way to see if your business is generating cash over a sustained period of time. It is pretty much impossible to go out of business if you are paying your bills on time and your bank account balance keeps growing each month. Sounds simple … and it is, but many CEOs and business owners don’t think of it that way.

Looking at a minimum three-month trend will help you identify red flags. For example, if sales have increased by 15 percent, but your cash position is declining, there's likely an issue with your accounts receivable. It means that there is a cash flow timing problem on those sales and it's incredibly risky for a business to do that, especially if you don't realize you are doing it. On the other hand, if the cash position is improving but sales are declining, it means the company is making good improvement in internal operations, efficiency, and financial management - but the company may have a serious sales or marketing problem to solve.

Check the Soundness of Your Company

One way to check the vitality of your business is to calculate the following:

Cash in Bank / Monthly Expenses = Number of Months Until Bankruptcy

This ratio shows you how many months your business can survive if sales suddenly stopped and none of your customers paid their bills. It is a ratio developed to get the attention of non-finance oriented entrepreneurs. It’s intended to scare you into paying much more attention to cash management and not just sales.

So, for example, it is possible for a business doing $1 million a year in revenue to double sales and go bankrupt in the process. Whether this happens or not depends on how quickly the cash is collected from customers and deposited in the bank relative to when you have to pay the bills for the increased expenses associated with the new revenue. If the entrepreneur has to increase expenses today, but collects that additional $1 million six months from now, the company can very easily go bankrupt before the money is collected. Company success depends on more than sales, production or resource utilization. Management often does not realize that timing can be the difference between success and failure.

So, another useful metric is to chart your company's accounts receivable and accounts payable aged by month. The accounts receivable numbers reveal the cash coming into the business and highlight any problems with old receivables, meaning money you have had trouble collecting from customers. The accounts payable numbers show the cash commitments of the business over the next thirty days to vendors. Since you're on the hook to pay your bills, any aging trend in the amount of money you're owed could spell trouble. As a top executive, when you see a quarter of accounts receivable over sixty days old, it could be time to panic. Or, you could take action now.

Control Overhead Costs

Most CEOs and business owners focus on growing revenues, but they also need to keep an eye on how much they're spending on overhead (rent, salaries, etc.) to support those revenues. A quick way to do that is to calculate what percentage of revenues is used to pay overhead:

Overhead Expense Percentage (OEP) = Overhead Expenses / Sales

Admittedly, the number by itself is not that useful. What makes it powerful is when you track it over a 12-month timeframe. Any fluctuation can reveal problems. For example, if a company's sales drop 20 percent, but the OEP grows, it means the company's overhead has stayed the same while sales dropped, and the company is taking on significant financial risk if management doesn’t cut overhead to get the OEP back to its historical level. Many small businesses collapsed because their owners failed to cut enough overhead to compensate for a loss in sales.

Look Forward From Your Financial Statements

Checking up on the health of your business requires more than just the numbers in your financial statements. Since financials are generally backward looking, they measure results. To look forward, you need to look at operational metrics.

Top CEOs and business owners track metrics in each area of the business. For example:

Marketing and sales: track the backlog (work already signed but not yet billed/produced) and sales pipeline (prospective work in the sales process). These are important because they give you a forward-looking view of potential revenues.
Production: track utilization, which measures how efficiently the company is using its resources.
Human Resources: By tracking suggestions and complaints (such as notes put in a suggestion/complaint box) you can learn how engaged your employees are. Another suggestion is take a green/yellow/red measure, where people provide the color dot that represents how their day went. When you count up all the dots and track it over time, you can begin to get a sense of your staff’s productivity and morale.
New Business-to-Repeat Business ratio: This ratio tells you the revenue contribution from new clients and the revenue contribution from existing clients. Healthy businesses depend on bringing in new clients as well as generating repeat sales from existing clients. If new client sales are outpacing existing client sales, you may have a customer retention problem. If revenues generated from existing clients are outpacing that from new clients, you may have a marketing and sales problem. The right ratio for your company will depend on what kind of business you're in. Some businesses have a 1:5, where repeat business outpaces new business by a five-to-one ratio. Some companies have the opposite and both may be the right ratio for each company. As with other metrics, measuring and recording this ratio over time will show you what the ratio should be for your company.

You should prioritize what matters most to your business when coming up with other potentially helpful metrics, such as ones built around customer satisfaction and supplier performance.

Focus Strategically

While monitoring a daily dashboard is great for tactical business management, there are also monthly or quarterly metrics that can highlight more strategic changes in your business. Examples of metrics that tell you if you're staying relevant to the market (and which markets are best) include:

Percentage of revenue from new products/services
Revenue mix by product
Revenue mix by customer segment

Again, the best way to keep on top of your company's financial picture – and to ensure that you sound the alarm before big trouble has already arrived - is to use a mix of current and long range metrics taken both from your financials as well as the operational side of your business.

By seeing how individual parts contribute to the whole, you'll be able to best identify where your business may be stumbling. Once you've zeroed in on the trouble spots, you'll have the opportunity to take the necessary steps to fix them. And, that leads to the growth and ongoing success of your business.