Attacking a Profitability Problem

I’m amazed by the myriad of “tips” and “secrets” you can find on the web, lists of things you could do to solve virtually any problem. The experts creating these lists mean well, its good food for thought. But most would also admit that there is no magic, one size fits all, recipe for success, particularly when it comes to solving a profitability problem.

Be it a company with 10 employees or 500, success in attacking a profitability problem is almost totally a function of having an accurate definition of the problem, and coming to that definition is easier said than done. Common pitfalls when doing the needed analysis include: confusing symptoms with the root cause, defensive thinking, and a scope or focus that is either too narrow or too broad.

Moreover, it’s very important that the definition also be actionable. Analysis may have identified the problem as one product, a clear money loser on its own, but dropping that product may risk losing key customers who buy multiple products and prefer to use one supplier to fill all their needs. The problem needs to be redefined so that the solution avoids assuming a high risk of undesirable results, such as creating another profitability problem.

If profitability is a concern, wise CEO’s will invest in the analysis required to come to an accurate and actionable definition of the problem. It is equally wise to consider the value of using an outside expert who can bring a high level of analytical skills to the table, and provide greater assurance of independence and open mindedness in the analytical process.

JCJCo., Inc. provides business and financial consulting services to companies in transition. We tackle financial management challenges commonly caused by high growth, rapid changes in the marketplace, business combinations, employee turnover and other unusual or disruptive events, filling the need for expertise on an interim or outsourced basis.

Financial Modeling and Strategic Planning

FINANCIAL MODELING:
A KEY PART OF THE STRATEGIC PLANNING PROCESS

Most CEO’s have correctly concluded that success requires constant change in what a business does and how it does it, an ongoing and well thought out response to constant changes in the marketplace. Many CEO’s have also come to recognize the benefit of having a strategic plan in place to help identify the timing and nature of changes needed to succeed. And some CEO’s have come to realize, through experience, that a good strategic plan can make the difference in meeting growth objectives, or surviving the storm.

In developing a strategic plan, it is important, if not critical, to make financial modeling a part of the process.

Strategic Planning – Overview:

Developing a strategic plan is a “top down” process, starting with an analysis of how a business “fits” within its marketplace. Once the business’s current position is defined, it is compared to what is seen as an achievable and better position, the new strategic objective, found through an analysis of market risks and opportunities compared to business strengths and weaknesses. The strategic planning process then lays out the steps that need to be taken, a series of sub-objectives, which represent the path to this new spot on the marketplace map, the strategic objective.

There is more than one way to get from point A to point B, and development of the strategic plan is akin to designing a tower out of blocks. It is important to start with a strong foundation, and to carefully choose the what, when and where as new pieces are progressively added, each block filling an identified need. The choice of blocks, and the choice of when and where to add that block, represents the execution strategy.

Last and certainly not least, the strategic plan must be interpreted and tested in a financial forecast, or business model. If expertly created, this model will provide a detailed picture of the strategy, answering questions about feasibility, and defining the expected business value created by any particular strategic plan. And perhaps most importantly, it also becomes a basis for budgeting, and for monitoring performance as you move toward the objective.

Strategic Objective:

The selection of a strategic objective involves two main types of analysis:

• A market assessment – Identify the broader, big picture risks and opportunities that exist in the marketplace given the nature of customers and competition, who and what they are today, but also who and what they may be tomorrow, how the market may change. The key purpose of the assessment is to identify trends in supply, demand, margins and customer preferences, and other market characteristics that represent either a risk or opportunity, things to be taken advantage of, or avoided, through management choice.
• A business assessment – Identify the strengths and weaknesses of the business, the things that make it unique in comparison to others in its marketplace. Unique characteristics can give a business an edge over the competition, a strength to exploit, or can represent a limitation, things that need to be overcome or avoided when choosing the path forward.

The combination of this market and business assessment provides a strategic framework, a map of the terrain, with a pin stuck into the position a business is in today, and another for where it wants to be tomorrow. The location of that second pin should be reasonably achievable, a “best fit” of a particular business in its marketplace given its unique strengths and weaknesses. And the financial returns promised by achieving that position should be commensurate with risks that must be assumed to reach that position. In comparison to the selected objective, any other position in the market would represent either taking more risk without sufficient additional reward, or a reduction in reward without realizing a sufficient reduction in risk.

The marketplace is fluid, and new risks and opportunities will be presented over time. Having created this strategic mapping, a business has a frame of reference, a tool that helps recognize key marketplace changes, and can help determine how its strategy might need to be changed in response to developments in the market. Management’s ability and willingness to “pivot” can be a key determinant of success.

Execution Strategy:

With an objective defined, the strategic planning process must then identify the best means and method to get from point A to point B, the business’s execution strategy. As if constructing a building, the process begins by defining the foundation of the business, and identifying the building blocks that move the business toward its strategic objective. When adding building blocks, choices on timing and positioning can be as important as selecting the block itself. Decisions to add one block before another, or position a block next to one, or on top of another, can determine the stability of the business, and what the business can become.

Every business is made up of a distinct set of functional characteristics, or critical components, including:

• Brand
• Products and/or Services
• Production
• Distribution
• Customers
• Capital

There are many ways for a business to fulfill each of these critical, functional components. And there will likely be more than one combination of components that could create a business with the desired characteristics. In selecting components, the key is to create a total package of operational, marketing and financial strengths that enable management to generate profits, and successfully react to the inevitable changes they will face in their marketplace.

Assembling the targeted components will not happen overnight. The components needed to create a business reflecting the strategic objective are acquired or developed over time. The execution strategy must therefore give each component a relative prioritization in comparison to all other components. And that prioritization will reflect the position of each component in the “design” of the business, and its relative importance in achieving the end objective.

The result is a set of sub-objectives, laid out in a relative order of both importance and timing. And it is this ordering, and the financial characteristics of the ordering, that define the level of risk assumed in the execution strategy. The optimal ordering of sub-objectives will balance the risks assumed against the rewards expected upon achieving each sub-objective, taking into consideration:

• the time and investment needed to acquire or develop each component,
• the likely reaction from customers and competition to “component building” steps taken
• the impact of having one component on being able to acquire or develop another

Financial Model:

Creating a financial model is the last, but no less critical, step in the process of developing a strategic plan. The model is essential to defining the financial implications of the execution strategy, and in particular, how much risk and reward is inherent in plan.

The process of identifying a strategic objective and defining the execution plan is, by definition, based on somewhat general, broad concepts. But the financial modeling exercise is all about details. Assumptions and expectations that led to a choice of an objective and the design of the execution plan are turned into specifically defined revenues and costs, laid out over time.

In combination with these revenue and cost details, the financial forecast also reflects the business component choices made, and the ordering of sub-objectives. The prioritization and time required to achieve each sub-objective is specifically laid out, enabling a calculation of expected growth rates, funding needs and returns on investment, all based on what profits and cash flow the execution strategy is expected to generate. If not for the financial forecast, it would be impossible to see with any specificity how feasible the execution strategy really is, and whether or not the strategy is likely to meet return objectives.

Results from the initial modeling of the execution strategy may lead to a need to make changes in the plan. For example, the plan may call for offering discounted pricing to gain a foothold in a new market. The model may point out that this will lead to operating losses, and an unacceptably low level of liquidity. In light of this knowledge, management may want to defer the new market entry until internally generated capital is available to support the discounted pricing strategy, or it may want to alter tactics, relying on a more aggressive marketing campaign as opposed discounted pricing. The financial model provides a means to very specifically test this kind of change in execution strategy, and identify the best path forward.

Also, results from the initial modeling might show that the strategy does not meet return objectives. For example, the plan may call for heavy investment in plant and equipment at an early stage. In order to fulfil that sub-objective, a sale of equity may be required to meet the funding need. Control of productive capacity may well be key to the strategy, but the financial model may show that pursuing that objective too early would result in an over-dilution of existing investors, reducing returns to below acceptable levels. As an alternative, management may utilize contracted manufacturing facilities to meet production objectives, and alter the pace of investment in its own plant and equipment, using its own profits as opposed to a sale of equity to fund investments in P & E. The financial model can specifically test how such a change would affect growth rates, profitability and investor returns.

The financial model is uniquely suited to defining and testing how the business will meet its funding needs, the capital component of the execution strategy. Capital comes in the form of internally generated funds (profit), debt (with various lender alternatives available) or equity (which can be offered in combination with debt). The cash flows expected from any given execution strategy are specifically laid out in the model, and if the strategy results in insufficient profits to meet capital needs, the business must meet the need by raising debt or selling equity. The financial model provides a means of testing the risk and return impact inherent in using one capital source vs another, including its form and structure.

And lastly, the financial model provides a means of testing resilience of the strategic plan to changes in market conditions. New competition may place pressure on margins, or a weak economy can cause delays in meeting revenue targets. By changing the amount or timing of revenue and profitability assumptions, market changes can be simulated in the financial model to test how “stress resistant” a given strategy may be. A high degree of sensitivity, be it in terms of liquidity or other financial measures that define financial health, suggests a high degree of risk, and a likely need to adjust one or more component of the strategy.

If the financial model is expertly prepared, it can be the most valuable tool in a CEO’s toolbox. It is essential as a means of testing the feasibility management’s plans, how objectives are to be achieved. It is also essential to identifying changes that may need to be made in the plan to eliminate unacceptable risks, and improve returns. And as the business evolves, the model provides a means of monitoring progress and making adjustments to meet performance targets, and the strategic objective.

With a financial model in hand, a CEO has the information needed to make good decisions, pinpoint potential problems, and make changes in what the business does, and how it does it, before it’s too late.

JCJCo provides outsourced CFO and business consulting services to entrepreneurial and high growth companies. We help our clients develop performance metric measurement and management systems that reflect the client’s strategy, and delivers essential information needed by the business owner or CEO to monitor performance, make business adjustments, and meet growth objectives.

What is Permanent Working Capital?

Working capital is a business’s investment in “current assets”, less the capital provided by carrying “current liabilities”. Current assets typically include cash held in operating accounts, inventory and accounts receivable. Current liabilities is the amount payable to trade, plus other short term financial accommodations, such as bank loans.

The amount of working capital fluctuates due to many things. A change in sales volume can cause a change in receivables, and potentially inventory. And a change in production volume, or a change in vendor payment terms, can also cause working capital requirements to fluctuate.

“Permanent” working capital is the normal or “standard” amount of investment in current assets less current liabilities. It assumes a steady, unchanging level of sales and production activity and no changes in terms of trade. With an understanding and quantification of permanent working capital, one can then monitor or project fluctuations around the norm to better manage a business’s cash flow and funding requirements.

If a fluctuation around the norm is a short term phenomenon, it will reverse itself over the short term. And when the reversal occurs, the cash flow and funding effect of the initial change will be reversed. If a fluctuation is permanent, then the cash flow and funding effect will be permanent, it will not reverse itself.

Understanding whether a change in working capital is temporary or permanent is critical to management of cash flow and a business’s funding strategy. Investment in permanent working capital is no different than investment in any other long term asset, like machinery and equipment, and funding for that investment should be long term. But temporary fluctuations in working capital can be safely met with short term debt, or even a temporary change in cash on hand.

The following lays out a sample calculation of permanent working capital. Note that averaging three YE numbers, as is done in this example, is not a good practice. Business activity may have changed significantly in more recent times, and when using only 3 measurements, any one could inappropriately skew the calculation. Twelve month end measures over the last year, or perhaps 18 over the last year and a half, is likely to provide a more reliable calculation.

Also note that, in this hypothetical case, permanent investment in inventory is high compared to industry averages. If this business could reduce its normal inventory, it could achieve a reduction in permanent working capital required, freeing up capital for other purposes.

image for permanent wc

JCJCo provides business and financial strategy consulting services to emerging entrepreneurial and middle market companies, in many cases in the role of “Outsourced CFO”. If your business has evolved to the point where greater financial management expertise is required, JCJCo can fill that need at a cost that is “right sized” for your business.

Joseph C. Jessup
8/30/15

Should You Invest in Performance Metrics?

In the post titled “Common Reasons Not to Use Performance Metrics”, I outlined a few of the justifications used by businesses for not making an investment in developing and monitoring a strategy centric set of performance metrics. I also offered some opposing arguments, suggesting an owner or CEO should question those justifications, especially if business growth is a key objective.

Extreme examples can help put the growth point in perspective, so let’s consider Microsoft and Facebook. Both were once total startups, then small businesses, and now they are anything but small. Granted, each had an unusual growth opportunity by virtue of playing in a new, large and unfulfilled market. But, their evolution was no different than any other company seeking growth. They started with a product that solves a problem, then sold that product to a group of customers. Once established as a small business, they then attacked the hardest part of the growth challenge, business expansion.

The evolution from small business to growing company is very hard to achieve, largely because it requires shifting from being run by a single horse or small leadership group, to a decentralized broad based company. In other words, success in the growth phase of a business’s development is dependent on the business’s ability to develop organizational capacity.

Developing and employing metrics is an integral if not essential part of building organizational capacity. Employing a formalized set of strategy centric performance metrics serves not just to keep leaders informed, but also to communicate what people need to do for the business to succeed. The selected metrics package defines the execution plan imbedded in your business strategy, and is a highly effective means of maintaining focus on that strategy throughout the organization.

What if you’re not Microsoft or Facebook, you don’t play in a new, large and unfulfilled market? Irrespective of business growth prospects, all companies must deal with changes in their external marketplace or internal operations. And the smaller the business, the fewer the moving parts, so adjusting to change can be tantamount to a wholesale change in the business model. Making such a wholesale change can be both difficult and time consuming.

For smaller businesses, if a need to adjust to market or operational change is not recognized early, it can threaten the business’s survival. Perhaps a talented leader or a barebones performance monitoring system focused on revenue or customer satisfaction will recognize problems before they become disasters. But the risk can be reduced by investing in and regularly monitoring a well devised set of strategy centric performance metrics.

So what is a well devised set of performance metrics? As pointed out in my first post on this topic, and as suggested by Robert Kaplan and David Norton in their writings about a “Balanced Scorecard”, selected performance metrics should be balanced among 4 key areas of concern:
• financial performance,
• operational performance,
• the customer’s view of performance, and
• innovation, improvement and response to fundamental market changes.

The selected metrics in each of these 4 areas should reflect the business strategy, be measured regularly, compared to industry benchmarks or competitive intelligence, and shared with key employees throughout the company. Irrespective of business size, investing in a strategy centric set of performance metrics can be important, but it is an especially important, if not critical, for any business that wants to grow.

JCJCo provides outsourced CFO and business consulting services to entrepreneurial and high growth companies. We help our clients develop performance metric measurement and management systems that reflect the client’s strategy, and delivers essential information needed by the business owner or CEO to monitor performance, make business adjustments, and meet growth objectives.

Some Common Reasons Not to Use Performance Metrics

In the post titled “Performance Metrics – a CEO’s Best Friend”, I described some observations made as a participant in a peer to peer “think tank” about performance metrics, sponsored by SmartCEO. The main takeaway was that the smaller the business, the less likely a formal set of performance metrics were employed by management to help make business decisions.

So why is this the case? Why don’t smaller businesses invest in defining a set of metrics that reflects their strategy, and take the time to set up a process to collect data and track those key metrics? In my experience, the most common justifications are:

• The smaller the company, the closer the owner or CEO is to the action, and the more likely he or she sees what’s happening in most aspects of the business on a daily basis. That owner or CEO is also likely to have a personal version of performance metrics embedded in their thinking. They have experience and knowledge, and are comfortable in relying on their own ability to gather, assess and make business decisions based on their own personal expertise.
• The smaller the business the less budget is available to invest in a data generation and reporting system, and the less time is available to feed the data collection process. With limited resources, the emphasis is on generating revenue, and making an investment in performance metrics is not categorized as a revenue generating expenditure.
• The most valuable asset in any company is arguably its customer base. And the smaller the business, the less likely it has significant other assets under its control. For these reasons, smaller business thinking tends to be very customer centric, focused on customer satisfaction, or things needed to attract new customers. While all sizes of companies should monitor customer centric metrics, the smaller the business the more likely they see customer metrics as being all that is needed.

It’s not that smaller businesses do not use some form of performance metrics, they do. An owner or CEO’s knowledge and experience is a form of metric, as is a focus on revenue or customer relationships. But relying on these justifications for not developing and employing a broader, strategy centric set of performance metrics has inherent risks.

A singular on non-strategically aligned focus for management decision making, be it revenue, costs or customer relationships, can result in critical changes in the business or its marketplace being overlooked. And most barebones methods of monitoring performance are inherently short term in their focus, which is inconsistent with managing toward achieving longer term objectives, and in particular, growth targets.

Also, while a talented owner or CEO’s closeness to the action and innate decision making ability can be an effective substitute for metrics, some words of caution are needed. That individual has only so much capacity, and if growth is an objective, he or she will soon be far less directly involved in all aspects of the business, and metrics are critical to supporting organizational growth.

Even if growth is not an objective, he or she will not be with the business forever. And as an aside, that individual’s decisions about the here and now can be tainted by the natural tendency to support past decisions. A wise owner or CEO will hire people capable of assuming decision making authority, share or test his or her own decisions among this team, and invest in performance metrics. Any business that is reliant on one individual to succeed is assuming an unnecessary level of risk, and performance metrics provide a roadmap for sharing decision making within a management team.

In a final post on this topic, I will expand on the reasons why all businesses should make an investment in developing and monitoring a strategy centric set of performance metrics, particularly if the business wants to grow.

JCJCo provides outsourced CFO and business consulting services to entrepreneurial and high growth companies. We help our clients develop performance metric measurement and management systems that reflect the client’s strategy, and delivers essential information needed by the business owner or CEO to monitor performance, make business adjustments, and meet growth objectives.