Increasing Financial Visibility (Part 2)

Note: This article is an editorialization of a webinar presentation by Fred Parrish, President and CEO of the Profit Experts, creator of the Profit Beacon software, and co-author of The E-Myth Chief Financial Officer.) The recorded webinar is available to members of Woodard Alliance. Join for free for 30 days to view this and other webinars in the Transformative Advisor series.
An Introduction by Joe Woodard 

I’m starting Part 2 of this Transformative Advisor series by restating and reinforcing the difference between the terms “trusted advisor” and “transformative advisor.” (See Part 1 of the series for more information.) 

The difference is more than just semantics. Trusted advisors can be passive (i.e., trustworthy) or active (i.e., coaches/mentors to their clients). The former is “trusted” but is not intentionally, systematically, or consistently transformative. Only an active trusted advisor (i.e., “Transformative Advisor”) intentionally and persistently improves the condition of their clients and they so with impacts that are financial, technological, operational, and managerial. In other words, I am transformative if, and only if, I increase the wealth of my clients, enhance their business cultures, make their businesses more scalable, increase the value of their businesses for succession purposes, increase the business owners’ work-life harmonization, etc.  

So, I have a key question for everyone reading this article: Are your clients made perpetually and materially better as a direct result of their interactions with you?  

If not…or if yes and you would want to step on the gas…financial advisory is a great area of focus for transformation work. 

So, enjoy the rest of this article where Fred Parrish maps the maze on financial advisory services. 

Why Offer Financial Advisory Services 

Small business owners are running their businesses without visibility, and as a result they are unable to predict cash flow problems, detect underperforming programs/people, measure liquidity, adequately manage banking relationships, or make informed decisions based on financial performance trends. By creating visibility, you can transform businesses, and you do this by monitoring several key financial and operational measurements. 

To ensure maximum performance, we need to look at financial data, which is, in essence, the quantitative indicator of operational performance. Without accurate and real time accounting data to give you the history, combined with the ability to use that history to forecast future financial performance, you will have no objective way of evaluating what is happening in the business. Therefore, it is extremely important to think about the connection between operational data and financial data. 

To put that information to work, we must understand the company’s needs. We must help business owners understand the financial impact of every decision they have made or will make in the future. So, we must understand what those needs are as we go through this process. Otherwise, we can’t know what systems and tools we should be using to get the information we need to change and improve the outcomes for that client’s company. 

We must understand what is happening in the business, what the business owner intends to do, and what impact they think the market is going to have on their current operations. Then we can think about what systems and tools should be in place to give us the information, so we can analyze that information and project it into the future to get predictive capabilities and a plan to address the capabilities we predict. 

Once you are able to determine the needs of the company and identify and implement the appropriate systems and tools, then it is extremely important for you to stay engaged with your client and involved in these processes on a regular basis. This is advantageous to the client in two ways: First, you are their expert who can coach them, and second, within the context of a client relationship you have the ability to stay engaged and focus proactively on your client’s needs, functioning, effectively, as a member of their leadership team.  

As a financial advisor, implement a three-step process to ensure maximum performance levels: 

• Plan. Quantify the different aspects of the strategic plan that your client has developed, perhaps with your participation, determine the different milestones, and work through the plan to manage the company to reach them. 

• Evaluate. As you cross milestones/goalposts in your plan, evaluate the clients progress (or lack of progress). Look at the original plan, examine how the company has been performing up to this point in time and determine what you need to change. 

• Modify. If the evaluation has uncovered an issue that is different from the plan (and variations are likely), it is important to understand why those variations exist. Is something in the business or the market changing the dynamics of the company’s operations? If so, you need to look at it differently from the way you look at something that has not met a target because you were not managing it appropriately. Can you change the way you manage it so it can reach that milestone? 

And then the cycle continues. There is a specific cycle for you to implement as a financial advisory that supports this approach to performance management. Each of these analyses inform the plan and any modifications you wish to make to the plan: 

• Critical metrics. We need to look at these indicators more often than we would look at a monthly income statement – daily or weekly. 

• Performance variations. We do a comparative analysis at the end of each month to determine where these are occurring and what we will do about them. 

• Operational evaluation. We do this on a quarterly basis. Do we need to change the strategic plan to accommodate variations in the market around the company or changes inside the company? Should we manage differently to reach our targets?  

Without financial dynamics, intelligence and data, there is no way to objectively evaluate how the company is performing. There are two key principles for financial dynamics:  

1. Every profit-and-loss has both horizontal and vertical relationships.  

1. These relationships are usually both manageable and predictable. 

Key Areas of Focus for the Financial Advisor 

• Experience over Time: Unless something material has changed like competitive landscape, or economic variables, experience over a period of time is a fairly good predictor of the future. If we are following the cyclical process of performance management discussed above, then we will know where variations are occurring and where modifications will need to be made to adjust our targets and manage to the next time period. It’s extremely important to realize that although we cannot predict the future, we can manage to it. 
• Vertical and Horizontal Relationships: Vertical relationships are by line item or General Ledger account. Horizontal relationships measure their performances over periods of time. These amounts will often vary, except in accounts like rent that tend to be fixed, and these amounts tell you what is happening today and what may happen going forward. We need to be able to look forward, guiding our clients in the specific targets around which they need to manage. 
• Revenue and Gross Margin: Revenue and gross margin are key to driving good results at the bottom line. The client needs good lines of business, or collections or products and services, to produce satisfactory net profits. When we can chart variations over periods of time, such as in trend lines, we can find averages and identify changes over time, such as seasonal highs and lows, or unexpected anomalies, such as one-time contracts, drop-offs in business or revenues from a new client. You can use Excel to create charts and trend lines to help identify and analyze variations in relationships and plan around them. 

• When analyzing revenue, we must look at revenue overall to find general trends, but we must also look at the details such as individual revenue streams. What mix of business will be most profitable over time? We want to make sure anomalies and short-term effects don’t affect our long-term projections. 
• We also want to know what the relative impact on gross margin will be. We need to get the business owners away from the idea that all they need to do to improve their bottom lines is increase their revenues. We need to analyze direct costs and overhead to make sure that there aren’t any issues. For example, the client may be selling too much of the wrong product or service? If so, this could negatively affect the gross margin and the company’s profitability. 

• Contribution Margin: Monitoring contribution margin is a powerful approach for managing revenue and gross margins, applicable in specific situations where conditions are perfectly aligned. Contribution margin equals additional total revenue minus total variable costs. We want to know what additional cash flow results from improvements in gross margins that is available to absorb existing fixed costs. Contribution margin analysis can be especially useful in situations where the company will incur certain costs regardless of business volume, such as government contracts.  

Key Ratios for the Financial Advisor 

Some ratios are important to understanding and ensuring a company’s stability: 

• Working Capital: Working capital equals current assets minus current liabilities. It shows the company’s available cash beyond its current obligations. It helps in planning for future capital needs, such as expanding or supporting its operations, securing funding or paying down debt. 
• Current Ratio: Current ratio equals current assets divided by current liabilities. It shows the company’s ability to pay its current obligations. The best way to use this ratio is over time. Trends in this ratio can help you make long-term decisions. If current assets are greater than current liabilities, your client can pay debt or expand its business. On the other hand, if current assets are diminishing as a percentage of current liabilities, we can avoid the idea of borrowing. If you can get ahead of the curve and know what is developing ahead of time, then you can have a favorable impact on those outcomes. 
• Accounts Receivable Turns: Accounts Receivable is the first place to look for cash that is not already in the bank. It is the quickest source of cash on the Balance Sheet. The ability to convert Accounts Receivable to cash is critical.  We need to ensure that our clients manage Accounts Receivable correctly every day. Billings must be as prompt and as frequent as possible. The more frequently billings take place, the sooner cash comes through the door. Clients must collect all payments when they are due. The longer an invoice is unpaid, the less collectible it becomes. We need all the terms and documentation so that there are no questions about invoices. And we must aggressively follow up, close to and after due dates. It’s easy to ignore collections until there is a problem, but by then, the possibility of full collection has diminished significantly. 

• Days Sales Outstanding (DSO): DSO shows us how long it takes to collect Accounts Receivable from customers. Days sales outstanding equals (A/R balance / average sales) x 30. The Accounts Receivable Balance and average sales in this calculation should be determined over a timeframe. The timeframes applied to Accounts Receivable balance and average sales are critical. It’s important to keep them consistent. 
• Inventory Days (ID): Inventory is the next source of cash on a Balance Sheet that is not in a bank account. It must be kept at optimum levels to maximize returns on the dollars invested. The client needs to understand the shelf life of the inventory. The client needs to intentionally monitor and manage any factors affecting the life of inventory items to maintain the healthy balance/tension between overstocking shelves (which ties up working capital, increases overhead and increases the propensity for obsolescence) and back ordering (which reduces sales to competitive influences and/or harms short term cash flows). Inventory days (ID) equals 365 / (Average COGS over time period / Inventory balance over time period). It estimates how many days it takes to convert inventory to cash.  Time periods in this calculation must be consistent. 
• Days Purchases Outstanding (DPE): DPO equals (Accounts Payable balance over time period/ Average purchases over time period) x 30. Time periods in this calculation must be consistent. Average purchases includes items bought on account, but it does not include anything paid as incurred, such as payroll or rent. This ratio shows how long it takes to pay vendors. 

Levering these ratios is key. When we gain as much “distance” as possible between the dynamics of a business by comparing the days sales outstanding, inventory days and days purchases outstanding, the more success we’ll have in improving that company’s cash position if we manage it appropriately. 

Getting Started: First Steps for the Aspiring Financial Advisor 

When you engage with your clients early in the year, you have access to their year-end numbers to work on their year-end bookkeeping, financials and tax returns. Coupling that with financial analytics and ratios for year-round work. You can provide your clients with additional value in an initial consultation and by taking care of cash flows later in the year. 

Some transformation work that you can begin doing immediately includes performing some visibility transactions in three phases: 

• Run the ratios in this article on at least one client; 

• Meet with the client to determine corrective responses, and 

• Hold the client accountable to make the changes. 
  

Do this for at least one client and measure the increase in wealth. By doing so you will measure the value of your Transformation Work. These measurements will give you the economic courage to value price that engagement – in other words to price as a percentage under the wealth you generate rather than as a percentage over the cost you incur! 

Click to return to Part 1

Click to continue to Part 3