In an earlier column, we presented the FocusCFO Value Pyramid and made the following point: While growing your sales revenue is important and usually the focus of most business owners, building a solid foundation of processes contributing to your business’ health is essential to scale and build enterprise value, which is the ultimate goal.
Business owners often get immersed in day-to-day operational activities and lose sight of key financial indicators that can impact the health and value of their company. Any good CFO will march through a checklist of items that, if managed effectively, can build value in the company and help it pursue profitable growth. Here are three financial problems that can derail business owners.
Dozing Off at the Cash Spigot
It’s no surprise that cash flow is a core CFO hot button, but aside from simply finding ways to boost cash, there are cash considerations that go well beyond the monthly bank statement and the cash-flow forecast (if the business owner even has one).
Is the business optimizing its cash management? This could mean being more selective in accepting a new client, a job or buying equipment – all depending on the potential cash flow and ROI of the job or investment. The distress of fluctuating cash balances driven by seasonal trends can be forecasted and prepared for ahead of time, perhaps by identifying profitable opportunities to smooth variability and mitigate those dips. Similarly, if the business is flush with cash, is that cash being deployed for optimal return? An investment should return more than the company’s cost of capital (a discounted cash-flow analysis will help here) and not hijack working capital. And beware of investing in earnings-diluting activities (see below for more details). At a minimum, don’t let that cash balance sit idle without earning something if you can help it.
If the business is tight on cash, does leadership know if and when it might run out? Run projections based on reasonable assumptions and consider risk-adjusting the results by 10-15% to account for the unforeseen. Understand which levers can be pulled to increase cash. The company may be experiencing value erosion (more on that below) or might face working capital issues like aging inventory, bills being paid too soon or idle assets to liquidate. Sometimes business owners don’t fully know where the cash goes. They will say, “Revenue is higher and I’m not a wasteful spender, but what happened to my bank balance?” Think about how best to prepare to obtain financing from a bank or investors.
Know what the bank wants to see ahead of time to make the credit decision easy for them, an approach that will also help nurture the banking relationship. Seek financing when the business is not desperate for money and while financial statements are strong.
Value Eroding Behind your Back
Are the company’s products, services and locations delivering profits that are accretive (rather than dilutive) to existing earnings? Key financial indicators that address this question include gross margin, the breakeven sales point and EBITDA (earnings before interest, taxes, depreciation and amortization) as a percentage of revenue. Wouldn’t it be great to know your profit by client? I find that plotting client margin on a bubble graph is often a revealing exercise. The results may encourage the business owner to revisit the client’s pricing (raise price) or even drop the client.
Every business has a bottom-line EBITDA as a percentage of sales. When resources such as labor, capital and other expenses are deployed in an activity that generates a lower EBITDA percentage of sales than the business as a whole, value erodes. A business can’t just “make it up on volume.”
Every business should know its breakeven sales for products, services and locations. Slice and dice expenses into variable and fixed costs. Then take those fixed costs and divide them by gross margin as a percentage of sales to arrive and how much sales revenue is needed to achieve breakeven. Remember, breakeven is not good enough! Strive to meet or beat your overall EBITDA targets and/or the goal set for the company. In fact, check industry benchmarks to see how the business stacks up against the competition, and determine if the business is achieving that standard. Then ask why or why not.
A Weakening of the Foundation
What indicators may be silently pointing to increased risk festering in the business? A “roll up your sleeves” CFO attack of a company’s financials involves trending monthly historic data, preferably over two years of history plus the current year. Then run all kinds of ratios, such as gross margin, EBITDA percentage of sales, working capital measures like inventory turnover and much more. Update the spreadsheet with each new month’s data. Why is this helpful? Seeing trends (plot them on a graph too) helps to reveal symptoms of problems that have yet to surface. Trends can also point to poor operating practices and a lack of oversight. Awareness of trends and what a solid number looks like will help the business owner routinely “inspect what he expects.”
However, history is just part of the story. A company’s systems should be “real time” enough to catch trend outliers as they happen. In the restaurant business, for example, a point of sale (POS) system can capture daily sales, average guest check value, wait-staff labor as a percentage of sales, overtime and much more. Seeing a shift in these indicators can point to changing customer attitudes, dining behavior, the quality of customer service, etc. On a monthly basis, a prompt monthly close such as three days after month-end is also helpful to catch shifting business dynamics and provides flexibility to address issues before the current month adds to the problem.
At the end of the day, the business owner should take advantage of these financial tools to be aware of what drives value in the company and how to spot shifting indicators that might compromise value, cash and profitable growth. A CFO can help pull together the analysis and provide suggestions to drive the company forward and help accelerate its growth.
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