Thursday, November 1, 2007

Your Month is not over Until You Have Accurate Financial Statements

Do any of these statements sound familiar:

- "I don't understand why some months I make a 15% net income and other months I lose 7%. I can't trust what my financial statements say."

- "Our profit is low this month because we bought a lot of inventory that we haven't sold yet."

- "Our profit is low because we paid for the next twelve months of insurance this month."

- "Our profit is higher than normal because we invoiced our customers for work we haven't actually done yet."

Owners and managers of small and medium-sized businesses often make these and other similar remarks, implying that the company's financial statements are wrong. The consequences of not having accurate monthly financial statements can be devastating. We have seen situations where millions of dollars, hundreds of jobs, and entire companies were lost because of inaccurate financial statements.

For the purposes of this brief discussion, financial statements refer to the income statement, balance sheet, statement of cash flows, and any other industry-specific report (like a Work-In-Progress report in the construction industry) that helps the company identify its successes and opportunities for improvement. While ensuring these statements are accurate may cost a little more than the company is currently spending on its accounting functions, the cost is usually well worth the expense.

Accounting personnel usually perform non-revenue generating activities, which can cause some business owners heartburn. If their activities are set-up to effectively and efficiently create accurate monthly financial statements on time each month, the accounting staff is truly an invaluable asset to the company. Our experience shows that neglecting this aspect of a business will cost an entrepreneur much more in the long run than the relatively low cost associated with producing accurate internally-prepared financial statements each month. We will discuss one of the causes for and several benefits derived from accurate financial statements.

We are not suggesting you shouldn't watch your bank account. We are, however, suggesting that start-up businesses typically rely on the balance in their bank account as the critical measurement of their performance. As a company grows and becomes more complex, this is a very ineffective way to measure the company's real performance. Yet all too often growing firms struggle to break this habit and the philosophies associated with it.

In over 90% of the businesses with which we have worked, one of the main causes of inaccurate financial statements is the utilization of cash-basis reporting principles. In essence, cash-based accounting puts cash coming into the business and cash going out of the business into the same accounting period, regardless of if they are related to one another. For example, if in the month of December I buy furniture to re-sell but I don't receive any cash from sales of furniture in the same month, then my cash-based financial statements would tell me that I lost a lot of money in December. But did I really? Sure my cash was negatively impacted, but I still have valuable assets that I will likely sell the next month. Cash-basis financial statements do not portray the performance of the firm.

Conversely, accrual-based financials strive to match revenues to related expenses, and vice-versa. This means we shouldn't show the expense of purchasing the furniture for re-sell until the period in which we actually sell it. The results are financial reports that explain exactly how the firm is performing. Interestingly, accrual-based financial statements will solve each one of the statements in the introductory paragraph.

Accurate monthly financial statements create additional benefits. Your internal accuracy will empower your CPA to be more effective in tax return preparation, calculation of penalty-free quarterly estimated tax payments, and other tax-planning activities. You will become one of their favorite clients, and you know how willing you are to go above-and-beyond for your favorite customers. Your credibility as a viable business will skyrocket with bankers, bonding companies, professional licensing boards, and other outside professionals who may be critical to your ongoing success. When the time comes to value your business, accurate financial statements will ensure the valuation is complete. We have seen companies receive valuations far below their actual worth because their financial statements did not show the true picture of their business.

If you get nothing else from this article, please make sure you remember this - if you take care of this part of your business, you will reap short and long-term rewards. You will have better information from which to base your leadership and strategy. You will satisfy outside professionals that you manage all aspects of your business. We have found that organizations that do not have accurate financial information can quickly lose their competitive advantage. If you refuse to allow your month to end until you have accurate financial statements, you will empower your firm to maximize profitability, cash flow, and value as well as capitalize on future business opportunities.

Saturday, September 1, 2007

How to Leverage Your Business without Debt

Should we buy or rent the piece of equipment we need?  Should we hire a full-time salaried employee or should we subcontract the work to an independent contractor?  Business owners and managers often only answer these and other similar questions with the firm's financial leverage, meaning its use of debt and equity, in mind.  Businesses should also consider another form of leverage which exists in every company - operating leverage.  This leverage measures the firm's fixed versus variable expenses.

How is Operating Leverage Measured
If a company has high fixed costs and low variable costs, then it has a high degree of operating leverage (DOL).  An example would be a law firm, because its main expenses (salaries, rent, and insurance) are fixed regardless of the sales volume it produces.  A company with low fixed costs and high variable costs has a low DOL.  An example would be a construction company in which most of its costs vary based entirely on sales volume (materials, subcontractors, and job-related labor).  The companies in the example below have the same net income, but very different operating leverage:

Law Firm (High DOL) with sales of $1,000,000. Variable costs of $350,000, or 35%. Gross profit or contribution margin of $650,000, or 65%. Fixed costs of $450,000, or 45% of sales. Net income $200,000, or 20% of sales.

Construction Co.(Low DOL) with sales of $1,000,000. Variable costs of $700,000, or 70%. Gross profit or contribution margin of $300,000, or 30%. Fixed costs of $100,000, or 10% of sales. Net income of $200,000, or 20% of sales.

What Benefits and Risks are Associated with Operating Leverage?
Assuming sales increase 25% in both companies, let's see how the results compare:

Law Firm (High DOL) with sales that grow to $1,250,000. Variable costs of $437,500, or 35%. Gross profit or contribution margin of $812,500, or 65%. Fixed costs of $450,000, or 36% of sales. Net income $362,500, or 29% of sales. Profit growth of 81.3%.

Construction Co.(Low DOL) with sales that grow to $1,250,000. Variable costs of $875,000, or 70%. Gross profit or contribution margin of $375,000, or 30%. Fixed costs of $100,000, or 8% of sales. Net income of $275,000, or 22% of sales. Profit Growth of 37.5%

Clearly, the law firm experienced more profit growth than the construction company, even though their revenue growth was identical.  This is the magnification effect that comes from operating leverage.  Conversely, if the firm's revenues decreased, the law firm would experience a magnification of its negative profit growth, creating less net income than the construction company.  Greater risk exists in firms with higher operating leverage, yet the potential for better returns could make that risk attractive.

How Does Operating Leverage Impact Your Business Decisions?
In order to assess the risk versus return scenario of your operating leverage in your business decisions, you need to ask yourself two questions: (1) Are you going to grow or shrink in the short and long-term?  (2) What is your firm's tolerance for risk?  All things being equal, a business that is going to grow would wisely invest into fixed costs instead of variable costs in order to magnify its profit during that growth.  Conversely, a shrinking firm should look to minimize its fixed costs.  It is no surprise that buying instead of renting equipment and hiring full-time labor instead of subcontracting work are more risky than the alternatives.  Perhaps the most enlightening point is that with a little planning and foresight, the decision made could significantly help or protect the bottom-line.

Consider the following questions as you determine your firm's operating leverage strategy: How does your degree of operating leverage compare to your competitors'?  What competitive advantages may or may not exist in your industry for the company with the highest degree of operating leverage?  The strength and future success of your business model probably depends, in part, on how you utilize operating leverage.  When correctly applied, the principles of operating leverage will allow you to maximally leverage your business without incurring additional debt.

Sunday, July 1, 2007

Do Unto Your Vendors as You Would Have Your Customers Do Unto You

In the short and long-term, your business will benefit greatly by paying your vendors the way you want to be paid by your customers.

Customers who pay early will, over time, receive the highest quality and best service and price offered by their vendors. Do you respond more quickly and intently when your quickest paying customer presents problems with your product or service? Are you more willing to think outside of your normal operating procedures to help solve that customer's problems? If you have any responsibility for the cash flow of your business, then your answer would probably be YES!

Anecdotal and empirical research suggests the same conclusion - you will receive additional benefits in the long run from your vendors if you pay them quickly. How would your vendors classify your payment timeline? Are your payment policies getting your business more or less from your vendors? Regardless of your answers, consider the potential short-term impact of an early payment policy.

If you currently spend $100,000/month with a vendor, and you typically pay them in 40-days, it may be worth a lot to that vendor if you accelerate your payment cycle to just 10-days. In fact, for this example, let's assume your vendor offers a 2% discount for doing so. Would the 2% discount be worth tying up your cash by paying down your accounts payable by $100,000 to get your company in-line to pay for all of your purchases with that vendor within 10 days?

Assuming your cash flow from operations can keep you at or below 10 days with this vendor for the next 12 months, and assuming that you borrow from your line-of-credit (12% interest per year) to make the one-time catch-up payment of $100,000, let's see if your business will receive any economic benefit. You will receive a total discount on your purchases with the vendor of $24,000 ($1.2 million in annual purchases times 2%) and you will pay $12,000 ($100,000 at 12% per annum) in interest to cover the one-time payment. All other things being equal, this means you will actually net a $12,000 gain by accepting their offer of a payment discount. You don't have to hire a CFO figure out the advantages of this scenario.

Whether or not you have the option to use advantageous early-pay discount terms with your vendors and suppliers, your business will still benefit in the short and long-term from a strategy to be one of their best paying customers.

With a weekly cash flow report produced by your internal bookkeeper, accountant, or controller, you should be able to determine how and when to speed-up your payments to your vendors. This will inevitably improve your business relationship with your vendors. Without a weekly cash flow report, it may be very difficult for you to have any type of strategy to receive the highest quality and the best service and prices from your vendors. A well-planned and executed cash management and finance strategy will allow you to truly partner with your vendors to gain a significant and sustainable competitive advantage. If you do unto your vendors as you would have your customers do unto you, you will receive short-term benefits and long-term rewards!

Tuesday, May 1, 2007

Be the High Price Leader

"Business is a game of margins, not volume" (How to Sell at Margins Higher Than Your Competitors," Steinmetz and Brooks).

If you are tempted to cut your prices by just 10%, you might think that you can make up for it by increasing your sales volume by 10%. This is NOT true! Assuming you earn a gross margin of 30% (after all directly related costs are considered), you would have to increase your sales volume by 50% just to return to your previous gross margin. In other words, a 10% price reduction means you have to do 50% more work just to recover from the price reduction.

In down markets, your competitors will often drop their prices to try and gain a competitive advantage. You will be tempted to follow suit if your business has slowed and you are worried about covering your overhead and other fixed costs. You should deal with a slowdown in business by reducing your overhead and fixed costs, not by cutting prices.

According to a recent survey, only 13% of consumers feel price is the biggest influence on their loyalty to a company's product or service. 85% derive their loyalty from service and quality (Survey conducted by Genesys Telecommunications Labs - Printed in USA TODAY, May 2007).

Improvements in your customer service and quality will typically pay dividends for years to come, mainly because you can keep your prices higher than most, if not all, of your competitors. If you can successfully be the high-price leader, your bottom-line will be your reward.

Thursday, March 1, 2007

The Best Way to Grow

Although every business wants to grow, some types of growth are certainly better than others. Consider the Following 2 options:

OPTION 1: Grow Sales by 20%, and net income increases 50%.

OPTION 2: Grow Sales by 50% (a lot more work and risk than Option 1), and net income only increases 20%.

The best way to grow is when net income growth out-paces sales revenue growth. For every additional unit of sales, we want to generate more profit, not less. How can we accomplish this?

Jim Collins, the author of Good to Great, found that the more an organization sticks to its core competency, the more opportunities the company would have for the best kind of growth - the growth where net income increases faster than sales!

What is your core competency? It's what you do well and, when you do it, you've proven that it can make money. If you are a trade contractor, then it is your trade. If you are an attorney, then it is the law. If you are a widget manufacturer, then - I think you get the point.

I have experienced many occasions when, in its desire to grow, a company strays from its core competency and involves itself in a business and industry it doesn't know very well. Sadly, these new ventures begin to drain time and resources (most importantly, CASH!) from the main business. In essence, the core competency of the firm subsidizes the less successful venture.

Sticking to your competency requires a great deal of discipline, but it is the best way to grow your company. By sticking to your core, you will find the most profitability and enduring growth opportunities!