A systematic financial review can lead to greater profits

by Mike Rudd

There are several elements within a small business environment that should be analyzed and reviewed to establish potential profitability as compared to current performance.

Financial statement review
In a review, three to five years of financial statements should be analyzed and categorized. Compare the performance of each category within the chart of accounts over the financial review time period. Categories should include types of revenue, variable or direct costs, indirect overhead, general and administrative overhead, debt service and leases.

Break down each dollar amount into a percentage of revenue to determine operational variances within each line item. Review individual circumstances that contribute to variances and their impact on company profitability. Combine the bestperforming percentages to establish the business�s optimal financial performance.

Quantifying financial impact
The financial impact of a business owner�s management practices should be reviewed.

Accounts receivable. Lack of consistent monitoring and specific collection procedures lead to reduced cash flow, restricted access to product and increased borrowing. By reducing the accounts receivable collection cycle, a business is able to increase the amount of cash flow on an annual basis, reduce borrowing and increase profitability.

Inventory analysis. In the case of a stocking distribution company, inventory is one of the single largest assets it has. The management of this asset plays a significant role in the success or failure of the business. Excess inventory on hand reduces profitability due to handling costs, breakage, shrinkage, reduced cash flow and increased borrowing.

Sales and margin mix. The gross margin mix of the individual revenue categories determines the overall margin available to the business for indirect overhead, administrative overhead and profit. If the product revenue mix is skewed toward low margin products or services, then the revenue stream will not compensate for reduced margins. Increased sales could actually lead to decreased profitability.

Break-even pricing. Break-even is the point of revenue generation that has covered the associated variable costs and produced enough gross margin to cover the company�s indirect and administrative overhead. Utilize break-even pricing to understand and create a pricing structure that allows for new product introduction and customer development and takes into consideration the inherent competitive advantage of additional gross margin without the burden of overhead.

Labor incentives. Increase labor productivity by developing and implementing excess profit-based incentive programs, performance job descriptions and management information systems. Average employee productivity can be increased, and the reduced overtime, reduced warranty, scrap and waste expenses, and additional capacity will increase profitability.

Reducing variable or direct costs. A business can reduce material costs by negotiating better terms or pricing, consolidating purchases, utilizing buying groups, committing to one supplier for annual purchases and reducing theft, waste and warranty work.

Review the performance gaps between your business and peers within the industry. Identify gaps in profitability, productivity, costs and financial ratios. That information should be combined with the problem costs associated with the lack of appropriate and consistent systems and controls, in addition to procedures that must be embraced and implemented to achieve desired company profitability.

Each business is unique and should take into account special considerations when establishing its viability.

Clients of The Fremont Group—and particularly those of Team Fremont—do a monthly financial review with our affiliate and find this one of the most critical, long-term benefits of our work.

Material Costs

There are numerous factors that determine the company’s material costs.[1] They include:

1. Price negotiation;

2. term negotiation;

3. utilization of discounts offered;

4. systems for assuring that company receives what was ordered at the price that was negotiated;

5. assuring credit for damaged goods or short deliveries;

6. controls that we are paying the negotiated price–once;

7. establishing appropriate inventory levels and maintaining such;

8. controlling obsolescence in inventory and damage in storage;

9. controlling theft;

10. freight negotiation;

11. maintaining adequate inventory to assure ability to fill orders;

12. terms charged;

13. same day billing;

14. And collections.

[1] As the monitor of the material costs is a percentage of revenues, all of these factors can be correct and the problem can fall in pricing. A Company cannot have control of material costs if you have a random system of pricing or if a company fails to have systems of up-dating pricing based upon the doctrine of true costs.

Good Debt; Bad Debt

I often hear the goal of a business owner as “I want to pay off my debt.”  When questioned more closely the source of this goal is the frustration and perceived risk of having debt and the debt payments.  The idea that the owner would make more money if he didn’t have the debt is a little illusory—the debt also helped build the businesses.  What is good debt?  There are two criteria in answering this question—the type of debt and the use of he debt.  Is owning a home a good thing?  Of course and few of us would own homes if we had to save the money and pay cash, but would it be a good thing to put the purchase of your home on a credit card?  Long-term assets need to be purchased with long-term debt. The converse is also true—don’t pay off your credit card with a home mortgage.  Short-term assets need to be purchased with short-term debt. So the first criteria is to match the type of debt to the type of purchase.  The second (and probably more important criteria) is the use of the debt funds.  A good use of debt in a business is to finance growth (inventory, cash flow, etc.) and to purchase assets that produce income in excess of their cost. Obviously we don’t want to use debt to purchase non-income producing assets (like toys) for a business.  Be careful about using debt as a tax plan.  Businesses that run their business with the objective of minimizing taxes are missing the point—the business needs to be run for a profit.  Of course all debt—even good debt—brings with it risk.  One reason the owner gets the big bucks is to make the decisions that balance the use of the debt with the risk.