Business Performance Assessment
If you are in a business for profit here is your challenge:
Marshall the resources to create a solution for market needs. Market your solution/product and sell it at a price that delivers reasonable profit. Do it every day!
External factors make this challenge doubly difficult. The deepest recession in eighty years, rapidly expanding technology, advancing social and fundamental economic change to name a few. Consolidation of competitors to form a larger and more efficient unit, consolidation of clients who demand higher service levels at static prices, low pricing by competitors who are more efficient or willing to accept lower margin, new products that disrupt markets to name a few more.
How are you and your business holding up? Let’s look at some tools that can help you answer that question for yourself.
Here are some useful metrics. Your financial statements are historic documents. They are useful for managing your business only when you relate specific line items to create an operational assessment ratio.
These are the tools a lender or investor will use to evaluate your business performance:
- Current Ratio: Current Assets/Current Liabilities
Accounts Receivable, Inventories, Cash and Cash Equivalents/Everything you have to pay in one year. Ideal is 2
- Quick Ratio: Current Assets – inventories /current liabilities
Current AR and Cash/Trade Payables. The optimal ratio is 1 (a one to one relationship).
- Inventory Turnover: Cost of Goods Sold/Average Inventory Value
This number should be as high as you can make it. If you only make product or service only for orders it will be high. If you have to have product in inventory to get an order it will be low. Inventory traps a certain amount of working capital. In general if you are not turning inventory six or more times per year, look for ways to increase turns.
• Drop shipping programs to push inventory back to suppliers.
• Elimination of manufacturing bottlenecks to reduce inventory slush pools.
• Elimination of slow moving items from inventory programs to reduce capital requirements.
• Reduction of SKUs offered as inventoried items.
• Buy from distribution sources instead of manufactures to reduce inventory cost.
With current changes in the economy some business models previously carrying large inventories will no longer work. An example is the polished stone business. In the USA much of the product comes from Europe, the mid East and the Orient. With prevailing exchange rates and easy credit offshore suppliers were willing to fund broadly extended terms. This led distributors to load up on product and carry high payables. They trained the customer to be very discriminating which required broad choice from inventory and immediate delivery.
In today’s credit climate the numbers just don’t work in this country or other developed economies. Ultimately the consumer will have less choice in the market place. Distributors who cannot deal with change will disappear.
- Receivables Turnover: Net sales for the month/Receivables. If the ratio is 1 you are collecting at the same rate you are shipping. That’s optimal. If not you will want to work on collections or payment terms
- Average Collection Period: (days sales outstanding)
Accounts receivable/net sales (year)/365. Manage this to equal your terms. Example net 30 terms that work would result in day’s sales outstanding of 30. If it is higher you may want to work on collections.
- Payables Turnover: Cost of sales (year)/trade payables. This ratio provides information on how effectively you are using credit and paying bills. Increasing payable aging within a reasonable range will provide additional working capital (owned by your suppliers). Clearly if you get it too far out your quick ratio will be adversely effected.
- Debt/Equity Ratio: Total liabilities/total assets. This ratio indicates the overall solvency of your business. Higher debt than equity is what is known as “upside down”. This is never good. In new businesses with high potential growth and profit rates may legitimately be upside down with high debt for a defined startup period. Ultimately all businesses need to attain positive equity.
- Gross Margin Percentage: Gross Profit/total sales. You may have intended to price for a specific gross margin. This ratio will assess whether you were successful over the long term or if you did failed to accurately estimate total costs. In today’s competitive environment overestimating cost in the pricing equation may be just as problematic as underestimating it.
- Net Return on Sales: Net Profit/total sales
Net profit is only significant when related to the sales number. Most businesses that make and market products target a 20% net profit number and achieve 5% to 10%. Pure service businesses should be able to achieve 20% or more.
Net profit is what fuels investment in growth, pays dividends, makes businesses worth money in a sale of stock or assets.
- Earnings Before Interest, Taxes, Depreciation and Amortization: EBITDA. This is the true and most universal measure of business value. It defines the ability of the business to create value for investors. Virtually all business sales both stock and assets are based on EBITDA. Strategic buyers (those who can benefit beyond actual current profit due to product or service synergies) will pay multiples of EBITDA when they grow by acquisition. Multiples from 3-5 times for conventional companies and 10-15 times for service and high tech companies are common.
Let’s move on to performance factors that are softer measures and even more challenging.
To have a team of investors, managers, workers, clients and suppliers that is happy and works together each fulfilling their purpose requires attention to additional business performance fundamentals.
People Factors (Relationship Equity)
• Provide strong value and service to clients.
This is never static due to the advance of technology and competitive pressures. Also the requirements of clients change calling for changes in your product or service offer.
• Provide regular and significant dividends on shareholder investment.
There is always an opportunity cost of money even if it is your own. It is your responsibility to create a business proposition that delivers a fair return on invested money.
• Operate fairly with suppliers.
Be tough but fair. Be honest and demanding. Pay enough to allow suppliers to make a reasonable profit even when you have the leverage to force prices down. Once the tide turns you will be glad you were fair to them.
• Harness both skill and passion of key people.
Highly skilled and experienced people who serve your business want to feel a degree of autonomy. They want to increase their mastery and they want meaning in their work. If you provide that you will get their passion as well as their skill.
• Offer people who do the work meaningful tasks, respect, good working conditions and fair compensation and benefits.
If your business is not succeeding here it will manifest in adversarial positioning. Get to the source of any such problems and create a fair solution. I believe a little extra cost of labor or fringes rewards you with a happy work force works best overall.
There are businesses that I define as “Organic Businesses”. Organic businesses posses characteristics that cause them to survive and even prosper despite management mistakes, client losses and difficult economies. Building these factors into your business will help you perform better and look better than you may be!
Sustainable Competitive Advantage:
These are the reasons your clients buy from you and your company. Unless you do the research to discover what these are your guess is most likely wrong. I recommend you read Creating Competitive Advantage by Jaynie L. Smith. Smith describes how to discover your real competitive advantage and claim it in your marketing and selling efforts. Competitive advantages are worth money.
Market Force Driver:
There are certain market driven forces beyond the control of industry that arise from emerging needs and result in greater available revenue and profit. Examples are:
Needs to build/consume green
Requirements for extra sustainability/durability that favor your business
legislation or requirement for certification that you provide
Technology changes where you are at the advantage
Find a market force driver, position your business to serve it and increase your opportunity for success.
Culture trumps virtually any other single factor. A prevailing positive attitude that results in Can Do, Make it Happen, Beyond Expectations, A Team traditions gets things done that are otherwise impossible. This factor causes deadlines to be met, budgets to be met and customer expectations to be exceeded.
Great culture develops where everyone is expected to pull their weight, where accountability is valued and teamwork reigns.
When the business scale is optimal the organization is powerful and wins more easily. Revenue and gross margin affords the required staff, capital equipment, production facilities, technology and training to meet client needs.
Life cycle of product or service: Change is accelerating product life cycles are shorter as a result. Where are you on the life cycle curve? Can you produce the next generation of product first? Will you be the winner with a disruptive technology or will you be the victim?
Product Positioning: Do you have definitive positioning as cost leader, best of class, most innovative? Companies with established positioning may be better positioned to maintain their niche then grow in another.
The final and perhaps the most important performance factor:
The single most important thing you can do is retain customers after you get them. It costs up to six times as much to acquire a new customer than to retain a current customer. Create a metric and measure customer retention. This is the percentage of customers recurring from period to period. Customer purchases recur at varying rates in different businesses. For new car dealerships customers may buy new cars in three to five years. For a book store the customer may buy every month.
Customers leave or stay for a variety of reasons. They include customer service, product quality, merchandising, company image and product acceptance.
Statistics indicate that customers are more profitable and have stronger relationships with businesses as the relationship becomes longer. Determine why customers leave and fix the reasons so that they can stay.
You already have an exit strategy. It may be well planned. If not your strategy is liquidation at an inopportune time. I hope it either sale to an individual or a group at a time you are ready or sale to a strategic buyer intentionally selected or one who selected you. These are intentional strategies. They do not happen accidentally or in a vacuum.
Either of these desirable and intentional strategies requires that you plan and act for the time when the business no longer needs you to operate. That takes years of training a new CEO/Owner and development of a support team. Sale to a family member or key employee invariably requires that you carry financing. Earnings from the business pay you out over time. You assume the risk that the new operator will fail. The best of all options is sale to a strategic buyer at a strong multiple of EBITDA. This option requires that no more than 15% of the business depend on a single client. The buyer will want someone other than you to be responsible for sales. Preferably, several sales people would share this responsibility. They will want a strong operational executive in place. They won’t write the check unless they believe the company can produce strong net profit into the future. All of these things require that you pay close attention to performance factors years in advance and develop the business to show great metrics.