None of us like to see a business failing — whether it’s our own, the one we work in, or someone else’s. Unfortunately, many businesses do fail. Often for similar reasons. Often following a similar pattern. So:
- What is that pattern? and
- What can be done about it?
Let’s look at this from two angles:
We all know the signs, really. The chipped paint, the fading business signs, the aging business vehicle. Then there’s the inefficient service, the paper-based systems that take up so much time, and the obvious flaws in those systems — such that sometimes the customer service fails altogether. And, sometimes, even product quality diminishes.
Finally, there are the workforce changes. What workforce changes? Well, unfortunately, the bright go-ahead young people just keep moving on, disillusioned at the way the business operates. Meanwhile, the stick-in-the-mud plodders — intent only on getting paid for showing up — just keep on turning up. Don’t get me wrong, businesses need people who are happy to keep following systems, week in, week out; year in, year out. But we also need an inflow of bright ideas from people with a vested interest in implementing them. Sometimes, however, the workforce change is not the people, but the demeanor of the people — as the stress of the failing business (even if it’s not even been noticed yet) — takes its toll on the team.
Also outside, is the view from the suppliers — who find payment for goods takes longer and longer, coupled with excuses rather than reasons. And, there’s the bank, which sees the constant drain in the bank account and fields the many requests for overdraft extensions or loan increases.
So, prospective customers avoid the business because of how things look. Existing customers (start to) look elsewhere because of the diminished service/quality. And suppliers and the bank have second thoughts about extending credit.
It’s not a pretty picture, is it? And this is from the people who don’t actually know what’s really going on. They may not know the numbers, but they smell the rot starting to set in.
As Kate Zabriskie put it:
Strangely, the inside represents a broad knowledge range. Firstly there are those who know the numbers. These won’t be many. Indeed, in some small businesses — where the owners either keep it to themselves or actually don’t keep track themselves — there will not be anybody. Pity help that business!
Secondly, there will be employees — probably those bright ones who keep leaving — who have their eyes open and see many of the things discussed above that the outsiders see. Finally, there will be employees who are oblivious. No, they won’t all be the turn-ups I also mentioned. Some will simply be dedicated workers, who always believe the best, and keep on giving their best, not realizing a significant step-change is required (from everybody).
Sadly, if the bright young things have all flown the nest, and those in the know (if any) are inactive, the business will slide, gently at first, down the slippery slope until it gets to the point of no return.
So, what should those in the know — or who should be in the know — be looking for? Well, they need to ensure the financial record-keeping it up to date at all times. Then they need to read and understand the financial statements on a regular basis. By that, I mean monthly. At the same time, they should be reviewing the business’ KPIs (*).
(*) If they don’t understand the financial statements and KPIs they can do one of my courses. This knowledge alone could save them $000’s, let alone help them make even more. Compared to this the courses are cheap to access.
Remember, as B. C. Forbes put it:
When reviewing the financial statements and KPIs what should they focus on? Let’s break it down by statement, then the KPIs.
Balance Sheet (= Statement of Financial Position)
First, let me emphasize the name in brackets. Assuming accuracy, that’s exactly what this statement should show — the position of the business. There are standard financial KPIs that will make abundantly clear whether that position is a good one.
As far as the detail on the statement, it all depends on how detailed the Balance Sheet is — and they should be looking at the detailed version. If the business is in strife, you would expect to see a combination of any or all of the following:
- Declining cash (/increasing overdraft),
- Lower accounts receivable — not because debtors are paying better, but because sales are lower,
- Increasing inventory (due to declining sales not being met by decreases in purchasing),
- Increased accounts payable (due to limited cash making paying bills difficult),
- Increasing loans (including shareholder loans — to prop up the business), or a decrease in the speed of loan reduction,
- Declining equity — as losses eat up accumulated profits.
Questions that can be asked if (some of) these are observed include:
- Can existing loan facilities be rearranged in some way, to take some pressure off?
- Can any inventory be returned?
- Can the inventory purchasing system be fine-tuned, so stock is purchased only as need (this may need some supplier co-operation)?
- Would it be possible to run a sale to clear stock?
- Can existing debtors be encouraged to pay more quickly?
- Do the terms of trade need reworking to ensure prompter payment, and reinforcement is more clearly spelled out?
- Can an arrangement be made with key suppliers?
- Can any unneeded capital items be returned or sold?
All the above is not to say that the Balance Sheet is the only statement you should be looking at. The Income Statement (= Statement of Financial Performance) will also have a fairly clear story to tell, as will the Cash Flow Statement (= Statement of Cash Flows). In that light, Robert Kiyosaki is quoted as saying:
Income Statement (= Statement of Financial Performance)
Once again, the name in brackets is significant. This statement truly does show how the business is performing. There are also a number of standard financial KPIs that relate to this statement that will also reveal what’s going on. In this statement, with these KPIs, and in the other statements and KPIs, it’s the pattern that must be looked for. For example:
- Declining gross margin. This raises a number of questions, including:
- Can this be traced to individual products/services or categories thereof?
- Can this be resolved, or should they be dropped?
- When was the last price increase made?
- Is it time for another?
- Can the products be sourced more cheaply?
- Can an alternative, cheaper product replace them?
- Can services be performed more efficiently?
- Declining net margin. Subject to the above points, some other questions can be asked:
- Are particular expenses tracking up? Why, and what can be done about it?
- If premises costs are unsustainable, can they be renegotiated? Or should the business move premises?
- Are marketing costs being spent effectively? (Is this effectiveness even being measured?) What can be changed to make it more effective?
- If sales commissions are being paid, are they linked to margins achieved? (I.e. they should not be linked to orders taken, nor even sales — which may or may not be paid for.)
Cash Flow Statement (Statement of Cash Flows)
I’m going to cut to the chase here — is cash flowing out or in? Our earlier discussion questions impact all the parts of this statement — operating, investing, and financing.
Remember, as Eliyahu Goldratt said:
In short, he said, the goal of a business is to make (continuously more) money. I’ve written elsewhere (https://beanstalkknowhow.com/blog/the-truly-profitable-business/) about how the reason behind this — to achieve (continuously more) social good — is important.
Key Performance Indicators (KPIs)
There are many of these, some financial and some not. The non-financial KPIs will still have financial consequences. Here are just some examples:
- Foot traffic — the number of visitors to the shop. This is useful when compared to sales over the same period — giving an average spend per visitor.
- Average sales amount per transaction. In the above example, this uses the same sales figure but divides it by the number of sales transactions. (After all, not everyone who visited will have made a purchase.)
- Average sales per salesperson. This helps show who the more successful salespeople are. Their skills can then be harnessed in training others (assuming they’re not just hogging the till).
- The average margin achieved per product, per product category, and by product supplier.
- Work in Progress — the value of stock sitting on the factory floor in various states of manufacture. The reality is that the value should only be the value that the machine or process it is sitting next to can process over a set period (e.g. the next day or week, depending on the constraints within the system). In a service business, this will be based on the number of hours spent on a job that has not been billed.
- The number of products produced/services delivered in a period.
- The number and value of orders in the business pipeline.
- The number of quotes prepared in a time frame. This can then be coupled over time with the number of quotes accepted in a period to establish the average quote acceptance rate. This, too, can be devolved down to a per salesperson ration. Once again, high achievers can give tips to others.
There are many financial KPIs for which a pattern should be monitored. These include the following:
- Sales Growth = Total Sales this period ÷ Total Sales last period. This measures the increase in Sales from over the previous period.
- Gross Margin — as discussed this is Gross Profit ÷ Sales as a percentage. Over time a business would want this ratio to be improving, or at least stable. Different industries will have different ‘norms’ for this ratio. For example, a supermarket would have a much lower margin than a corner store.
- Burn Rate — Operating costs per week / month / year. This is a good guide for what minimum gross margin must be achieved per period.
- Operating Costs (a.k.a. Opex) to Sales = Operating Costs ÷ Sales as a percentage. The lower this ratio is, the better — of course!
- Net Margin — as discussed this is Net Profit ÷ Sales as a percentage. This is sometimes called the Operating Profit Margin.
- Working Capital — simply, this is Current Assets less Current Liabilities.
- Current Ratio = Current Assets ÷ Current Liabilities. Needless to say, you want the resulting number to be greater than 1.
- Quick Ratio (sometimes called the Acid or Acid Test Ratio) — this is a refined version of the above ratio, and is calculated as (Cash at bank + Accounts Receivable + Short-Term Investments) ÷ Current Liabilities. A result less than 1 means the business cannot pay its bills. Ideally, this should be in the 1.5 to 3 range.
- Cash Ratio — this is the most conservative of the Liquidity Ratios (which include the two ratios above), and is calculated as Cash ÷ Current Liabilities.
- Return on Equity = Net Profit After Tax ÷ Total Equity. This is an indication of the return on the investment of the owner(s).
- Return on Assets — similar to the above, this is Net Profit After Tax ÷ Total Assets.
- Debt to Equity Ratio = Total Liabilities ÷ Total Equity. Where this is high, it reflects that growth is being funded by borrowing.
- Account Payable Turnover = (Purchases + Expenses) ÷ the average of Accounts Payable over the period (*). The result is the number of days it takes for Accounts Payable to be paid by the business.
- Accounts Receivable Turnover — similar to the above, this is Sales ÷ the average of Accounts Receivable over the period (*). This result is also the number of days — this time the number of days it takes for Accounts Receivable to pay the business.
- Stock Turn = Cost of Goods Sold ÷ Average Stock for the period (*). Once again, the result of this ratio is a number of days — the number of days of stock held. The lower this is, the less cash is tied up in stock.
(*) Simply, this is (the opening balance + the closing balance) ÷ 2.
As I’m sure you can see it is important we measure all pertinent activities so that adverse patterns can be stopped and favorable patterns enhanced/replicated. I’ll give the final word to Peter Drucker:
This post was first published at www.beanstalkknowhow.com on 14 August 2019.