Everything that we have talked about in the previous 4 posts will come together in this one. We have to ask the fundamental question about our financial results; what do they mean? There are three ways that we can look at the results. First, we can look at them in a vacuum, without regard to trends or comparisons. In doing so, we can only answer the simplest of questions. Did the organization make money? Do they have sufficient assets to fund future activities? Do they owe more than they own? It is difficult to go beyond a simple analysis without looking at trends and comparisons.
The first thing that I have to do in order to analyze an organization’s performance is to rationalize the results so that we can compare them to prior results or other organizations. Specifically, we need to take size out of the picture. We do this by restating our financial statements as a percentage of revenues for all of the Income Statement items and the resources needed to support each dollar of revenue for all of the Balance Sheet items. We did this in the last lesson, but I wanted to reinforce the point here. I like to look at both the trend and the comparison at the same time for each metric. I think it gives me the best perspective. That’s how I’ll cover things here as well. I am going to cover one financial ratio for each bucket that we have looked at so far, going over the ratio, its calculation, some characteristics and some thoughts on discussing each metric.
Revenue Growth
Formula:
Revenue Growth % = (Current Rev– Prior Rev ) / Prior Revenue
Characteristics:
- Revenue growth % shows us the growth in revenue from the prior year.
- Usually bigger is better.
- Watch for unusual growth due to business combinations or mergers.
- Watch for negative cash flow caused by working capital trends being negative or very poor. (More on this one later)
Things to Consider:
- Is growth keeping pace with prior years?
- Is revenue growth able to maintain market share in comparison to other organizations?
Operating Profit Margin
Formula:
Operating Profit Margin = (Revenue – Cost of Operations) / Revenue
Characteristics:
- Operating Profit Margin or “Profitability” shows us the % of Revenue that is left after operations.
- Cost of Operations usually includes Cost of Goods Sold, Selling, General and Administrative expenses, R&D etc. Usually all costs associated with running the business are included except for taxes, interest, and special items.
- Positive is always best. A negative profitability % is an indication that the Company is losing money.
Things to Consider:
- We mainly focus on whether or not costs are direct or indirect. It is also important to consider whether or not they are fixed or variable. High fixed costs can be a sign of inflexibility. Exceptionally high variable costs may make it difficult to realize any economies of scale.
- If you are working with operating margins that fluctuate just above or below zero, you may want to switch to Operating Costs as a percentage of revenues for any trend comparisons, it will give you a truer picture.
- Also known as “Operating Income”, “Profit Margin”, “Profitability”, “Operating Income”, “Operating Income Margin” or “Operating Margin”
Cost of Goods Sold (COGS)
Formula:
Cost of Goods Sold % = Cost of Goods Sold / Revenue
Characteristics:
- This metric tells us what % of each dollar of revenue it takes to produce the product or service.
- Cost of Goods Sold includes things like raw material costs, labor, heat, light and power to run the plant and certain indirect costs like plant supervision and the cost to purchase the materials.
- Be aware that each company may not classify costs exactly as indicated above and that there may be differences in classification between companies in your comparative group. Most times if there is an obvious difference in classification in COGS the other metric being impacted will be Selling General and Administrative (SG&A) expenses.
Things to Consider:
- Watch out for companies that continue to adjust their accounting model towards and away from activity based costing. They could be trying to muddy the waters by moving expenses from one pocket to another. In the end, they own all of the pockets.
- When this occurs, look to the “Operating Profit Margin” instead.
- The inverse of this metric is widely known as “Gross Margin”
Selling, General, and Administrative Expenses (SGA)
Formula:
Selling General and Administrative Expenses % = Selling General and Administrative Expenses / Revenue
Characteristics:
- This metric tells us what % of each dollar of revenue it takes to cover SG&A expenses. Usually lower is better.
- SG&A consists of general expenses like office expenses and payroll, sales and marketing costs etc.
- Be aware that each company may not classify costs exactly as indicated above and that there may be differences in classification between companies in your comparative group. Most times if there is an obvious difference in classification in SG&A the other metric being impacted will be Costs of Goods Sold (COGS).
Things to Consider:
- Watch out for companies that continue to adjust their accounting model towards and away from activity based costing. They could be trying to muddy the waters by moving expenses from one pocket to another. In the end, they own all of the pockets.
- When this occurs, look to the “Operating Profit Margin” instead.
Liquidity Ratio and The Cash Conversion Cycle (CCC)
Formula:
Liquidity Ratio = (Cash + Collections) / Accounts Payable
Cash Conversion Cycle = Days in Inventory + Days Sales Outstanding – Days Payable Outstanding
Characteristics:
- In the treasury and cash management world, people will refer to a “Liquidity Ratio” which is a measure of a company’s ability to pay its debts.
- For the CCC, lower is better because more of the organization’s cash requirements for AR and Inventory are being financed through AP.
- The CCC ratio indicates how many days of working capital must be financed either with cash or debt.
Things to Consider:
- Watch out for negative trends here, they can quickly put a company out-of-business
- Understand the difference between a negative trend (The CCC is getting bigger) and a negative CCC (the organization is producing working capital and not consuming it).
Days Sales Outstanding (DSO)
Formula:
Days Sales Outstanding (DSO) = Accounts Receivables / (Revenue/365)
Characteristics:
- Usually lower is better – be careful to understand the peculiarities of the industry you are working in.
- Watch for large sales at year end which will impact the metric.
- Watch for the granting of extended credit terms which will have an impact.
Things to Consider:
- Comparisons are very important here because customers within specific industries tend to pay along similar patterns. If this metric is out of sync when compared to peers, it might be a good place to start
- DSO is restricted to non-interest bearing items and therefore does not include any financing or credit card businesses
Days in Inventory (DII)
Formula:
Days in Inventory (DII) = Inventory / (Cost of Goods Sold/365)
Characteristics:
- This Metric tells you how many days of inventory the company is holding at the end of the period.
- Usually lower is better. Be careful not to go too low and cause out of stock issues.
- Watch for major purchases of inventory at period end.
- Watch for cyclical businesses whose inventory will fluctuate at different times.
- Some people prefer inventory turns – Just divide 365 by your DII to get turns
Things to Consider:
- Good inventory control requires a balancing act that involves accurate forecasting, scheduling and execution, along with low allowances for spoilage, quality issues, and theft.
- Too much inventory is costly to maintain while too little inventory can result in unsatisfied demand.
Fixed Asset Utilization (FA)
Formula:
Fixed Asset Utilization $ = Net Fixed Assets / Revenue
Characteristics:
- Usually lower is better – that means they have less money spent on fixed assets.
- Fixed assets consist of things like plant, equipment, motor vehicles, computers etc.
- Be careful of companies who lease their facilities and equipment.
- Be careful of companies who outsource much of their production.
- Some companies require a much larger investment in fixed assets.
Things to Consider:
- Investing in fixed assets is usually an investment in the future and the value of the investment will depreciate over time (this is a good thing).
- As investments depreciate, the return on the investment increases
- Watch for companies that may be at the beginning of an investment that they are still expecting returns from
- Also watch for companies that are showing a great return but have not invested in the future and are therefore not prepared to react to market opportunities.
Days Payables Outstanding (DPO)
Formula:
Days Payable Outstanding = Accounts Payables / ((cost of operations – depreciation) / 365)
Characteristics:
- Potential difficulties matching receipts with Purchase Orders.
- Invoice payments to vendors may not be timely- resulting in missed discounts and/or late fees.
- Possible poor visibility of third party logistics activity for inbound consigned or VMI inventory locations.
- Receivers may not be easily matched to supplier invoices
Things to Consider:
- For most organizations, this metric is set by either policy or circumstance and there is usually not much that can be affected by process change or technology.
- The impact of improving the payables process is usually felt in SGA.
Equity and Total Value Created (TVC)
Formula:
Equity $ = Total Equity / Revenue
Total Value Created (TVC) = Net Operating Profit – Capital Charge
Characteristics:
- The Capital Charge represents a fair return to creditors and investors
- Any positive number is good, value for the owner/investors is being created
- Any negative number is not good and indicates that value is being destroyed
- The TVC trend can tell us a lot about the direction that a company is heading
Things to Consider:
- Equity refers to the portion of our assets that are not financed by our suppliers or creditors. It includes money invested in the business as well as any retained earnings from operations that have been kept in the business. As equity is mostly concerned with ownership and what belongs to them, the primary equity ratios are geared towards potential and current investors.
- When we look at overall performance, we try to combine both the performance and the position. We do this by taking an additional charge on the income statement for the condition of the balance sheet. A company that has a lot of equity or too much debt will be carrying a high capital charge. A leaner company with less debt and fewer investments will carry a smaller capital charge.
Summary
So now how do you find the opportunities hidden in the numbers? That’s a very good question. Opportunities are found where a company is performing differently than their peers or where a company’s trend is in a different direction than we would expect. When I find a difference that is destroying stakeholder value, I know that I have found the place to start asking questions. At Stratascope, we use a bubble chart to put all of the ratios side by side so it is easy look for the low hanging fruit. The lower the bubble is, the more room there is for improvement, the larger the bubble is, the more value there is in addressing the opportunity. See the image below:
Performance Comparison Bubble Chart
It is important to note that while I use the terms “value” and “opportunity” and “improvement” with you, it is highly inappropriate to express our assumptions this way to our prospect. Great! So how do you use this stuff? … It’s all in the wording. Instead of saying “You appear to have a significant opportunity to lower your costs.” – Which, even though it is better than “You have a Cost of Goods Sold problem” it is not as good as “I can see that you are managing your direct costs differently than some of your competitors. Can you share your perspective on the situation?” This way, we are not assuming there is a problem, we are observing a fact and soliciting an opinion. This can be powerful stuff in a sales conversation that can lead to a serious amount of insight being disclosed by your prospect. Use it carefully and you will be rewarded!
In my next post, I will show you how we can adapt our model to meet the needs of other specific industry types so that we can analyze and speak to the performance of any organization with which we are dealing.
-Bruce A. Brien, CEO, Stratascope Inc.
