Many managers believe that because a capital expenditure is initially recorded on the balance sheet and the expense can be spread over a number of years that there is only an incidental effect on the profitability of the company – a kind of corporate “freebie.” This is true enough when taken as a single event, but over time the cumulative effect of acquired assets can create a very large expense that has to be managed (and explained) for many years to come as a damper on profitability.
The profitability of the company has a direct affect on the perception held by banks, leasing companies, trade vendors and potential investors regarding the relative risk and/or value placed on the business. This perception, in many cases, will determine your ability to maintain existing financing arrangements or to secure additional funding for the operation going forward. Be very certain the investments you make are necessary and the return is sufficient. You will live with the results for a very long time.
Friday, November 12, 2010
Monday, August 9, 2010
Scaling the Profit Mentality
As the size of the company increases so does the level of resources made available for developing extensive complex systems and procedures used to “manage” all areas of the business. In large companies there are operating divisions which have multiple departments and many functional areas within departments. There are often teams with cross-functional members to address nearly every issue that arises. And there are a lot of people to do the things that need to be done. This is all good and, in most cases, completely necessary.
However, the larger the company, the more levels of management there are and the further the operating staff is removed from the development of the financial model that will determine the company’s future. There is distance between the direct detailed knowledge of the requirements and the ultimate execution of the activities that most often impact the outcome to the greatest degree. This distance dilutes the message which then blurs the intent of the directive. The basic assumptions are that there is a certain dilution that occurs as a message is communicated through the various levels of the organization and additional dilution that occurs as it is translated across non-finance functional lines. There are an infinite number of factors that may determine the degree to which the dilution actually takes place from person to person.
Without a fundamental understanding of the overall objective (which should be making a profit) and an instinctive ability to make the right financial decision at the right time in order to hit the targets, the actual outcome can quite often be very different from the desired outcome. The development of a “Profit Mentality” across the entire organization will ensure that every decision is undertaken with a common purpose in mind: the true profitability of the company.
Take your company to the next level of profitability. Visit The Profit Experts to find out more.
However, the larger the company, the more levels of management there are and the further the operating staff is removed from the development of the financial model that will determine the company’s future. There is distance between the direct detailed knowledge of the requirements and the ultimate execution of the activities that most often impact the outcome to the greatest degree. This distance dilutes the message which then blurs the intent of the directive. The basic assumptions are that there is a certain dilution that occurs as a message is communicated through the various levels of the organization and additional dilution that occurs as it is translated across non-finance functional lines. There are an infinite number of factors that may determine the degree to which the dilution actually takes place from person to person.
Without a fundamental understanding of the overall objective (which should be making a profit) and an instinctive ability to make the right financial decision at the right time in order to hit the targets, the actual outcome can quite often be very different from the desired outcome. The development of a “Profit Mentality” across the entire organization will ensure that every decision is undertaken with a common purpose in mind: the true profitability of the company.
Take your company to the next level of profitability. Visit The Profit Experts to find out more.
Wednesday, May 5, 2010
Using Payback Period to Evaluate Purchases
A fairly simple and straightforward concept for evaluating the wisdom of a purchase is to determine the payback period. The payback period, defined as the time required to recover the initial cash outlay for an item or project, is calculated by determining the hard dollar value that will be realized each month from acquiring the asset then dividing the total purchase price of the item by that number.
For example, let’s assume you are considering the purchase of an asset that will return $100 per month in reduced expenses (or possibly increased gross margin) through more efficient operations. If the purchase price for that item is $1,000 the payback period is 10 months (.83 years). However, if the price is $10,000 the payback period is 100 months (8.3 years). Considering the fact they each return $100 per month of benefit, which item would you buy? There are situations when making multiple purchases over time of lower cost items that have a shorter useful life will be a more effective use of cash than the purchase one higher cost item that will last for many years. You should do the math to determine the payback to make the appropriate decision.
Although the payback period calculation can be complicated by inducing an untold number of complex variables such as inconsistent returns year over year, discounted cash flow considerations, lease vs. purchase options, etc., the very simple approach presented above is as effective in nearly every case. The more sophisticated the formula, the more opportunity there is for incorrectly determining the assumptions that influence the outcome.
For example, let’s assume you are considering the purchase of an asset that will return $100 per month in reduced expenses (or possibly increased gross margin) through more efficient operations. If the purchase price for that item is $1,000 the payback period is 10 months (.83 years). However, if the price is $10,000 the payback period is 100 months (8.3 years). Considering the fact they each return $100 per month of benefit, which item would you buy? There are situations when making multiple purchases over time of lower cost items that have a shorter useful life will be a more effective use of cash than the purchase one higher cost item that will last for many years. You should do the math to determine the payback to make the appropriate decision.
Although the payback period calculation can be complicated by inducing an untold number of complex variables such as inconsistent returns year over year, discounted cash flow considerations, lease vs. purchase options, etc., the very simple approach presented above is as effective in nearly every case. The more sophisticated the formula, the more opportunity there is for incorrectly determining the assumptions that influence the outcome.
Friday, February 26, 2010
Back to Basics: Inventory Management
Inventory is the amount of goods kept in stock for use in producing the company’s revenue. These are items that are either consumed during the activity that is undertaken for the sole purpose of making the company’s products available or they are items that are directly incorporated into the products produced. There are four primary types of inventory.
Inventory management will have a direct impact on the profitability of your company. It can be either a positive impact or a negative impact, but it will have an impact. The answer to effective inventory management is a well-organized system of planning and control that is consistently followed. The level of sophistication is not the overriding issue; it is the continuous effort of monitoring the process and executing in accordance with the established management guidelines that will make the effort a success. A haphazard approach to inventory management is certain to result in a long list of unwanted surprises. Through the affect on profits, these surprises can dramatically change your expectation for cash flow. If the magnitude of the change is significant enough, the result can be devastating to the business.
The technical aspects of accounting for inventory management can be extremely complicated and require years of formal training to handle properly. Although the effect of these different accounting procedures on profitability can be quite significant, it is also relatively short-term in nature. Over time, the end result is basically the same. Your ability to manage inventory for maximum profitability is not predicated on understanding the details of these technical issues, that’s why there are accountants in the world.
The issues that drive true profitability and therefore cash flow (ignoring the accounting stuff) are more operational in nature. These are associated with the efficient and effective use of the inventory sitting on the shelf. The kinds of items that might be included in inventory for any particular company will vary widely and could possibly require different methods and techniques for managing each type. However, the ability to anticipate the correct purchase volumes to be ordered at the right time and to effectively distribute and make use of the various items are the keys to success.
- Finished goods – completed products that are ready for sale to the customer.
- Work-in-process – products in semi-finished form that require additional material and/or more labor before becoming finished goods.
- Raw materials – items on which no labor has been expended that are to be incorporated into finished goods before completion.
- Indirect materials – materials and supplies that aid in the production of finished goods but which do not become part of the finished product. In service or other similar companies where there is no finished goods inventory, these may also be supply type items that are used specifically and directly in the provision of services.
Inventory management will have a direct impact on the profitability of your company. It can be either a positive impact or a negative impact, but it will have an impact. The answer to effective inventory management is a well-organized system of planning and control that is consistently followed. The level of sophistication is not the overriding issue; it is the continuous effort of monitoring the process and executing in accordance with the established management guidelines that will make the effort a success. A haphazard approach to inventory management is certain to result in a long list of unwanted surprises. Through the affect on profits, these surprises can dramatically change your expectation for cash flow. If the magnitude of the change is significant enough, the result can be devastating to the business.
The technical aspects of accounting for inventory management can be extremely complicated and require years of formal training to handle properly. Although the effect of these different accounting procedures on profitability can be quite significant, it is also relatively short-term in nature. Over time, the end result is basically the same. Your ability to manage inventory for maximum profitability is not predicated on understanding the details of these technical issues, that’s why there are accountants in the world.
The issues that drive true profitability and therefore cash flow (ignoring the accounting stuff) are more operational in nature. These are associated with the efficient and effective use of the inventory sitting on the shelf. The kinds of items that might be included in inventory for any particular company will vary widely and could possibly require different methods and techniques for managing each type. However, the ability to anticipate the correct purchase volumes to be ordered at the right time and to effectively distribute and make use of the various items are the keys to success.
Monday, November 2, 2009
On Raising Equity Capital
It is true that some companies will be able to fund operations from internal cash flow and will never need more than the occasional loan to achieve the objectives of their shareholders. However, this is the exception and usually only applies to companies where a relatively slow and methodical growth or a sustained level of performance is sufficient to meet the needs of the owners and management. In the vast majority of growing companies there will be the need to strike a balance in the capital structure between debt and equity at different times during the company’s life cycle.
Once it has been determined that additional capital will be needed to fund the company’s development and that equity is the appropriate form of funding – it is important to take it when you can get it. Certainly negotiate the best possible terms, but do not be unrealistic about your “promising future.” Do not fall into the trap of “if we can raise it now, we can always raise it later and probably on better terms.” Although it is certainly a possibility and you should always explore every opportunity to find the best alternative, there are no guarantees it will happen that way.
In fact, the principals of many very promising companies have been reluctant to take equity capital because it was thought to be too expensive. The owners/shareholders did not want to be diluted and the belief was that there would always be other opportunities to raise capital at the future date of their choosing. It was thought that the company could continue to generate sufficient cash to fuel growth or support the current operations until the time they were in a better position to get “a better deal.” This can be a grave mistake. Later when it becomes clear the company cannot generate the needed cash and additional funding is truly vital to the company, the world you live in has changed, the possibility for funding is gone and the company is found wanting without the means to fund growth with disastrous results. More often than not these companies do not survive or at a minimum their growth is impeded and they never achieve their full potential.
Once it has been determined that additional capital will be needed to fund the company’s development and that equity is the appropriate form of funding – it is important to take it when you can get it. Certainly negotiate the best possible terms, but do not be unrealistic about your “promising future.” Do not fall into the trap of “if we can raise it now, we can always raise it later and probably on better terms.” Although it is certainly a possibility and you should always explore every opportunity to find the best alternative, there are no guarantees it will happen that way.
In fact, the principals of many very promising companies have been reluctant to take equity capital because it was thought to be too expensive. The owners/shareholders did not want to be diluted and the belief was that there would always be other opportunities to raise capital at the future date of their choosing. It was thought that the company could continue to generate sufficient cash to fuel growth or support the current operations until the time they were in a better position to get “a better deal.” This can be a grave mistake. Later when it becomes clear the company cannot generate the needed cash and additional funding is truly vital to the company, the world you live in has changed, the possibility for funding is gone and the company is found wanting without the means to fund growth with disastrous results. More often than not these companies do not survive or at a minimum their growth is impeded and they never achieve their full potential.
Thursday, September 17, 2009
Back to Basics: Budgeting Methodologies
There are proponents of a myriad of budget methodologies and there are very legitimate arguments that can be made in support of their diverse opinions.* However, careful consideration should be given to the specific requirements of your organization and the level of resources available to manage the process. The last thing you want to do is establish a complicated and difficult process without the organizational wherewithal to pull it off. The chaos created under that scenario would do much more harm to the company (on many different levels) than any benefit that might be derived from the process.
1. Zero Base budgeting, by definition, requires that each effort begin with a clean slate – at zero dollars. The details for each line item are then built up based on the fundamentals associated with the specific requirements in support of an anticipated level of business. There is no presumption that a service or function will be necessary for continuing operations. Theoretically, any resources believed to be important in support of particular line items must be justified independently for each budget period. Although it is expected that historical data or trends will not directly influence the current budget decisions, there are certain situations where allowances can be made for minimal operating requirements to be considered essential while still requiring the remaining portion of the line item be validated separately.
This approach is often used in governmental budgeting processes since it reduces the entitlement mentality when appropriations are being determined for the allocation of public funds. It forces management for each program to re-justify the level of funding every budget year, and therefore, does not allow any inaccuracies of the past to directly affect the new budget. At a minimum, it would appear to eliminate the “creep” that can occur in an incremental process when proper controls are not in place.
Although this approach is reasonable in the public arena because of the unique requirements of a political environment, it requires a substantial effort in researching and collecting data needed to complete the budget process. The requirement for resources to support this effort seems to be quite onerous for any but the very largest private sector organizations.
2. Activity Based budgeting is founded on the notion that certain cost drivers or major activities exist in any particular operation. A driver could be anything that exists as a major activity in the business of the company (i.e. the processing of an order, a policy or a claim or, the presentation of a customer, a patient or a component for a certain service). All of the costs associated with the specific drivers (direct materials, direct labor, administrative salaries, office expenses, telephone, any associated overhead, etc.) are compiled as a cost per unit of activity for the purpose of presenting the budget in terms of the company’s products or services being delivered at some expected level. Each unit of activity would carry with it a specific and predetermined level of cost.
Depending on the number of individual drivers or the multiple variations resulting from unique characteristics in a specific driver (i.e. customers presenting for several different levels of service), you could have many smaller budgets developed somewhat independently. The compilation of these various budgets would represent the total budget for the organization. Once the information has been compiled, you must make certain that all cost components have been properly accounted for in the total and are representative of the company’s overall operating profile.
3. Incremental budgeting assumes that a valid baseline exists in the line items of the company’s historical financial information. Specific changes in conditions cause each respective line item to increase, decrease or possibly remain flat relative to the prior year(s).
This approach requires a disciplined effort of analysis in order to avoid any unjustified “creep” in the values associated with the prior years’ standards. To make this process effective, each line item must be reviewed with the purpose of validating the underlying factors that make up the overall total. For example, the application of some arbitrary “inflation factor” can grossly distort the results and seriously damage the potential of the organization through the pursuit of an improper target.
Although this method is most likely the least resource intensive to manage, without the proper controls there is the potential to allow errors from prior years to be perpetuated and anomalies in the numbers to be ignored going forward. In order to avoid these problems, careful consideration must be given to the changes in the operating details of the company relative to the expected volume of business when developing the budget.
Only you can decide the most appropriate method for your business given the available resources and specific requirements of the organization. Choose an effort that causes the organization to stretch a little and work to revise (improve) the process incrementally over time. The point is to start at a level that does not cause unmanageable stress in the company. If you persist in improving the process, you will continually reap benefits in the business.
*The Profit Experts can help you sift through the method that works best for your business. Visit us to find out how.
1. Zero Base budgeting, by definition, requires that each effort begin with a clean slate – at zero dollars. The details for each line item are then built up based on the fundamentals associated with the specific requirements in support of an anticipated level of business. There is no presumption that a service or function will be necessary for continuing operations. Theoretically, any resources believed to be important in support of particular line items must be justified independently for each budget period. Although it is expected that historical data or trends will not directly influence the current budget decisions, there are certain situations where allowances can be made for minimal operating requirements to be considered essential while still requiring the remaining portion of the line item be validated separately.
This approach is often used in governmental budgeting processes since it reduces the entitlement mentality when appropriations are being determined for the allocation of public funds. It forces management for each program to re-justify the level of funding every budget year, and therefore, does not allow any inaccuracies of the past to directly affect the new budget. At a minimum, it would appear to eliminate the “creep” that can occur in an incremental process when proper controls are not in place.
Although this approach is reasonable in the public arena because of the unique requirements of a political environment, it requires a substantial effort in researching and collecting data needed to complete the budget process. The requirement for resources to support this effort seems to be quite onerous for any but the very largest private sector organizations.
2. Activity Based budgeting is founded on the notion that certain cost drivers or major activities exist in any particular operation. A driver could be anything that exists as a major activity in the business of the company (i.e. the processing of an order, a policy or a claim or, the presentation of a customer, a patient or a component for a certain service). All of the costs associated with the specific drivers (direct materials, direct labor, administrative salaries, office expenses, telephone, any associated overhead, etc.) are compiled as a cost per unit of activity for the purpose of presenting the budget in terms of the company’s products or services being delivered at some expected level. Each unit of activity would carry with it a specific and predetermined level of cost.
Depending on the number of individual drivers or the multiple variations resulting from unique characteristics in a specific driver (i.e. customers presenting for several different levels of service), you could have many smaller budgets developed somewhat independently. The compilation of these various budgets would represent the total budget for the organization. Once the information has been compiled, you must make certain that all cost components have been properly accounted for in the total and are representative of the company’s overall operating profile.
3. Incremental budgeting assumes that a valid baseline exists in the line items of the company’s historical financial information. Specific changes in conditions cause each respective line item to increase, decrease or possibly remain flat relative to the prior year(s).
This approach requires a disciplined effort of analysis in order to avoid any unjustified “creep” in the values associated with the prior years’ standards. To make this process effective, each line item must be reviewed with the purpose of validating the underlying factors that make up the overall total. For example, the application of some arbitrary “inflation factor” can grossly distort the results and seriously damage the potential of the organization through the pursuit of an improper target.
Although this method is most likely the least resource intensive to manage, without the proper controls there is the potential to allow errors from prior years to be perpetuated and anomalies in the numbers to be ignored going forward. In order to avoid these problems, careful consideration must be given to the changes in the operating details of the company relative to the expected volume of business when developing the budget.
Only you can decide the most appropriate method for your business given the available resources and specific requirements of the organization. Choose an effort that causes the organization to stretch a little and work to revise (improve) the process incrementally over time. The point is to start at a level that does not cause unmanageable stress in the company. If you persist in improving the process, you will continually reap benefits in the business.
*The Profit Experts can help you sift through the method that works best for your business. Visit us to find out how.
Monday, July 6, 2009
When to take out a loan?
I was recently asked by a small business owner when it’s appropriate to take out a loan. This question is more important than it seems on the surface.
The purpose of external financing is to meet the company’s cash needs beyond its ability to generate cash flow internally. Therefore, the first step is to understand your internal cash flow dynamics and how changes in the business will affect the expected cash availability. What cash will you need and when will you need it? Without this information you could very easily take on debt that is unnecessary or put the company in a position where the debt payments are higher than your ability to pay. Either way you ultimately do long-term damage to the company.
Ideally, you should only take on debt to finance an opportunity in the business. Growth opportunities could be through increasing organic revenue, additional product/service lines, sales & marketing initiatives to improve market penetration, acquisition of another business, etc. Cost reduction actions could result from an equipment purchases for operational efficiencies, implementation of certain operating strategies, staff training or upgrades, etc.
However, you must be careful to avoid falling into the trap of believing your own propaganda and “counting your chickens before they hatch” so to speak. Make sure you know how long it will take to reap the benefits of these actions before you pull the trigger. In my experience it always takes twice as long and costs twice as much as originally thought to do anything. Also, given the difficulties in finding a willing lender and the cost associated with business loans, be sure to have sufficient availability (of cash or loan capacity) in place at the outset to accomplish the desired results. Otherwise, you may be short of cash at a critical stage.
If you find yourself borrowing to fund a stable or static business you must quickly understand the reasons for the funding requirement. The only reasons for a cash shortfall in this situation are short-term seasonal or timing issues, an imbalance in your asset allocation or significant profit leaks in the business.
The purpose of external financing is to meet the company’s cash needs beyond its ability to generate cash flow internally. Therefore, the first step is to understand your internal cash flow dynamics and how changes in the business will affect the expected cash availability. What cash will you need and when will you need it? Without this information you could very easily take on debt that is unnecessary or put the company in a position where the debt payments are higher than your ability to pay. Either way you ultimately do long-term damage to the company.
Ideally, you should only take on debt to finance an opportunity in the business. Growth opportunities could be through increasing organic revenue, additional product/service lines, sales & marketing initiatives to improve market penetration, acquisition of another business, etc. Cost reduction actions could result from an equipment purchases for operational efficiencies, implementation of certain operating strategies, staff training or upgrades, etc.
However, you must be careful to avoid falling into the trap of believing your own propaganda and “counting your chickens before they hatch” so to speak. Make sure you know how long it will take to reap the benefits of these actions before you pull the trigger. In my experience it always takes twice as long and costs twice as much as originally thought to do anything. Also, given the difficulties in finding a willing lender and the cost associated with business loans, be sure to have sufficient availability (of cash or loan capacity) in place at the outset to accomplish the desired results. Otherwise, you may be short of cash at a critical stage.
If you find yourself borrowing to fund a stable or static business you must quickly understand the reasons for the funding requirement. The only reasons for a cash shortfall in this situation are short-term seasonal or timing issues, an imbalance in your asset allocation or significant profit leaks in the business.
- If the problem is short-term then make sure you understand the associated dynamics and manage your cash very carefully. This is not the time to spend on unnecessary items. Be sure you can come through the timing issues debt free. Otherwise, there’s something else happening in the business.
- If you find the asset allocation is inappropriate – accounts receivable, inventory, fixed assets are sucking up too much cash – take action to correct the issues as quickly as possible. Depending on the extent of the problem and the market conditions this could take time. Stay focused and diligent. The problems must be corrected for the long-term health of the company.
- If the issue is the result of profit leaks (which always translate into cash problems) you must take action immediately to adjust the business to the current market conditions. Get your expenses in line with revenue until the company’s profits stabilize. Once the company is stable you can then begin to build the business with a careful and balanced approach.
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