In Part 1, I outlined the 10 financial figures and ratios, how to compute them and what they show. However, to make the most of this information you must understand what the information is telling you and how to apply this information in your business. The 10 figures and ratios were grouped into three types – Profitability, Activity and Liquidity.
If we find that the profitability numbers are low, we can take some quick steps to improve the numbers.
“How do we do this?” I hear. “We are selling as much as we can and we can’t afford the investment in more staff or materials, and even if we could we don’t have the capacity!” Or, “It is a competitive marketplace and we have to sell our product as cheaply as we can.”
How about increasing your revenue by 2% every year? Cost pressures rise with inflation – the raw materials, fuel etc. all rise by a small amount gradually. When they do, your profitability – gross margin – is getting squeezed.
Let’s say you buy a coffee every morning on your way to work for $3.60. It’s convenient, and the coffee is good. One day, you go to pay for your coffee and the price has increased to $3.70 – you would most likely pay the $3.70 and continue your normal daily routine and continue paying $3.70. This is a price increase of 2.78%.
These slight increases either protect your Gross Profit Margin or goes directly to your overall profitability. Furthermore, how many customers would you be likely to lose? Customers that are so sensitive to such small increases are often customers that you are better off not retaining. To minimise the impact try even smaller but more regular increases, perhaps quarterly – the impact on the customer is even less noticeable.
Another way to look at this is –
2% increase = it is unlikely you would lose a customer
10% increase = would you lose less than 10% of your sales in dollars?
50% increase = would you lose less than 50% of your sales in dollars?
Reduce Cost of Goods Sold
This is a lot harder than increasing profit as you are restrained by the variable components making up the cost of goods sold, and the volume being produced and/or sold. Apart from improving profitability, I think the process of looking at how you can reduce the cost of goods sold will give you a much better understanding of the drivers, pain points, restrictions, and opportunities in your business.
But here is a list of ideas – not all, and maybe only a few will be applicable to your business.
● Source cheaper inputs or materials. I worked with a steel manufacturing company and the supplier of a raw material would sometimes restrict supply to keep the average price higher. Not only did this affect certainty of supply, but it also kept the cost of goods sold high. This company turned around and sourced an alternative raw material from overseas, which in turn led to a joint-venture proposal.
● Just in time – buy the materials when you need it. The same steel company had an inventory policy whereby if they sold a particular item they would reorder the material immediately. While I was with the company, they sold steel for a wine vat and reordered the materials – that hadn’t sold steel for a wine vat for the four years prior and they probably haven’t since.
● Buy in bulk – yes, I just said buy just in time, but if you have the capability and the working capital, you may find buying in bulk will lower your per unit input cost and the cost of goods sold.
● Reduce waste – particularly if the cost of the raw material is high. Let’s say you make granite benchtops – a high-cost material. If you can use exactly the right size material, you will minimise the waste and reduce your cost of goods sold.
● Standardise product features – remember what Henry Ford said about the Model T Ford – you can have it in any colour as long as it’s black. Reducing options and non-standard features will reduce your costs.
● Look at total cost – the material cost is just one factor – what about funding costs, delivery costs or delivery time. Could you pay for the material quicker and get a more favourable price? Could you order earlier and reduce postage costs with slower delivery?
● Team up with someone else – could you team up with someone else to get a better price?
● Get a long-term supply contract – At Byronvale Advisors, we discount our hourly rate to clients that enter fixed price or retainer contracts. Apart from providing certainty of cashflows for us, it lowers the price for the client, and it provides them price with certainty.
Activity ratios tell the business how efficiently they are using their short-term assets, especially cash.
Having lots of capital tied up in inventory and debtors means the business has to get the cash to pay for them – either through its own reserves, borrowings or by delaying paying creditors.
What is optimal depends on the industry and the products being sold, but as a generalisation: –
Debtor days < Creditor Days – have your customers paying you before you have to pay your suppliers
In the example above Debtor Days were 38 days and Creditor Days were 60 days – customers are paying quicker than the need to pay the suppliers.
Inventory Days < Creditor Days – you are selling the inventory before you have to pay for it
In the example above Inventory Days were 61 days and Creditor Days were 60 days – inventory is being sold about as quickly as the suppliers are being paid for it.
With inventory there are a few common factors to be mindful of: –
● Accounting valuation method can affect the overall valuation of the inventory.
● Obsolescent or hardcore inventory can affect the inventory valuation and days. Accounting standards do also have rules for writing the valuation of obsolete inventory down.
● Buying inventory at a discount can both positively and negatively impact Inventory days. There is a balance between the value of the discount and the cost to fund the increase in inventory.
Discounting sales can affect working capital positively and negatively. Offering customers a discount may increase the sales and/or decrease debtor days. If the discount increases the sales but does not decrease debtor days, then consider the impact of working capital and cost of funds. Likewise, if the discount reduces debtor days but does not increase volume, what is the impact on gross margin and profitability?
Chasing debtors is never fun, but remember, the debtor amount is your money that someone else has. Would you be comfortable lending the customer the same value in cash that you withdrew from your bank account? It makes a big difference to your bank balance if they pay you.
I have only ever had one client that turned into a bad debt. It was when I had sent several reminders and finally threatened legal action that they put themselves into voluntary liquidation. During this period my wife had been saying I should have been pursuing the client and threatening legal action but my rhetoric question to her was “If the client walked into our house, found my wife’s purse and took all the cash out of it, put it in their pocket and walked out the door what would you do? You need to invest the time to ensure you are paid in a timely manner and pursue late payers.
A caveat on Liquidity Ratios – the ratio is just the start of the conversation. Ratios need to be benchmarked against like businesses and over a period of time. After the ratio is determined analysis also needs to be undertaken of the makeup and timing of the liabilities.
A not-for-profit client had a balance sheet similar to this:
Prepaid Expenses 60,000
Total Current Assets 80,000
Income in Advance 21,750
Provision for Prize Money 7,500
Provision for Grants 6,200
Trade and Other Payables 32,300
Total Current Liabilities 70,150
Current Ratio = 1.14
Quick Asset Ratio = 0.29
Cash Ratio = 0.29
A quick glance would indicate that this organisation can pay its short-term liabilities by liquidating its short-term assets. However, by looking at the Quick Asset and Cash Ratios would indicate it could only cover 29% of current liabilities if it had to liquidate its assets quickly, and this would not even cover the trade payables. The Quick Asset and Cash Ratios however do not look at the timings of the current liabilities in the calculation. In the above example in a ‘fire sale’ situation the Income in Advance contractually would not need to be paid.
The prize money provision was also payable towards the end of the 12-month period. The major creditor in the Trade Payables has, over a period of time, demonstrated they were lenient on enforcing payment terms. So, if I were to adjust the Quick Asset Ratio and Cash Ratio to reflect only the items that are immediately payable, the ratio would be 2.33 or 233%.
So, liquidity ratios are very useful, but require a little more skill in interpretation.