Early Indicators Of Poor Fiscal Fitness

On your initial visit to a doctor’s office you will customarily be asked to complete a questionnaire concerning your personal and family medical history. Have you ever had these habits or symptoms? Has anyone in your family ever had these diseases?

Why the negative questions? They are helpful diagnostic tools for determining conditions, tendencies or habits that may be an indicator of an increased probability of certain difficulties. It helps the physician spot a condition that, if recognized early enough, may be successfully treated to avoid further problems.

A recent study identified ten management conditions that were commonly related to business failures. While a medical history questionnaire is for early diagnosis of potential physical problems, these ten conditions can form the basis for a management questionnaire to insure your fiscal health.

1. Inadequate Record Keeping. Even the sharpest of minds in the smallest of businesses need adequate information to make profitable decisions. Companies that end up in bankruptcy proceedings invariably have poor record keeping systems.

Profitable sales are a hit and miss operation without adequate cost information. Your ability to control operating costs on a timely basis is dependent on knowing those costs on a timely basis. Inadequate management information can be evidenced by not enough of the right information or too much of the wrong information.

2. Cumulative Losses. Damaging business losses occur from the cumulative effect of little leaks in profitability. Without the cumulative drain of the little leaks, your business will be healthier in good times and be able to withstand the shocks in bad times. While traumatic events appear to trigger business failure, it is a traumatic event impacting a weakened structure that results in most failures.

3. Growth. While growth is an objective of most all businesses, a period of rapid growth often is a predecessor to financial difficulties. Rapid growth will place a strain on a company’s internal resources and systems. It is accompanied by increased expectations from its customers and the possibility of new competition if those expectations aren’t met.

4. Product Development. Retaining and even investing in obsolete product lines is a tendency shared by troubled companies. It’s difficult to determine when a “bread and butter” product line is past its prime, but it’s a decision that must eventually be made. If all successful products have a finite life, a company must be able to develop new products to stay in business.

5. Customer Information. A set of customer needs defines a business purpose. A business that doesn’t know its customers will never reach its potential. Companies with a small customer base are especially vulnerable. How broad is your customer base and how intimate are you with the current needs and future directions of those customers?

6 Family Business. The transition from one generation to the next is a particularly vulnerable time for a successful family business. Adequate preparation of management successors is a difficult and sensitive task. A business that serves its customers first, will serve its family best.

7. Management. The development of managerial skills generally lags behind other areas resulting in a dangerous lack of coordination and confusion in a growing business until such time as appropriate management and administrative systems are in place.

One person management, the most common and effective system for getting as business started, eventually becomes a limiting factor. An inadequate understanding of the impact of one person management is a common factor is the disappointing results from investor buyouts of entrepreneurial companies.

8. Internal Conflict. The internal conflict that develops as the objectives of partners grow apart are an unfortunate cause of business disruptions. Partnerships should have written agreements that contemplate the potential dissolution of the partnership.

9. Technical Competence. Entrepreneurs starting something new and investors that are anxious to diversify are often accidents waiting to happen. Many business problems can be quickly traced to a lack of technical, marketing, or managerial competence in a new industry. That doesn’t preclude one from being successful in a new area, but it does argue for gaining experience and seeking advise prior to starting.

10. Neglect. Unpleasant surprises spring from the sea of neglect. Absentee management is common warning sign of a potentially unhealthy situation. With competent management and good communication, absentee ownership can be successful. Absentee owners who retain significant managerial power will have problems.

Because its your business, check your level of fiscal fitness for the early warning signs of poor health.

Return On Investment

Fundamentally all management decisions boil down to return on investment decisions. What’s the cost of this program and what’s the expected benefit? What’s the monetary payback of this decision in relationship to the resources invested? How much time will I have to spend on this project and are the anticipated results worth the effort?

Return on investment (ROI) analysis is often thought to be a formal decision making tool for the larger company and the financial analyst. In actuality, ROI analysis should be a central part of every manager’s decision making process.

A typical ROI is computed by dividing a return, such as net income, by an input, such as total assets. Similar analysis can be done with most all resources and results.

Return on investment is an indicator of the productivity of your investment decision. Manager’s investments are not strictly financial. Time and other resources are equally important. An ROI is a measure of output for a given level of input.

You may not be able to compute an ROI as accurately for some management decisions as for some financial decisions. However, if the process forces you to focus on the relationship between the inputs and the outputs for each decision, you will make better decisions.

When you look at the ROI of any enterprise, there are two obvious ways to improve the equation. You can increase the numerator (output) or you can decrease the denominator (input). A third and less obvious way is to increase the denominator (input), in such a manner that it effects a proportionally greater increase in the numerator (output).

Simply because a return on investment analysis yields a quantified answer, does not mean that you have to make your decisions solely on the numbers. There is still room, and in fact need for, qualitative inputs in the decision making process.

Experienced decision makers are always searching for numbers that can measure their performance. Good decision making, however, doesn’t rely exclusively on numbers. As a manager you have a responsibility to recognize when the numbers don’t make sense or when the direction that the numbers indicate is incompatible with the character and philosophy of your organization.

Complacency is not an uncommon characteristic for the management of successful private business. Owners of small businesses can become complacent because they have achieved an adequate personal income, they have reasonable security, and they are relaxant to examine the alternatives to a formula that is already working well.

Because of this natural bias towards complacency for the owners of successful enterprises, they should more closely scrutinize each of their decisions for its ROI. The owners of a well established firm owned valuable property that had a low depreciated cost basis. Because the owners drew a reasonable salary and the business had been profitable, they had not examined the potential return from selling the property and investing the proceeds elsewhere. A return on investment analysis indicated that the sale and reinvestment of proceeds would nearly double their total return.

Managers make decisions to invest in people. They recruit, select, train, and work with their employees. If your output, or the return that you are getting from your people, is insufficient, perhaps you need to invest more to get a better result.

For example, suppose that one of your operations commands an inordinate amount of your time because one of your managers is weak. Despite the drain on your time, the results of that operation are still below average. It’s time to look at your ROI for this manager and determine if a higher level of investment on the front end would yield a higher return on the output end.

The extra time and money that you may spend on recruiting and selecting a truly qualified person to manage your operation, would be a bargain when compared to the current drain on your time. Time and effort spent training your manager would have avoided many costly problems. The cost of retaining a really good manager would be small when compared to the opportunities that may have been lost

Experienced managers have a certain “business sense” that enables them to make good decisions. They also have a tendency to become complacent in a smooth running operation. Opportunities can be lost. Because it’s your business, develop the discipline to subject major decisions to a return on investment analysis.

Accounting For Management

“Decision making” is the work of the manager. “Bean counting” is thought to be the work of the accountant. To many non-financial managers accounting remains an unsolved mystery,a burdensome boring necessity of business.

Accounting, however, has a second dimension in addition. Managerial accounting is as indispensable to the “decision maker”. as financial accounting is to the “bean counter”.

Financial accounting and managerial accounting are different. While they share many of the same concepts and follow similar procedures, they provide different information for different purposes. Financial accounting is primarily concerned with providing consistent data to those outside of business. Managerial accounting is concerned with presenting information for decision making to those inside the organization.

The time focus of financial and managerial accounting is different. Financial accounting looks backwards and reports past performance. While managers should be concerned with historical performance, they are more concerned with the future impact of today’s decisions. Managerial accounting has a forward orientation and provides pro forma financial reports that project the impact of current decisions.

Financial accounting is concerned with fairly reporting the results of the business in its entirety. Management is also obviously concerned with the overall results, but the everyday decisions that management makes usually deal with individual activities within the business. If overall performance is less than desired, management must isolate on those activities within the business that can be improved. It is managerial accounting rather than financial accounting that provides the tools for this analysis.

Financial accounting statements are prepared on a routine calendar schedule. Managerial accounting reports are prepared whenever needed. Effective use of managerial accounting requires that a determination be made how frequently and how closely a particular business activity needs to be reported.

Because financial accounting reports historical results, there are exact numbers available and estimates are infrequent. Managerial accounting, however, is often concerned with events that have yet to happen. The focus on the future requires that estimates be used. Because they provide insights into future activity, estimated numbers are not necessarily less useful than the actual numbers.

Financial accounting is performed according to a set of covenants called Generally Accepted Accounting Principles (GAAP). This standardization is necessary so that the performance of different businesses can be compared by outsiders. Since managerial accounting produces information for use by people within the organization, it is acceptable to use whatever concepts that the particular business finds useful. While internal reporting will often closely follow GAAP procedures, it can be tailored to fit specific needs.

Decision making is the work of the manager. The decision making process has four basic steps. It begins with the defining of a problem, includes identifying and evaluating alternatives, and concludes when a decision has been made to choose and implement one of the alternatives. The use of management accounting is indispensable at each step in the process.

Operating budgets are a basic managerial accounting tool. Budgets begin with a set of assumptions upon which certain projections are made. Deviations from budget provide managers with an opportunity to initiate changes to enhance future performance.

The development of a Key Area Results System (KARS) is an effective use of managerial accounting. The problem with typical financial accounting reports is that they say too much, too late. During the second week in December, you find out volumes about what happened in November. The problem is that November’s history and it’s December that now occupies your attention.

A KARS program is designed to give you approximate, but timely information about current activity. In a KARS program you identify those key operating results that largely determine the financial performance of your business and then find ways to gather information that will give an immediate indication of their direction.

Direction is the key word. You don’t need precise results, your financial statements will provide that after the month is over. What you do need is a timely sense of direction so that you have the opportunity to effect the results. Knowing in December what decisions you should have made in November is a small consolation.

Because it’s your business, you will be judged by the historical performance as presented by financial accounting. However, it is the information provided by managerial accounting programs that will enable you to make the timely decisions that can positively impact those results.

Excess Compensation

How much is too much? How much is enough? What’s fair and who decides? Only the marketplace knows.

Compensation decisions are some of the most important and difficult decisions that business owners have to make. Ultimately, the amount of money available for compensation is determined by the value the market place is prepared to pay for a company’s products and services.

A private business has finite resources which must be carefully allocated to a number of activities. You can’t pay what you don’t have. If you do, you won’t stay in business too long.

The marketplace is the mechanism that provides efficient answers to most compensation questions. Not always the answers we’d like to hear, but answers nonetheless. When the market’s guidance is not followed in the short run, it will certainly impose harsher solutions in the long run.

Even in the best of companies, there are inequities in compensation programs. To remedy all of the inequities at once would prove too costly. Management must make the best of a rapidly changing, imperfect world in order to stay competitive and solvent.

In our economy, employment can be found in either the public sector or the private sector. Within the private sector, employment opportunities can be further divided into two groups, large public corporations and smaller private businesses. While the small privately owned business must adhere to the dictates of the market place, that’s not always the case in other areas.

The laws of supply and demand are the principle forces for maintaining a balanced wage structure in the economy. If the supply exceeds the demand, prices don’t go up.

Could you imagine a business, deeply in debt, with ten applicants for every position available, proposing to increase compensation by 50%? That’s what the recently defeated Congressional pay raise proposal would have accomplished.

Although the issue of a Congressional pay raise was defeated, you can be certain it will raise its ugly head again in the not too distant future. There are a number of persuasive arguments that can be put forth to support higher governmental salaries, but, the fact remains that the jobs are in high demand at the current pay rates.

How many businesses are going to be able to provide a 3.6% cost of living raise to its employees plus a minimum 8% raise in the coming year? That’s what is being proposed for top federal officials.

Contrary to many published reports, top public sector compensation is comparable to compensation in smaller private businesses. And while the pay is at least comparable, the fringe benefits and job security are superior.

It is the smaller private businesses that have proved to be the most competitive sector of our economy. I know a number of privately owned businesses that would like to do more for their employees, but their financial structures just couldn’t absorb the costs.

It’s quite probable that many of the better public sector employees are underpaid. But that’s also true in many businesses. It’s particularly true in organizations, public or private, where job security is high.

But why should a debt ridden bureaucracy increase wages with an abundant supply of qualified applicants available? It’s interesting to note that more and more socialist economies around the world are looking to free market solutions to alleviate their economic woes while certain segments of our economy ignore market logic in favor of the special interests of entrenched minorities.

The multimillion dollar executive salaries for the top officers of large publicly owned corporations are equally disturbing. Those salaries are set by Boards of Directors that are supposed to represent shareholder interests but, in actuality, are more beholding to the managers they are supposed to be supervising.

If there is an abundant supply of qualified Congressional candidates at $80,000 and federal administrators at $45,000, there is a tremendous supply of business executives available well below the one million dollar level.

What’s the damage? It distorts the system. The eventual result will be economic inefficiencies, higher inflation, increased taxes, or a combination of the three. All burdens that the efficient small privately owned business will eventually be called upon to bear.

It’s ironic that the only I.R.S. regulations that deal with excess compensation pertain to the owner/managers of privately owned businesses. If any business organization should be allowed to pay its executives what they want, it should be private corporations.

Because the market’s remedy for these excesses will be inflicted upon us all, it’s your business to know what’s going on.

Two Handed Economists Forecasts Prudent Management

Despite the continuation of moderately positive economic indicators, questions about an economic slowdown and possible recession are frequent topics of conversation.

Why the concern? Well, perhaps it’s because nothing lasts forever and we all realize that the current period of economic growth has been one of longest. Every winning streak eventually comes to an end.

Forecasting the economy is risky business. Even the most successful economists have a tendency to be ambidextrous. You know, “on one hand the economy may improve, but on the other hand it might not.”

Not being ambidextrous, I’m reluctant to make economic forecasts. However, there are some observations that can be more useful than crystal ball gazing. Whatever the future economic environment, your business must be prepared to successfully operate in it.

While the economy as a whole has been enjoying a long period of prosperity, certain sectors of the economy have had problems. During the early days of the expansion, the manufacturing sector of the economy was in the doldrums. It wasn’t too many years ago that economists were talking about a service based economy and the permanent decline of the basic industries. As things have turned out, it has been the manufacturing sector that has showed exceptional strength and prolonged the expansion.

What about those service industries? The financial services industry has had a difficult time these last few years. Don’t try to tell the many unemployed Wall Streeters that everything been robust during the last two years.

The point is that although the economy as a whole has continued to prosper, certain sectors of the economy have had their own “industry mini recessions”. These “mini recessions” that have hit the manufacturing, financial, farm, and other industries at different times may be one of the reasons that the overall expansion has lasted so long.

With the exception of economic disruptions brought about by government policy, a recession is the normal self correcting mechanism to the excesses that are created during a period of growth. The inefficiencies that develop during a period of expansion are brought back into balance during a period of recession.

The same factors that cause the whole economy or a sector of it to enter a recession will cause your business to have problems. Don’t wait for a recession to trim the fat in your budget. The responsible fiscal measures that are taken at the beginning of a slow down often could have been taken earlier.

Companies don’t get into trouble during times of recession, they get into trouble during times of prosperity. If excesses and inefficiencies have accumulated in your business during this period of sustained prosperity, start eliminating them before a recession does it for you.

Most of the specific actions that you would take to weather a recession are prudent management action at any time. Effective cost controls, improved productivity, lowering overhead, debt reduction, and good inventory management are good practices for all seasons.

Too often the cuts that are necessitated by a slow down in business are the ones that “I should have made a long time ago.” When a number of companies in one sector of the economy haven’t made those decisions “a long time ago”, a recession occurs. After they do make them, the seeds of a recovery are planted.

Why wait? Good companies prosper in good times and bad. Be vigilant to eliminating the excess and inefficiencies in your business and you will be prepared for the future, whatever that may be.

If a broad based economic recession were to occur it most likely would be induced by government monetary policy. The very painful back to back recessions that occurred in 1980 and 1981-2 have been largely attributed to the policies of then Federal Reserve Chairman Paul Volcker. In an effort to collar inflation, the Fed shrank the growth of the money supply and drove up interests rates.

The monetary policy of the Federal Reserve Bank is again being closely watched as it continues to balance on the high wire of economic growth between that bridges the gaps of inflation and recession. The Fed policy making committee pushed rates upwards during much of the last year but has let interest rates drop slightly during the summer months.

Read all the economic forecasts and prognostication for insights, information, and entertainment. Because its your business, you best preparation for the future is to run a tight ship. Eliminate the excesses and inefficiencies that exist in your business. You’ll prosper in good times and bad.

My view of the future is positive. But on the other hand, I’m always an advocate of prudent management.

Demand

The total revenue of any product or service is a function of the price and the quantity sold. The “law of demand” states that there exists a negative relationship between price and quantity demanded. That means, if the price goes up, less will be demanded, as the price goes down, more will be demanded.

When shown on a graph for a range of prices, total revenue appears as a parabola or an inverted letter U. At one extreme where the price is very high, there will be no sales and thus no revenue. At the other extreme where the price is 0, there will also be no revenue. The maximum total revenue is achieved at some point in between.

Determining demand at different pricing levels, the “demand curve”, will enable a business to price their products to achieve maximum revenue. Economists have chosen to gage this relationship between price and quantity with a measurement called “elasticity”.

Price elasticity of demand can be defined as the ratio of the percentage change in quantity demanded to the corresponding percentage change in price. Examine, for example, the percentage change in quantity demanded when there is a price change of one percent. If the quantity demanded changes by the same one percent, the elasticity is said to be “unitary”. If the quantity demanded changes by more than one percent, up or down, the demand is considered “elastic”. If the percent change is less than one percent, the demand is considered to be “inelastic”.

Since determining the “elasticity” of demand is the key to maximizing revenue, let’s use rubber bands for a demonstration. The area inside the rubber bands will represent total revenues, price x units sold. Rubber band #1 will represent total revenues when prices are decreasing and #2 will represent revenues when prices are increasing.

The total revenue for rubber band #1 will increase as prices are decreased from an excessively high level. Expand the area within the band with the pressure of your fingers representing the increased units demanded by lower prices. The “demand” curve in this situation is considered by economists to be “elastic”. Maximum revenue, that point at which the area within the band will no longer expand as a result of lowering prices, is achieved just prior to the point of “inelasticity”.

The total revenue for rubber band #2 will increase as prices are increased from a starting level of zero. Expand the area within the band to represent the expansion of total revenues brought about by increasing prices. When the total revenues increase as a result of increasing prices, the demand curve is considered by economists to be “inelastic”. Again, maximum revenue, that point at which the area within the band will no longer expand as a result of increasing prices, is achieved just prior to the point of “elasticity”.

With both of the rubber bands, we have approached the point of “unitary elasticity”. Total revenue is maximized at this point. Locating this point is probably only theoretically possible. However, as a practical matter, the closer your pricing policy comes to this point, the greater the profits. There is perhaps no more important decision that a business makes than the pricing of its products. Too often, too little time and attention is given to this most important decision.

When the demand is elastic, a price decrease results in a more than proportionate increase in quantity. So total revenue will increase with price decreases when the demand is “elastic”. When a decrease in price results in a less than proportionate increase in quantity, the demand is defined as “inelastic”. Total revenue will decline with a further price reduction when the demand is inelastic. Total revenue will be enhanced, however, with a price increase in a situation with inelastic demand.

Understanding of the demand curve and the concept of “elasticity” are valuable to decision makers in both the public and private sector.

The frequently discussed “Laffer Curve” is utilized to explain how total tax revenues will change when tax rates are changed.

The Laffer Curve represents total tax revenues and takes the parabolic shape of the inverted U. At one extreme where the tax rate is 100%, there would be no revenue because there would be no incentive to produce. At the other extreme the rate would be zero and that too would result in no tax revenue.

As tax rates decreased from 100%, total tax revenue will increase while the demand curve remains “elastic”. As rates are increased from 0, total tax revenues will also increase during the “inelastic” segment of the demand curve.

The point that economist Arthur Laffer was making is that at some point, an increase in tax rates actually will end up reducing total tax revenues. Determining that point of “unitary elasticity” has been elusive for public policy makers.

If the demand for your product is “elastic”, a lowering of your prices may increase your total revenues. If the demand for your product is “inelastic”, an increase in price will enhance total revenue. Because its your business, create the pressure to expand the area within your rubber band.

Budget Business

It’s that time of year again. The big companies started “doing it” awhile ago. Most smaller businesses are just getting started. Some will still be “doing it” in January and some others won’t even give “it” a try.

“It” is the annual budget. Not everybody who is “doing it” is enjoying it and few are benefiting from it as much as they should. Take a look at last year’s effort.

How frequently have you used it during the last nine months? Was it worth the effort that went into it? Has it helped you make better decisions during the last nine months? The answers to these questions will determine the level of enthusiasm for this year’s annual budget.

It doesn’t have to be that way.

Done properly, a budget will increase the quality of your life by adding an element of predictability to your business. It will provide an objective standard for communicating the plans around which meaningful organizational development can take place. Budgets provide a control mechanism for increasing profitability.

Budgeting often deteriorates into an accounting exercise rather than the management decision making process that it should be. Financial statement preparation is an accounting function. Budgeting is a part of management’s planning function and should involve all of those charged with implementing the plan.

For the budgeting process to be successful there are three important prerequisites. First, the process must have the support and active involvement of the top managers. Without that support, sufficient time and attention will not be dedicated to the process. Budgeting either be forgotten or soon become a burdensome administrative activity that has no positive impact.

Next, the budget must a constructive tool for improving the overall operation of the business. Deviations from the budget should only be a means of focusing management attention on areas that need improvement. Unfortunately, budget deviations often provide an opportunity to assess blame. Improper use of the budget as a control mechanism will result in dysfunctional organizational behavior such as “padding the budget” and internal bickering.

Finally, all operational managers responsible for implementing the budget must be involved in creating it. The budget needs to be built by those making the everyday decisions and then used by them when making those decisions. Budget discipline must be accepted at all organizational levels.

A budget typically begins with a forecast of sales that is followed by a series of operating budgets that are accumulated into a set of pro-forma (budgeted) financial statements. The sales forecast is important because it is the initial step in the budgeting process and many of the operating budgets are based on the projected sales level.

Accurately projecting sales is difficult because it involves both internal variables, items such as pricing and promotion, and external variables, items such as customer decisions, competition, and economic trends. Making important forecasts based on external factors can be particularly frustrating. While it will never be done with absolute accuracy, estimates need to be made. However inaccurate your sales forecast maybe, no one will be able to do it better than you and your sales staff, the people closest to the action.

Successful budgets don’t rely on a single approach to forecasting sales. They have forecasts based on several different information sources, customer inquiries, market share projections, recent trends, or competitive analysis, and then reconcile them into a consensus forecast.

Analyzing the internal factors that will effect the sales forecast should be an active process, not a passive one. The questions to ask are active, “what can we do differently, better, or more imaginatively to meet our sales objectives”, not passive,”what do we think our customers will buy from us this year.”

The close association between planning and budgeting has led to overlap and confusion of these two important management functions. Strategic planning often becomes an exercise in extended budgeting with an emphasis on numbers rather than the quality of the thought that supports those numbers.

Planning is the first and foremost function of a good management system. Budgeting is not planning, but it is an important part of planning.

In the beginning, most organizations run “by the seat of the pants” and do so fairly successfully. However, their potential is limited until such time as they develop a process that enables them to focus and control their activities. The more competitive the environment, the greater the need for planning and budgeting.

Make Sure The Price Is Right

Pricing is the neglected orphan of business. There is no more important decision a business will make than the pricing of its products.

Revenues minus expenditures yields a remainder commonly referred to as profit. Revenue is the product of price and volume. These simple formulas highlight the prominence and impact of pricing. Product quality, marketing strategies, customer service, and cost control all get considerable attention. Perhaps the weight of competition and market forces make pricing decisions appear inevitable rather than discretionary.

Cost information will establish a floor for prices. Three generally accepted cost based pricing approaches are cost plus, target rate of return, and a break even analysis. Each approach requires a knowledge of the actual cost of the products being sold. Determining cost is easier in some business, like retail, than in others, like manufacturing. The more difficult it is to determine cost in your business, the more important it becomes to do it.

Market information will establish a ceiling for prices. Market oriented pricing methods include competitive and demand approaches. A common error for small businesses is pricing products too low. The “I can do it cheaper” theory is flawed because if you can do it cheaper, chances are that somebody else can do it also.

Undercharging in the early stages of a new venture is also common. “Timid undercharging” is the result of an entrepreneur being overly optimistic concerning their costs and overly cautious concerning the value of their product. Price conveys image, give your company a positive image. Remember it is always easier to lower prices than it is to raise them.

Lowering prices for higher volume is a pricing strategy that always looks good on paper but rarely translates well into reality. Few businesses have the marketing and financial strength to profit from this strategy. Innovative pricing strategies that improve profit margins are the most productive.

One manufacturing business sold between five and six million products per year priced between seventy-five cents and five dollars apiece. After implementing an exhaustive pricing review process that involved the controller, sales manager and manufacturing manager, the C.E.O. suggested that they add a “penny a piece” to each of their prices.

The “penny a piece” strategy directly impacted the company’s revenue. The increased profit was dedicated to the funding of a profit sharing program and remained a fixture of this company’s pricing strategy. Not a sophisticated approach some might say, but it was successful in focusing attention on the importance of pricing and in generating additional revenue.

Across the board price increases can do more harm than good. They are often justified as expeditious or because accurate detail information is not available. Completely accurate information is never available, but there is always some information available that will allow you to make a more enlightened decision than “five percent across the board”.

In addition to the fact that “five percent across the board” rarely ever generates a full five percent, across the board price judgments cause the subject of individual product pricing and profitability to be swept aside. There is no element in the formula of business success more important than pricing, it should receive constant and detailed attention.

Shortly after acquiring their business, the new owners saw profits began to decline and within a year the business was losing money. The reasons for the decline were unclear but certainly the management transition and the change in ownership were factors.

They were not confident with the cost information available for a detailed price analysis. They felt that a five percent revenue increase would restore the profit margins that the business had historically achieved.

The only problem was that their “five percent across the board” price hike didn’t generate a five percent revenue increase. The unit sales of some of the products remained the same and the price increase did generate a five percent increase in revenue. But the sales of other products actually declined, resulting in a revenue increase of less than five percent.

A brief analysis uncovered the following information. Nearly ten percent of the company’s products were generating a negative gross profit. In this particular business a gross profit of twenty percent translates to about break even, so this small group of products was generating a loss of $108,000.

The experience of the previous owners could accommodate this inefficiency, but clearly this was a problem that the new owners could not live with for long. They learned their lesson and soon a healthy bottom line returned.

Because its your business, price your products for a profit.

Debt, Darling Or Devil?

The torch of business leadership is passing from the generation that lived through the depression to the generation known as the “baby boomers”. Despite the obvious age differential , the attitudes of the two generations on a variety of business issues are remarkably similar.

On one issue however, their experiences and attitudes show a marked contrast. That issue is debt. The depression era business person developed a cautious approach to borrowing while many of today’s entrepreneurs cavalierly incur debt.

If the future is the history that we have neglected to learn, it is perhaps prudent to understand the considerations that led to the cautious attitude of the older generation. While I don’t number myself amongst the growing school of doomsday predictors, there are increasing numbers of businesses that are waking up with debt induced hangovers.

One of my first managerial jobs was with a small privately owned company. The Chairman and largest shareholder was credited with having “brought the company through the depression”. In the intervening years the company had not grown appreciably but had been successful in providing a nice income to its owners and employees.

While the company was in strong financial condition, the seasonal nature of its business required some bank borrowings for short term working capital needs. During the majority of the year the company was a net investor of short term funds.

At management meetings, it didn’t take me long to learn the Chairman’s primary area of interest. He would first ask the company’s treasurer about the status of the bank accounts. If the company had been borrowing at the time, he would then inquire as to”when will the bank be paid off.” Knowing of the company’s strong financial condition and the excellent bank relations, I was unable to understand the Chairman’s myopic focus on “when will the bank be paid off.”

It took me sometime before I could appreciate and understand the concerns of the man that had “brought the company through the depression”. Sales, product development and expansion were far more exciting topics. Credit was available to finance projects in these areas.

Time and experience with several businesses have since matured me sufficiently to appreciate the importance of “getting the bank paid off”. In recent times, unpaid loans are often “rolled over” or extended while in earlier times the control of a business may have been lost. The Chairman’s focus was on survival not growth. A business should have as its priorities survival, liquidity and profitability.

A number of companies, both small and large continue to accumulate debt in the pursuit of growth and the hopes of a better tomorrow. Debt can be effectively used to improve the financial leverage of a business, but for those who have established a pattern of extracting themselves from problems with growth financed by debt, there is an eventual price to be paid.

You have positive financial leverage when debt financing enables you to produce a greater total return than you would have been able to produce with your equity alone. Consideration also needs to be given to payback, risks and contingencies. Debt can be appropriate for capitalizing on established opportunities but is seldom appropriate for working out of problems. While additional funds may ease the symptoms, additional debt will often make the eventual financial hole deeper and more difficult than the current one.

If debt is part of the financial structure of your business and your financial controls are lax, you should take action to remedy the situation. Too often otherwise good business people with sales, technical or operational backgrounds find themselves “too busy” to fully review and understand the companies financial statements. This is an invitation to trouble.

There are indicators of a debt load that is becoming burdensome. Extending larger than normal discounts to customers for prompt payment or selling below established prices to generate cash flow are indicators of a pending debt crisis. When your bank is looking for additional collateral, subordination of personal loans or an increase in restrictive covenants, you should get the message that someone is concerned that they have already lent you too much.

Increasingly innovative uses of debt capital have played an indispensable role in the acquisition, development and building of many of today’s businesses. Some companies however, are suffocating under the burden of excessive debt that was incurred without the cautious scrutiny exercised by a management that “made it through the depression.” Because it’s your business, maintain a cautious attitude towards debt so that you won’t have to “bring your company through the depression.”

Valuing The Closely-Held Business

It is a pretty straightforward matter to check the value of your IBM stock. Just pick up the morning paper and bingo, you have the daily value of most any widely held, publicly traded stock.

What about the value of your shares of stock in a closely-held corporation? This is not such a simple matter. Your shares may represent 100% ownership of a business you built or partial ownership of a business you invested in, inherited or received an interest in as a result of some other settlement.

There are many important reasons for knowing the value of your closely- held stock. Obviously if you are contemplating the sale of your interest, the current value is important. It is often assumed that the marketplace, “what a willing buyer will pay a willing seller”, establishes the price. That’s true, but that process is a negotiated one and the party with the most knowledge can use it to their advantage. Being in possession of an independent valuation and the facts that support it can be an invaluable negotiating tool.

Other common reasons for needing a current valuation of your closely-held stock include estate planning, shareholder agreements, recapitalizations, employee stock plans and property settlements. An important but often overlooked reason is just simply the need to know. If you are the owner, it can be comforting to have an outsider’s opinion of the value of your firm as you develop your plans for the future.

Regardless of the method employed for the valuation of the closely-held company, several factors, including expectations for its industry and the economy, will influence the results. The degree and dispersion of control is a significant factor in the closely-held firm. All other factors being equal, a controlling interest will command a higher per share price than a minority interest.

The valuation will also be influenced by the importance and continuity of the management. The intangible value of a business (excess of total value over appraisal value of net assets) will be discounted in the event of loss of key management. The tax implications of the assignment of values to assets can effect the valuation to both parties in the event of a sale.

With these general factors in mind, there are several well accepted methods which can be used to estimate the fair value of a closely-held business. For certain businesses, an Accepted Industry Method is commonly used. This would be appropriate for businesses such as health care facilities where a “per-bed” basis is used or a professional corporation which may be valued as a multiple of billings.

The Assets Method requires that all the company’s assets and liabilities be adjusted to current market values. For example, a ten year old building may have cost $200,000 and is currently carried at $100,000., but its present worth is $350,000. Once the net appraisal value has been determined, an adjustment is made if the company’s actual rate of earnings, based on the appraised value, is above or below an industry average rate of return.

The Comparable Price Method uses the price/earnings ratio of similar publicly held companies. The earnings of the subject company are adjusted for extraordinary items such as owners compensation and the resulting value is subjected to a discount to reflect the lack of marketability of the closely-held stock.

The Income Method capitalizes earnings over a five to seven year history. When employing this method it is important to consider the cyclical nature of the industry and insure that both the high and low points of the cycle are represented.

The Discounted Cash Flow Method involves forecasting the expected cash returns from the business over a five to seven year period. This method is appropriate for stable concerns whose earnings and cash flows are reasonably predictable. These amounts are then discounted by a projected risk adjusted rate of return.

Valuing a closely-held business requires professional judgment and consideration of a number of objective and subjective criteria. It is not an exact science. The validity of the result will be determined by the suitability of the method chosen and the facts that support the final valuation. Because its your business, you just might want to know what its worth.

Joe Driscoll is a management consultant whose column appears regularly in the Monday Herald.

Sources Of Funds

Does a business start with the product or the order? Which comes first the service or the customer? It’s the old chicken and the egg debate and there is probably no universally correct answer. Regardless of where you stand on which came first for a business, there is no disagreement that money is the lifeblood of all businesses. Without cash for working capital and financing for capital investment, no business will last for long.

At every stage in their life cycle, all businesses need to obtain capital at a reasonable cost. The need for capital is most pressing when starting a business or when managing the growth of an established business. You need to have an awareness of the various financing alternatives available and a solid understanding of the advantages of each alternative.

Funding sources can be divided into two major categories. First, internal funds are those sources of funds that can be found within the business itself. internally generated funds are the business owner’s most readily available source of low cost funds. Secondly, external funds are those sources of funds that are obtained from a wide variety of outside parties. External funding can be further be subdivided into two categories, debt financing and equity financing.

Lets take a look at internal sources of funds.. A closer look at debt financing, the sources and lending practices of local financial institutions, and equity financing, where to find investors and what they are looking for, will be subjects for future discussion.

When we begin to look for internal sources of funds, we begin on the asset side of the balance sheet. If you don’t have a balance sheet, make one. If you don’t know how, get some help from your accountant. Good management of even the smallest of businesses requires a regular review of assets and liabilities presented in a balance sheet format. The balance sheet is organized from top to bottom by the liquidity of your assets. Liquidity is the theoretical ease with which assets can be converted into cash. Since cash for growth is what we are looking for, let’s start at the top.

Assume a business with an annual sales volume of $600,000., an accounts receivable balance of $50,000. ranging from 30 to 45 days old and inventory of $30,000. An opportunity arises to purchase some new equipment that will improve profit margins and allow the company to increase volume by 50% over the next two years. To purchase the new equipment the business needs to make a cash down payment of $15,000. Where’s the extra cash going to come from?

Try spending an extra half hour a day on the phone following up on the receivables. Get those payments down to thirty days or less. Never underestimate the power of a personal telephone call when collecting payments. I am consistently amazed how this readily available source of funds and this extremely effective collection mechanism go unused in even the largest companies. All it requires is a little effort, tact and persistence.

If profit margins are acceptable and immediate cash availability is the priority, consider giving your customers an incentive for early payment. A wide variety of incentives can be effective. Use your imagination. Consider extra merchandise, increased service or discounts on future orders as well as the traditional cash discount. Don’t just type your early payment discount on the bottom of the invoice and expect the customer to take action. Just like any other special program, you will have to sell it if you want it to succeed. Get on the phone again, call your best customers and tell them about it. Send out a special notice with the next billing and announce it as a feature that will benefit both you and your customers.

Don’t overlook inventory when you need short term funds. While it will be difficult to reduce inventory as you look to expand your business, periodic inventory review will generally present some opportunities. Look first at excess items. Check with your suppliers to see if they can be returned. Don’t be bashful because the items are old, they might be just what your supplier requires to meet another customers needs. Also give thought to a direct sale of excess items, modifying designs to consume inventory and discounting slow moving items. Call your employees together and see if over the short run they can work with shorter lead times on supply items that will permit fewer purchases and a resulting temporary inventory reduction.

Use your imagination and you should be able to free up that needed $15,000 until other financing becomes available. Don’t overlook other potential sources of internal funds on that balance sheet. The sale of unused fixed assets or the renegotiation of supplier terms that will let you extend your payments may take a little more effort than managing the receivables and inventory, but they remain a fertile source for internal funding.

Conventional wisdom dictates that internal funding is not available to the entrepreneur just starting his business. Not true! Two major consumers of cash in a start-up business are rent and payroll.

Find a location that hasn’t been occupied for awhile and has thus not produced any recent revenue for the owners. Propose that in return for their deferring your rent for three months you will take a years lease and pay the back rent in full at the end of three months. You end up with an internally generated interest free loan that helps you meet your capital requirements and your landlord stands a good chance of having a full years lease on an otherwise unproductive asset.

Similar arrangements can lessen the cash drain of payroll costs at start up. Find employees that either have other sources of income and can “moonlite” for deferred wages or find individuals who are currently unemployed and will accept deferred payment for the promise of future employment.

Cash is the life blood of any business. Because “It’s Your Business”, remember to make a regular review of your balance sheet for sources of readily available internally generated funds.

Leveraged Buyout

Back not too many years ago it was referred to as “bootstrap financing” or simply getting a loan to buy a business. Now referred to by the acronym LBO, the leveraged buyout has become one of the most exciting and popular investment vehicles of the decade.

A leveraged buyout involves financing the acquisition of a business with a small equity investment and substantial debt. The debt financing is obtained and serviced by the assets and cash flow (net income plus depreciation and other non cash expenses) of the the business that is being acquired. Properly structured, an LBO allows an individual or group of investors with limited resources to acquire a business of substantial magnitude.

Leveraged acquisitions have been around for many years and were primarily utilized in the transfer of ownership of closely held businesses. In the later part of the last decade, a few aggressive and creative investment bankers began to apply the same principles to larger transactions. The timing was right, there were many highly publicized deals, a lot of money was made by some and the acronym LBO became a common place term.

The classic debt to equity ratio of a well established business might be one to one (one dollar of debt for each dollar of equity). It is not atypical for the debt to equity ratio in a newly acquired LBO to be ten to one. The key element for a successful LBO is acquired assets and resulting cash flow that are able to support the debt that is being incurred.

The underlining assumption is that, freed from whatever distractions that hindered the previous owners and provided with significant incentives, the experienced management group can maintain a cash flow that will provide for the retirement of the debt. This will result in a dramatically improved debt to equity ratio and the value of the business will increase rapidly.

Opportunities for LBOs exist with both large public companies and private businesses. Larger corporations decide to divest divisions for many reasons. They may be profitable but are requiring too much attention or capital. Perhaps the parent company sees greater opportunities in another direction and wishes to redirect its capital.

A majority of LBOs are smaller transactions that don’t make news headlines. Private investors supporting management groups in acquiring private businesses. Again the reasons for sale are many. The desire for liquidity, estate planning and succession of ownership are frequent sources of opportunity.

Let’s examine the structure, valuation and logic behind the type of deals that make the big headlines. Company X has been valued at $95 million and will be acquired by its current management and a group of outside investors. The buyers intend to finance the acquisition with $10 million in equity (their money, usually the contribution of the outsiders) and $85 million in debt (other peoples money, usually borrowed from large financial institutions).

The objective now becomes to maximize cash flow and reduce debt. The management plans to immediately sell off one of the company’s operating divisions for $35 million. This division in all likely hood will become “son of LBO” as its managers will join with another group of investors and follow the same course as the managers of company X. The proceeds of the sale will be used to reduce the original debt from $85 to $50 million.

After the asset sale the cash flow is estimated to be $9 million per year. It will be the objective of the management to improve that cash flow by a combination of operating efficiencies and modest growth. Despite the cash drain caused by the heavy interest payments, company X anticipates repaying $3 to $5 million a year in debt.

The magic of the mega bucks LBO is seen several years down the road. After about five years, the original investment of $10 million now controls a company with an annual cash flow in excess of $10 million. Conservatively valuing the company at seven times cash flow ($70 million) and after deducting the remaining debt, approximately $30 million, the initial $10 million investment is now worth $40 million after five years.

Actual returns in both large and small leveraged transactions can often result in returns far great than depicted in this example. This accounts for the rise to prominence of the LBO in the investment community.

Because it could be your business, remember the key elements for a successful leveraged buyout and keep an eye out for the right opportunity.

Buy Out

The company’s current Chairman founded the business eighteen years ago. He has seen it grow to slightly more than twenty million dollars in gross revenues. At age 69, he currently retains 68% ownership in the company. He wants to retire and sell his interest in the business.

The company’s growth has been financed primarily with debt. Current debt consists of a $700,000 loan from the company’s major shareholder, a three million dollar loan for working capital and an additional 1.5 million dollars in long term debt. Because of the substantial debt burden, most of the company’s operating profits have been consumed with debt service and as a result there has been little growth in retained earnings.

The company’s President has been active in the industry for twenty years and has held his present position since 1975. He is currently 57 years old, owns a 23% interest in the company and has special expertise in the sales area. The Chairman’s son is the remaining member of the key management. Now 39 years old, he has worked in a variety of production jobs since the company was founded and is currently the Vice-President of Production.

This situation is one in which I was recently involved. Change the percentages or move the decimal points to the left or right and you might find a strategy that can be useful in your business. The structuring of ownership transactions can have substantial impact on value.

The company has established a reputation for its broad product line, quality and service. The company’s products are distributed nationally. The company employs over 200 people in a newly constructed facility.

The industry in which the company operates has been reasonably decentralized with a large number of small suppliers and several other medium sized firms. As a result of recent technological developments, it is apparent that there will be greater concentration in the industry with the small suppliers becoming less competitive and the most aggressive of the medium sized firms growing rapidly.

One of the other medium sizes suppliers, whose annual sales recently topped $35 million, has just completed its initial public stock offering. A growing market, an industry trend towards consolidation and favorable trends in the financial markets combined to value the stock of this company at sixteen times their per share earnings.

An investment advisor was retained by the Chairman to find a buyer for the Chairman’s stock or the entire business. A buyer was identified.

An offer to purchase the entire business had an enormous impact on the other key members of management. The assumption of substantial debt, combined with the risks associated with a change in management, minimized the per share price the buyers were willing to offer.

The impact of the sale on the management, the difficulty with financial arrangements and the resulting minimizing of shareholder value combined to cause the company to explore other alternatives.

The company’s President, already a significant stockholder, and the Chairman’s son were the likely acquires. While they may not have felt they had the financial resources, they have other strengths. They already own a quarter of the company, they can provide continuity of management and they have complementary backgrounds in sales and production.

Their weak suit is in financial expertise and financial resources. Their strong operational backgrounds coupled with the attractive multiple that the financial markets have placed on the value of the stock of a similar company in their industry, creates an excellent opportunity for outside investors to support a management bid for the company.

An outside investment group was recruited to provide the resources necessary to execute the transaction. They provided the funds that enabled the company to pay off the $700, 000 loan to the Chairman. They received in return an option to buy his interest in the company within the next two years at the current book value. They provided additional funds to retire the entire working capital loan. In return they received significant equity in the company and a note.

The company’s Chairman has agreed to place his stock in a voting trust during the option period. The voting rights will be exercised by his son, the President and a representative designated by the outsiders. Both the President and the Vice-President, along with other key management members where granted attractive stock options.

It is the company’s objective to position itself for a public stock offering within the next two years. The decreased financial leverage resulting from the debt pay down will increase earnings. Continued sales growth will place this company on a par with its competitor that recently had a successful offering. The retiring shareholder will realize an immediate repayment of his loan to the company, a reasonably priced purchase of his stock within a short time and the continuation of the firm he founded.

Because its your business, explore all the options for structuring your business transactions.

Debt Financing – You Can Bank On It

Small and growing businesses are invariably undercapitalized and will need to borrow funds at sometime. Debt financing creates financial leverage for the business owner that can be rewarding as the business prospers. Financial leverage is the borrowing of funds and investing them in your business at a higher rate of return than the cost of the borrowing.

Banks and commercial finance companies are the two most common sources of borrowed funds for the small business. Let’s put the process in a perspective that is familiar to the business person.

The business owner is constantly buying products and works with a number of different suppliers on a daily basis. When it comes to money and banking however, it is often an infrequent and possibly intimidating experience. Let’s consider the money we need to borrow the same as any other product that we buy and let’s look at our bank the same as we do our other suppliers.

If money is a product like any of our other supplies, we should be sure that we have enough to meet our needs, but not so much that our “inventory” carrying costs will be high. We should insure that we use it efficiently because the excess use of any supply item or raw material will increase costs and decrease profitability. As with all purchased products, we should shop before we buy. There is a competitive market for most all of the products and services we use in our businesses and that includes the money we need to borrow.

If money can be viewed as a supplied product, then our banker can be looked at by the same standards as our other important suppliers. When you evaluate your other suppliers, price is not the only criterion for comparison. Service, delivery, quality and the ability to accommodate the special needs of your business are factors that you consider. These same standards should be used when you are choosing and comparing banks.

Now that you are ready to look for a business loan, where should you start? What should you be looking for and what can you expect to find?

The best place to start is with a financial institution where you have established relationships. Good business relationships are a most important of doing business. Business relationships aren’t really between business but rather between the people that own and manage the businesses. So if you currently have a business bank, start there. If you are just staring a business, begin with the bank that you use for your personal banking. If your current bank isn’t equipped for the type of business loan you need, they will be able to give you a personal introduction to one that can.

At the Monterey County Bank, they view their relationships with their customers as partnerships. They recommend that you make sure that your banker understands your business. If your banker is not trying to learn your business, you might have the wrong bank. Both you and your banker should be working together to insure that the bank knows and understands your business.

Three frequently used borrowing arrangements are lines of credit, term loans and working capital loans for accounts receivable and inventory. With a line of credit, a bank is extending a commitment to loan up to a specific amount under certain prearranged terms. The borrower draws on the funds as needed and pays interest only on the outstanding balance. The borrower is sometimes required to pay an initial commitment fee based on the entire amount of the loan .

Term loans are business loans with a fixed maturity, usually not more than seven years. Term loans are used for a variety of purposes from equipment financing to business expansion. They generally have a variable interest rate and are often secured by the assets acquired.

The financing of accounts receivable and inventory are probably the most common reasons for business owners to borrow. Once this was primarily an area for the commercial finance companies, but now it is an active area for all full service banks as well. Typically an agreement will be structured that will allow the borrower to assign the assets to the financial institution as security for loans that can generally range up to eighty percent of the value of the receivables and to fifty percent of the value of inventory. This can most often be accomplished without any involvement or notification to the customers that actually owe the money.

When looking for a business loan, your most most important decision is choosing your “supplier”. Anticipate your need to borrow as you would the need for any product. Begin with those that you know and shop wisely. Look to establishing the type of long term relationship you would have with any of your important suppliers. A good supplier of debt financing will help you choose the right product. Because “It’s Your Business”, the right product will let you benefit from the increased financial leverage.

Watch The Cash Flow

USX Corporation records a loss in excess of several hundred million dollars. The Bank of America and other corporate giants do the same. Not so long ago, the former International Harvester Company, now Navistar, recorded nearly a 1.5 billion dollar loss on a sales volume of approximately five billion. The independent businessman shakes his head and wonders how these big guys can do it and still be in business. He knows for sure what comparable losses of that magnitude would mean for his business. A large part of the answer lies in cash flow.

A small and successful company develops an innovative product that is well received by the market place. The company builds staff and gears up to meet the high demand for its new products. Floor space, equipment, personnel, inventories, receivables, payables and visions of limitless profitability all grow rapidly. Troubles soon follow, but why? All too often the answer lies in cash flow.

What is this thing called cash flow and why is my banker so interested in it? If sales and profits are on the rise, everything will turn out OK, right? Well maybe, but sales can be bought and and profits can be manipulated. But cash, cash is king. If your business is generating a positive net cash flow you have flexibility and you can survive forever. If you don’t have a positive cash flow, regardless of how impressive your sales and profits are, you must have a plan to meet the shortfall or big trouble lies ahead.

Peter Drucker, the foremost management scholar of our time, recently enunciated what he believes to be the five key indicators of corporate performance. Responding to the widely held concern that short term earnings are a grossly misleading indicator of a company’s health, Drucker suggests that how well a business is doing can evaluated by looking at market standing, innovation, productivity, cash flow and profitability. That’s right, cash flow right up there in the top five.

Concerning cash flow as an indicator of corporate health, Drucker notes that a business can run without profits indefinitely as long as the cash flow is adequate. However, the opposite is not true. He observes that there are far too many businesses, both large and small, that have to abandon their most profitable developments because they run out of cash. He warns that increased profits through rapid expansion of sales volume is a danger signal because it weakens rather than strengthens liquidity and cash position. The rapid expansion can be an indicator that the company has bought rather earned its additional sales. Bought sales, being accompanied by non-sustainable discounting and overly generous financing, can’t last for long.

In the closely held company, cash flow takes on even greater importance. With no outside investors to impress, the recording of profit is most favorably received by the tax collector. Management of the closely held corporation should nearly always place a higher priority on insuring a positive cash flow than on profitability.

Given the importance of cash flow, how do we calculate it and where do we find it? A company’s financial statement has three major sections, the balance sheet, the income statement and a statement of source and application of funds. It is the statement of source and application of funds that is commonly referred to as the cash flow statement.

The cash flow statement is generally divided into two parts. The first part looks at what sources provided funds for the business and the use of those funds. Net after tax profit plus non-cash expenditures such as depreciation comprises the majority of the cash generation. Other sources of funds can include new equity investments and additional long term debt. Uses of funds will include such items as dividends payed, capital expenditures, research and development expense and repayment of debts.

To determine the adequacy of your cash flow you subtract the total funds used from the total funds provided. The resulting answer will indicate whether you had an increase or decrease in working capital for the period. An increase in working capital indicates that your cash flow was sufficient to meet the cash requirements for your business. Regardless of what your income statement says, a net negative cash flow as indicated by a decrease in working capital is a situation which is non-sustainable and requires management attention.

The second section of this statement is an analysis of the changes in working capital. This section will tell you what items of working capital have changed during the current period. Regardless of whether your working capital is increasing or decreasing, this analysis will tell you where you are investing your money in the business.

The importance of cash flow is beyond question. Because its your business, make sure that your accountant regularly prepares a cash flow statement and that you spend as much time with it as you do with your income statement.

Joe Driscoll is a management consultant whose column appears regularly in the Monday Herald.

Understand The Cost

“There is a great difference between knowing and understanding: you can know a lot about something and not really understand it.”
Charles F. Kettering

The difficulty encountered in forecasting future revenues is often a major stumbling block in the decision making process. But revenues are only one part of the simple equation that measures business success. Getting a good handle on the other part of the equation, the expenses, is easier, equally important and frequently overlooked.

Developing a professional understanding of your costs and expenses, while it won’t help you predict the future, it will give you the means to manage these items, establish necessary revenue objectives and to better understand the relationships between expenses and revenues. Begin by defining each of your various expenses as fixed or variable, understanding the concepts of marginal contribution and operating leverage and then calculate your break-even point.

The process of classifying these expenses is not nearly as complicated as it may seem. Once you have established these definitions you will have an understanding of how these individual cost items will react as the volume of activity changes in your business.

The relationship of changes in an expense item and changes in the volume of activity result in the categorization of fixed and variable costs. Fixed expenses are those which are related to the passage of time and not related to the changing levels of business activity.

Those items which you have committed yourself to for at least the next year in order to run the business in a normal manner are fixed expenses. Items such as rent, depreciation, insurance, taxes and salaries are properly defined as fixed expenses. Fixed expenses will be expressed in absolute dollar terms.

Those items that will fluctuate in close relationship to the variations in business activity are variable expenses. When the activity of any particular volume measure such as units sold, units produced or dollars sold increases, the amount of a variable expense item will increase proportionately. When the volume decreases, the expense item decreases. Expenses such as manufacturing supplies, raw materials and sales commissions are all variable expenses.  Variable expenses should be quantified and expressed as so much money per unit of output. For example, raw materials cost $2.50 per unit or labor costs $.34 for each dollar of sales.

It is about at this time that a gray area known as semifixed or semivariable expenses arises to paralyze the process with confusion. Remember two things, first this is your business that you are dealing with and not some abstract example in an accounting book, and secondly you will not be judged by the perfection of the process but rather by the decisions that you make as a result of the process.

Don’t get hung up on perfecting the definitions of fixed and variable. Most will be quite obvious. If you are locked into the expense for the better part of a year regardless of what happens to sales, it’s fixed. The rest are variable so long as you can identify there cost per unit of volume.

In business, your exposure to risk is a function in part to the extent to which a firm’s costs are fixed. If your fixed costs are high, a small decline in sales can lead to a large decline in profits. Therefore, all other things remaining the same, the higher a firm’s fixed costs, the greater its risks.

The extent to which a business uses fixed costs in its operating structure is called operating leverage. With a high degree of operating leverage, a business has great risk but has a greater opportunity for reward in that a small increase in sales will result in a large increase in earnings.

Marginal contribution is the contribution which a sale makes toward covering your fixed expenses. If a product sells for $1.00 and the variable costs associated with it are $.60, each sale makes a contribution of $.40 towards the company’s fixed cost.

An understanding of the behavior of the cost structure is indispensable for making major decisions. The potential profit from new activities can easily be projected by comparing variable costs and anticipated revenues.

The concept of contribution margin forms the basis for calculating your break-even point. With your expenses properly classified, the formula is as follows. The break-even point in sales dollars “S” is equal to the sum of the fixed costs “FC” plus the variable cost per dollar “VC” times sales “S”. Expressed as a formula it looks like this, S = FC + VC(S).

You know your costs. Because it’s your business, make sure that you understand them and use that understanding in the decision making process.

Reading Your Financial Instrument Panel

Whether your business is big or small, whether you are an investor, owner or manager, you will soon be looking at year end financial statements. You may know the business inside and out, but the annual financial statement can often look as complicated as the instrument panel of a jet airplane.

Assume for a moment that your business is an airplane and that you are the pilot. Your financial statements are the instruments in your cockpit. They provide a wide range of key information that is essential to the safe piloting of your craft. Typically, if the bottom line of the business is acceptable, there isn’t much study of this seemingly complex data.

The reading of the instrument panel of your business is not as complicated as it might seem. Few figures in a financial report are highly significant by themselves. It is their relationship to other figures and other time periods that is important. Financial analysis is largely a matter of establishing those significant relationships and monitoring the trends.

Three widely used analytical techniques are 1) dollar and percentage changes, 2) component percentages and 3) ratio analysis. Using these methods, a quick glance at the financials give you a indication of progress or will flash warning signals if there are impending difficulties.

Reading a financial statement without applying these techniques and having standards of comparison is a waste of time. The past performance of your company and the performance of similar companies are two commonly used standards. Begin to build a historical base on your company and search out industry information from such sources as the library, trade associations, government reports and published financials.

When analyzing dollar and percentage changes, the dollar amount of any change is the difference between the amount for a base year and a comparison year. The dollar amount of change from year to year is of some interest, but reducing this to percentage terms adds an important perspective. The percentage change is computed by dividing the amount of change between the years by the amount for the base year. This will yield an analysis that will indicate if the changes in your business are uniform or if there is need for management attention in selected areas.

The percentage relationship between any particular financial item and a significant total that includes this item is a component percentage. When reviewing component percentages, you will begin to see the relative impact of various parts of your business.

One application of component percentages is to express each asset group on the balance sheet as a percent of total assets. For example, divide inventory by total assets and fixed assets by total asset value to determine their relative importance. Another application is to express all items on an income statement as a percent of net sales.

Ratio analysis is a commonly used method of comparison. It simply means to express mathematically the relationship between two significant numbers. The following are several frequently used ratios.

Current Assets to Current Liabilities. Current assets, those assets that are listed in the top section of your balance sheet and which are expected to be converted to cash within a twelve month period, are divided by current liabilities, those liabilities that are falling due within one year. This ratio is one of the most common and is referred to as the current ratio. While there are many exceptions, it is generally assumed that a healthy current ratio is two to one. Selected industry averages are as follows; general retail, 3.15 to 1; grocery wholesalers, 1.83 to 1; electronic component manufacturers, 2.56 to 1.

Net Profits on Net Sales. Take your net earnings after all taxes and divide by total net sales. Retailers in the building products area average 2.93%; wholesalers of industrial machinery average 2.64%; producers of pharmaceuticals average 6.73%.

Net Profit on Tangible Net Worth. Tangible net worth is the total equity of the stockholders and it is computed by subtracting total liabilities from total assets. Divide net profits by tangible net worth. This ratio is looked at as one of the most important indicators of profitability. A 10% return is regarded as a minimal acceptable return.

Net sales to inventory. Divide annual net sales by the inventory as carried on the balance sheet to obtain a measure of inventory turnover. Strict accounting requires computation of turnover by comparing annual cost of goods sold with average inventory. However this specific information is sometimes not readily available for easy comparison. Retailers average turnover is 5 to 1, wholesalers do somewhat better and inventory turns in manufacturing are lower.

Total debt to Tangible Net Worth. Divide total current debt and long term debt by tangible net worth. This will yield an indication of the businesses ability to support the debt load. When this relationship exceeds 100%, the equity of the creditors exceeds that of the owners.

As you sit down to review this year’s financial reports, apply these basic analytical tools to make meaningful the complex data in the instrument panel. Because it’s your business, keep it flying straight and level.

Three Steps To Effective Budgeting And Forecasting

Budgeting and forecasting have never ranked high on the list of favorite tasks for the small business owner or the major company executive. However, if planning and controlling are two of the basic tasks of management, budgeting and forecasting must be done.

The “three step method” is a procedure that will get the job done for the small business owner and give an overview to the major company executive. It will yield maximum results with minimal input.

Let’s begin with making a couple of assumptions. First, “facts is facts” so lets be realistic and use the information available to us. Second, although nobody can predict the future, nobody knows our business as well as we do so let’s not be reluctant to make a prediction. And finally, we are most concerned with directions, trends and relationships and not with decimal point accuracy. In fact , since we can’t foresee the future we know we won’t be accurate. So let’s not get hung up on accuracy, just ballpark the numbers and get the show on the road.

The three step method requires three pieces of paper. Make thirteen columns across the top of the first page. In the first twelve put your monthly sales figures for the last year and in the final column put the yearly total. Round off the numbers so they are easy to use. Do not get hung up by incomplete information and don’t waste time on excessive information retrieval. For example, if you are trying to forecast for the year beginning with January and its only October, what should you use for the last three months of the current year. Guess! That’s right, guess! You won’t be that far off.

Next, take no more than one hour and think of all the factors that effect the sales in your business. Choose the three factors that will have the greatest influence on your business in the coming year. List them under your previous years sales including a plus or minus number for the percent that you estimate each factor will impact your next years sales.

Below the three major factors list your three major customers. If your business doesn’t have distinct customers, improvise. If you are in the retail business, list your three big sales periods. For example, Christmas, Labor Day and July 4th. Next to each of the three major customers, estimate the percent change in their next year’s purchases.

Finally, list your three major competitors and the percent impact they may have on your business in the coming year. If your business doesn’t have direct competitors, list the major competitive factors such as new technologies, substitutable products or changing fashions.

You are now looking at one piece of paper with a row of numbers across the top and three lists, influencing factors, customers and competitors, with each list containing three items. Now reproduce the chart at the top of the page on the bottom of the page. Only this time, after reference to the top numbers and evaluation of your estimates in the three sets of three, write in your forecast for the coming year. Take less than one hour and adjust the numbers until you are comfortable. You should now be looking at the world’s best preview of your business for the coming year.

Take a second piece of paper and begin to examine the costs involved in the operation of your business. For different businesses, the emphasis will vary here, but remember to stay with the threes and keep it simple.

Divide the page into three equal segments. Label the top section cost of goods sold and make the thirteen columns as you did on the first page. Fill the columns in with your cost of goods sold for the current year. If the information is not easily available, estimate. If you don’t have access to monthly information, take the annual information and estimate the monthly allocation or just do an annual analysis.

Calculate what the cost of goods sold was as a percent of sales for the comparable period. Take the January cost number and divide it by the January sales number on the top of the preceding page to arrive at the percentage figure. List the three major components of cost of good sold. Briefly consider what is in store for each of these components in the year ahead, and estimate a plus or minus percent for each. At the bottom of the first third, reproduce the thirteen columns. Evaluate the current years experience and consider the three major elements for the coming year. Make your forecast for the year ahead and compute what the the cost of goods sold will be as a percent of sales for the coming year.

In the second and third sections, review your administrative expenses and miscellaneous expenses in the same manner. Make sure to identify the three major elements for both categories.

On the third and final page, use the forecasted numbers to create your projected income statement. If you like what you see, get about the business of making it happen. If you don’t like what you see, you’re lucky because there is still time to develop strategies and take action to influence the coming year. That’s the real payback. If you wait till next year, its to late.

The three step method will give you a realistic look at the future with minimal effort. Because it’s your business, you will be able to adapt the three step method to explore other areas of your business in greater depth.