The end of the year is almost upon us. Only 9 full weeks left in 2015. The last quarter of the year always goes fast. There are simply more holidays and outside demands in the last three months of the year.
I wanted to take a break from big, high-level industry analysis for a moment and drill down into the nuts and bolts of financial management. As the year begins to draw to a close it is a good time to take stock of the current state of business. Here are six simple financial KPIs to look at every month to increase the value of your business.
Many of these financial KPIs are similar to metrics that the large consolidators use to evaluate individual locations across their networks. While there are many more complex metrics that are important to evaluate regularly, this is a list of what I consider to be simple financial KPIs that a business owner ought to be looking at on a monthly basis, if not more frequently.
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The first place I look when evaluating a business, even before looking at sales, is gross profit. Gross profit is one of the most important financial metrics of a business. Small changes in gross profit can have significant impacts on the overall value of your company.
A common mistake I often see is a business managing to sales rather than gross profit. The premise is that an increase in sales will take care of everything else. Often I see compensation plans that reward sales with little to no emphasis driving profitable sales. This is dangerous as it often provides the wrong incentives and does not align employees with ownership.
In the collision industry gross margin tends to be between 40% and 45%, depending on the sales mix and how paint rebates/prebates are booked. If a business reports margins significantly greater than 45% I become concerned about the long term ability of the business to sustain those margins and retain their customers. Less than 40% and I become concerned about the long term profitability of the company. In both cases I want to know what drives the margins, i.e. is it a pricing issue, a discounting issues, a cost of parts and labor issue, or a combination of all of the above.
After I look at the gross profit of a business the next number I look at is EBITDA. EBITDA, or earnings before interest, taxes, depreciation and amortization, is one of the most important drivers of business value. The value of a business is determined by its projected free cash flow. EBITDA is a quick approximation of cash flow that you can calculate every month.
A great way to incentivize managers and employees to think like owners is to create a compensation plan based on EBITDA. Because EBITDA is based off of earnings, not sales or gross profit, the benefit is that managers and employees will be focused on the “bottom line” is a similar way an owner is. But if you do decide to go down that route it is important to ensure that your EBITDA is clean. Often business owners have many discretionary expenses lumped into general administrative expenses. It may be wise to create an incentive program around a clean adjusted EBITDA number rather than a murky EBITDA number.
In the collision industry, you should expect to see clean EBITDA margins ranging from 12% to 20% for privately held companies. When I am evaluating a collision repair business I spend a significant amount of time recasting EBITDA number to come up with a standardized number. The way expenses are classified varies substantially from company to company, as does the amounts and types of personal expenses that often are run through a business. As a result when comparing EBITDA across companies it is very important to ensure that EBITDA is truly comparable. I am very hesitant to rely on multiples of EBITDA to determine business value for this same reason. Often I hear “I was offered 8x EBITDA and everyone else only gets 6x so I must be getting a good deal.” In economics we say there is no free lunch. (subscribers feel free to email me directly for a more in depth conversation on this).
Only after I have looked at gross profit and EBITDA will I then turn and consider sales. Sales, and more specifically, sales growth is important. But more important than sales growth is profitable sales growth. If a company is growing sales 25% annually, but unable to generate positive cash flow, the company is in a worse position than had sales been flat but gross profit increased by 25%.
But I do not want to be cavalier. Sales growth is essential to any business. It ought to be managed as closely as gross profit and EBITDA. Management teams and sales staff both ought to have sales quotas. But they ought to have gross profit and EBITDA expectations as well.
The silent killer of a business is poorly managed accounts receivable, also referred to simply as A/R. Accounts receivables is a balance sheet item and will not show up on any P&L/income statement. But receivables have a significant impact on the overall health and cash position of the business.
Accounts receivables are simply sales yet to be collected and are a natural part of the cash conversion cycle. The structure and norms of the industry often dictate the length of the collection cycle. High performing teams actively work to manage A/R.
When I analyze a company I look at A/R both as a % of sales as well as the amount of days outstanding. Leading companies in the collision industry have collection cycles anywhere from 18 to 25 days. Receivables as a percentage of sales is roughly between 6% and 9% of annual sales or between 75% to 90% of monthly sales. I also keep an eye on receivables written off as uncollectable as this often signifies a poor account collection management as possible estimatics/DRP compliance issues. For well managed businesses in the collision industry uncollectable receivables tend to be very low.
Active management of A/R ensures a company quickly receives cash from sales and minimizes working capital. The less working capital required by a company the more valuable a business. But as with everything it can be taken to an extreme. Over-aggressive A/R collection can actually hinder sales and lead to customer alienation if your terms are too out far outside industry averages.
Accounts payable, or A/P is also a balance sheet item. Whereas A/R is an asset, A/P is a liability. Accounts payable represent bills due that the company has not yet issued payment. A/P does not show up on the P&L.
But just as A/R has big implications for the cash position of the business, so too does A/P. Leading companies actively manage A/P so as to maximize the time available to issue payment to vendors. When I analyze a collision company I am more interested in the days outstanding than I am the percentage of A/P to COGS. At minimum, A/P days should be at least 30 days if not more in the collision industry. The Boyd Group, for example, reports days payable of 65 days.
But just as A/R collection policies can be overdone, so too can A/P payment policies. While large companies can leverage their significant purchasing power to negotiate favorable contracts smaller companies need to be cautious how they approach vendor negotiations. Stretching out payment cycles can have adverse impact on pricing and discount, and in the worst case scenario can cause a vendor to “fire” their customer or suspend credit purchases and demand immediate cash payment.
Inventory & Work in Process (WIP)
Inventory and work in process is a commonly overlooked item in many businesses. Both are a huge drain on cash when left unattended. The challenge of poor inventory and WIP management is that these items do not show up as a line item on a P&L. Instead both WIP and inventory are listed as assets on the balance sheet. Making matters worse, inventory accounting gets complex and tedious very quickly.
Whether you focus more on WIP management or inventory management depends on your sub-industry. Service and project based companies (i.e. collision and mechanical) focus on WIP as there is very little inventory outside of WIP. Distributors and retailers (i.e. dealerships, paint distribution and parts distribution) tend to focus on inventory as these companies resale finished goods with little to no WIP. Regardless, both excess inventory and excess WIP when left unchecked are a huge silent drain on cash.
In short there is a lot of room for improvement the entire automotive aftermarket industry, whether you are focused on optimizing WIP as a collision repair business or maximizing inventory turns as an auto retail dealership. If you are interested in a more in depth discussion around inventory and WIP optimization be sure to email me.
There you have it – six simple financial KPIs to look at every month to increase the value of your business. I am a fan of creating simple dashboards (i.e. charts and graphs) that show the change in these metrics over time. I have found dashboards to be much more effective at telling a story than pure numbers. Be sure to check out our Simple Financial Dashboard for a simple, automated and easy to way to manage your financials.
Until next week!