Finance 102 for Small to Medium-Sized Business Owners
(This is the second installment in a two-part series on smart finance for small to medium-sized business owners and managers. It is based on the work of Chicago CEO Coaching to help senior executives improve bottom-line results.)
“Three components make an entrepreneur: the person, the idea and the resources to make it happen.” -- Dame Anita Roddick
Last week, I provided my thoughts on company financial controls, principally regarding the financial data CEOs and business owners should look at in managing their companies. In this edition, I offer advice on how you can use this information in evaluating the strength of your financial position. As I stated in my last issue, “Finance 101,” readers who meet one or more of the following criteria will derive the most insight from this blog:
- Your business is incorporated; it is not a lifestyle endeavor or hobby, and you want to run it the way a successful company should be run;
- You are principally invested in the business and you lend your talents and training in service to the corporation on a consistent basis;
- You need outside financing, principally bank loans, from time to time, to finance growth and capital investments and/or
- You have an intention to sell the business some day.
If one or more of these characteristics describe you or your situation, then the following principles will apply to the evaluation of your financial condition:
1. Know your capacity to pay your bills (i.e., your current situation).
There are two calculations that help you evaluate your current situation:
- Your Working Capital – Current Assets minus Current Liabilities;
- Your Current Ratio – Current Assets divided by Current Liabilities.
As you can see, both calculations use the same data: Current Assets and Current Liabilities. Let’s assume that you have Current Assets of 250 and Current Liabilities of 100. Your Working Capital is 150 and your current ratio is 2.5 to 1. Is that good or bad? The answer is that it depends, principally on your industry and of course the particular facts and circumstances of your company and its history.
I have seen some companies that fit the calculation shown above, or greater, and other companies that have had negative Working Capital and a current ratio less than 1 to 1 (Dell Computer and some trucking companies come to mind). For most businesses, however, I feel uncomfortable when the Current Ratio is less than 2 to 1. In that profile, Working Capital is at least as great as all Current Liabilities which means that Current Assets are at least twice as large as current bills (Current Liabilities).
Here’s why. Current Liabilities are pretty solid, but Current Assets such as Inventory and Receivables don’t always pay off dollar for dollar. For inventories, it is not unusual to have obsolete or damaged Inventory that is sold at a loss. For Receivables, it is not unusual to collect less than you have on the books if you have a customer dispute or your customer is in financial distress, including bankruptcy. That is why it is important to measure your Inventory Turnover (cost of goods sold divided by Inventory) and your DSO, the number of days outstanding for your Receivables (Sales divided by Receivables), to keep a watchful eye on those Current Assets.
2. Work the Dupont Formula.
Most companies look principally at their Return on Sales (Net Income divided by Sales) in evaluating how well the company is doing. I prefer to look at Return on Invested Capital. Fortunately, Return on Invested Capital incorporates Return on Sales in this wonderful calculation called the Dupont Formula. The basics of this calculation are laid out in the following table:
Ratio | Numerator | Denominator | Result | Description |
---|---|---|---|---|
Return on Sales | Net Income =10 | Sales=100 | 10% | Operations Efficiency |
X | ||||
Sales to Assets | Sales =100 | Assets=66.5 | 150% | Asset Productivity |
X | ||||
Assets to Invested Capital | Assets=66.5 | Invested Capital=50 | 1.33 | Financial Leverage |
= | ||||
Return on Invested Capital | Net Income=10 | Invested Capital=50 | 20% | Return on Equity |
As you can see from the above calculation, Return on Sales is part of the calculation of Return on Invested Capital. However, it is part of a bigger formula used to calculate amounts owners are receiving for their investment in the company (which also has to take into account the productivity of the company’s Assets and the debt-equity composition of the company). As I mentioned in my last blog, according to Joan Magretta, author of Understanding Michael Porter: The Essential Guide to Competition and Strategy, “In the United States, from 1992 to 2006, the average company earned about 14.9 percent Return on Equity (earnings before interest and taxes divided by average invested capital less excess cash).” Generally, the higher the company’s Return on Invested Capital, the more valuable the company.
3. Calculate your Breakeven Sales number every month.
Why? This number needs to be computed to understand the dynamics of profitability for your company. However, if you are going to calculate this number, don’t use only the current month’s data. Use rolling 12 months data – I will explain why below. The 3 principal items of data to accumulate and total for a rolling 12-month period are Sales, Cost of Sales (Variable Expenses) and Operating Expenses (Fixed Expenses). With these numbers in hand, you calculate your Gross Margin (Sales minus Variable Costs) and Gross Margin Percentage (Gross Margin divided by Sales).
Your Breakeven Sales number is then calculated by dividing your Operating Expenses (Fixed Costs) by your Gross Margin Percentage. If your Breakeven Sales number is greater than your actual Sales number, 2 things should be considered:
- Reduce your Fixed Costs and/or
- Increase your Gross Margin Percentage by either:
- Raising your prices and/or
- Producing your goods and services more efficiently.
I realize this is easier said than done. However, I can’t think of a better way of looking at this issue. For most companies, actual Sales are usually greater than the Breakeven Sales number (Let’s call this a positive spread). What I have noticed about Breakeven Sales over time, however, is that they often increase as Sales increase. Sometimes the positive spread gets bigger and sometimes it even shrinks. Moreover, and this is why this tool is useful, for those times when Sales decrease, you may find your Breakeven Sales number becomes greater than your actual Sales number. In effect, you are running the business at a loss.
Do you want to wait until the end of the year to determine if you are running at a loss? Of course not! In that case, using 12 rolling months of data every month shows where you are trending. Yes, it is possible for one month’s losses to cancel out the prior 11 months of income, but it is usually several bad months that throw you into a loss. In that case if you do a rolling 12 months calculation you will see where you are trending and your warning signals will start beeping early.
Project your Expected Cash Flow—as best as you can
In my Finance 101 blog entry, I talked about looking at a Cash Flow Statement monthly. To take the Cash Flow Statement further, many companies are going to find it absolutely necessary to project their future Cash Flow. Most likely, the key trade-offs you need to look at in order to do this revolve around the net changes month to month in inventory, receivables and payables. For each of these items the trade-offs are very simply stated as follows:
- Inventory—purchases v. sale or other dispositions of inventory
- Receivables—collections v. new Sales on credit
- Payables—payments v. new items purchased on credit
Of all the calculations, this one is the hardest since it considers future data, which in turn call for many assumptions. A projection of a future balance sheet and income statement are the soundest tools to use in projecting future cash flow. If you are cash poor, this calculation may be an absolute necessity.
Taken together, the recommendations presented in my two latest blogs, Finance 101 and Finance 102 for Small to Medium-Sized Business Owners, offer a simple, but essential roadmap for achieving, monitoring and managing your company’s financial success. These are proven tools at work for CEOs and business owners in my coaching practice. They will give you the information you need to make decisions about where your business is headed, the investments you’re making, your progress and your plans against your desired outcomes and ROI.
As always, Chicago CEO Coaching is eager to hear from you about the results of the application of these principles to your business and their impact on your bottom line. Please share your thoughts and experiences here.
Copyright 2013 © John J. Trakselis, Chicago CEO Coaching
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