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TECHNIQUES
In uncertain times enhanced information, this section, helps management teams navigate successfully through whatever lies ahead. BREAKEVEN (1) for targeting profitability and Cash Flow adequacy, particularly in rapidly changing markets. CREDITOR STRAIN (2) for earliest detection - and remedying - concealed Funding and Solvency problems developing deep within the business:
(1) see Breakeven v Profitability Table Section IIIa.
(2) Section IV.
I BACKGROUND
BUSINESS DYNAMICS Limited ('BDL') is a 22 year old UK London based business-advisory service. Powerful techniques help companies achieve sound financial performance, particularly through difficult times.
Most sizes and types of business helped - SME's (Small & Medium sized Enterprises) large, multi-national, owner-managed. Examples given in Section III below.
Real-Time Operation
Modern companies need to operate on a real-time or near-real-time basis. Information used to guide and direct the business needs to be equally prompt, and take up as little as possible management time, cost and effort to prepare, process and use.
II A DIFFERENT FORM OF BENCHMARK IS REQUIRED
Two benchmarks go to the very heart of a company's operation:
- Breakeven Level - a direct indicator of Profitability & Cash Flow Adequacy. This section and Section III below.
- Creditor Strain - a direct indicator of Solvency & Funding Adequacy. IV below
BREAKEVEN LEVEL - Breakeven as a percentage of sales. Measuring operating Strength / Weakness.
A powerful Company Strength/Weakness 'Richter Scale' emerges:
- >90% 'Suicidal'
- 90%-80% 'Vulnerable'
- 80%-70% 'Secure'
- 70%-60% 'Strong'
- <60% 'Exceptionally Strong'
Breakeven affects not just profitability, but underlying financial strength and security of the whole operation. High breakeven companies are more likely to run into funding and solvency problems in a downturn than low breakeven. Low breakeven companies have more headroom for manoeuvre before being in active trouble as for instance explained at the start of section IIIa.
'Going-Concern'
Breakeven level is one of the key considerations for assessing 'going concern' along with working capital control Section VII, bank 'gearing' Section IIIa, extent of any creditor-strain Section IV and similar factors. The 'suicidal' label in the above table emphasises danger, so remedial action can be taken in time.
'Back-of-the-Envelope' Calculation
In the first instance Breakeven can be determined from publicly available audited accounts - total overhead (including interest paid) divided by gross margin (gross profit) percentage. For further detail see under Published Accounts heading below.
Strategy consists of "getting breakeven down" - towards a specific target of say ~ 75%. Explained under Funding Self-Sufficiency heading in Section IIIa.
As will be known, by far the most influential factor is margin improvement. A 1% improvement in sales price* / reduction in direct costs, for a 10% margin company, improves income** (£ gross margin) by up to 10%. To achieve the same effect by cost-cutting requires a formidable 10% reduction in overheads (cutting available resources in the process).
Breakeven-reduction / profitability-improvement is considerably more responsive to margin-improvement than overhead cost-cutting, again as will be known.
*Only in the unlikely event a 1% price rise causes more than 10% drop in sales, will overall income** not improve - the unexpected power of the move. To the extent that sales volumes are damaged by less, or considerably less, than 10%, higher profitability on lower turnover and therefore lower funding need (Section VII) results - the optimum strategy and outcome, particularly for weakening markets.
Profitability can nearly always be improved by bringing to bear the many techniques available for margin improvement - 'differential pricing', 'gold', 'silver', 'bronze', 'dog' grading of products and services, direct cost reduction etc etc.
Sales Volume / Margin Compensation
In the example given above, a 1% change in margin, for a 10% margin product, produces a 10% change in income (in round terms). The guiding rule is: "compare the change" 1% in this case "with the finishing margin" 9% or 11% depending on whether up or down.
If down, the finishing margin is 9%. Compare the change, 1%. Damage done 1/9, 11% loss of income. Requiring 11% increase in volume to compensate! (or 11% cut in overheads!).
If up, finishing margin is 11%. Income improvement 1/11 9%. Volume can fall by up to 9% before any benefit ceases.
Volume / Margin Compensation Table
The same calculations can be done for for the full range of margins and put into tabular form providing a powerful 'immediate' management tool - for sales people in particular. (Copy available, free of charge, on application to BDL).
Immediate answers can be read off to questions like "how much more volume would we need to sell if the customer requests a 5% reduction in price?" (For an existing 25% margin company it is 5/20, a massive 25%.)
Conversely, "if we increase prices by say 5%, what maximum volume drop can we suffer and still maintain existing income?" (5/30 or 17% for a 25% margin company).
High-Accuracy Gross Margin Measurement
As already seen, even small changes in margin have a surprisingly large impact on profitability and therefore strategic factors like accuracy of breakeven measurement, on which the whole structural 'shape' of the business depends See for instance under 'Going Concern' heading in Section II.
High-accuracy gross-margin measurement is vital for both operational purposes (eg product-gross-margin-ranking) and audit purposes (eg as part of assessing 'going-concern', higher breakeven companies obviously being disproportionably more risky than lower). Measurement details available from BDL.
Published Accounts
In determining breakeven from published accounts, where the split between cost-of-sales and overheads is not available, a broad guess can usually be made of the typical gross margin percentage applicable to the type of business in question. The balance of operating costs is then 'overheads'.
The split is not critical to the breakeven calculation. If variable costs get overstated, and gross margin therefore understated, by inclusion of what should strictly be an overhead, fixed costs get understated by a similar amount, cancelling the effect. And vice versa. (The reason why informed guesswork is able to produce surprisingly reliable breakeven benchmarks.)
Where an owner takes out virtually all profit by way of salary and bonus, the total can notionally be split between normal-rate-for-the-job, eg as chief executive, and profit distribution, only the former being included as 'overhead'.
Note that provided steps are taken to ensure all operating costs are included, the exact split between 'fixed' and 'variable' is not critical. For full precision 'Variable' Costs are those you would not have if you were not doing any business. They can also be recognised as 'Income-Generating' costs. No cost, no income. 'Fixed' Costs are those that stay broadly the same regardless of how much activity is taking place.
Other Companies' Strength/Weakness Indicator
Calculation of the 'Richter Scale' strength/weakness ratio forms a particularly quick and effective way of detecting strength / weakness of other businesses - key suppliers, key customers, competitors, acquisition targets - even where attempts are made to try and conceal (or even falsify) such knowledge (which can be detected per Section V).
IIIa GENERAL EXPLANATORY BACKGROUND
For those not fully familiar with the breakeven concept, further explanation might be helpful. Breakeven occurs where Gross-Margin-exactly matches Overheads (Fixed Costs).
Thus a company with an (average) breakeven point of 50% of sales, produces an operating profit equivalent to full overhead at 100% turnover.
At 75% breakeven, profits are equivalent to 33% of overhead (25/75). And so on. This applies whether measured daily, weekly, monthly or annually (a powerful operating tool, particularly when put into graphical form eg 12-month-moving-total graphs).
Breakeven v Profitability Table
BE% P/(L)%OH
125% (20%)
110% (9%)
100% 0%
90% 11%
75% 33%
60% 67%
50% 100%
40% 150%
High Breakeven Equates to Low Profitability - and vice versa
It will be noted that at high breakeven levels, profitability and cash flow become particularly 'thin'. And vice versa, ever more rapid improvements in profitability, cash flow and retained-profits result as "breakeven is brought down".
Low Breakeven - Unduly Strong Company
High Breakeven - Unduly Weak Company
It is a non-uniform relationship - demonstrating how (disproportionately) weak high-breakeven-point companies are and how (disproportionately) strong low are.
The 'Heart-Beat' Analogy
When you first go into hospital, your blood pressure and heart-beat are taken. Low beat (within reason) normal health. High beat escalating degrees of danger.
Breakeven is the 'heart beat' of a company. And is as quick, simple and straightforward to measure (and assess against the 'Richter Scale' of Company Health).
Consider a company operating at say 97% breakeven. Gross Margin on only 3% of turnover is available to produce a profit. (Gross margin on the other 97% offsetting fixed costs.)
At say 87% breakeven, gross margin on 13% of turnover is available to generate a profit. At say 77% 23%.
The last produces 8 times more profit, operating cash flow (cash profit) and funding-availability than the first.
'1:1' Gearing
Retained-profits 'strengthen the balance sheet' allowing banks to match the 'increased equity' with additional lending of up to a similar amount - the '1:1 gearing' concept - doubling the benefit. A virtuous cycle develops.
And alarmingly of course - the (rapid) reverse as breakeven rises.
'De-Risking'
Hence the need: 1) to monitor breakeven, like creditor-strain, on a real time basis 2) to include both as central features of all budgets and business plans. By which means the whole security of the company's operation can be 'de-risked'. Compare 'Going Concern' heading in Section II.
Funding 'Self-Sufficiency'
Once Breakeven gets below about 75%, operating cash flow + matching bank lending begins to outpace increased funding need (turnover-related + capital expenditure) as the company grows. Funding self-sufficiency results.
12-Month-Moving-Totals
A powerful form of monthly monitoring uses 12-month-moving-total graphs: P&(L), Sales, Breakeven, the difference between the two, OH, GM, the difference between the two, GM%, BE%, Stocks, Debtors, Creditors and Creditor Strain days.
Margin, Margin, Margin
The approach emphasises that " 'Gross Margin' - not 'Sales' - is the real income of a business". And the most sensitive and influential factor in bringing about company success (or failure). Gross Margin improvement needs to be the prime focus of management time, effort and attention.
IIIb BUSINESS STRATEGY
Strategic Benchmark
The design benchmark for a secure, profitable, well-funded business is < 75% of sales. [Few companies meet, or better, this target - how does yours fare?]
Strategic planning, budgeting, business planning and daily/weekly/monthly monitoring need to concentrate on:
- "getting breakeven down" (targeting ~75% etc)
- "keeping breakeven down".
BREAKEVEN is perhaps THE key benchmark in business, relating:
a) Gross Margin to Total Overhead (Fixed Costs, including interest paid), determining profitability, operating cash generation (cash profits) etc.
b) Profitability to Asset Funding Need (sales-related stocks + trade debtors - trade creditors, plus capital expenditure), dictating return-on-capital, return-on-equity, return-on-assets, ability to fund growth and a powerful contributor (or the opposite) to 'solvency'.
The Four Key Elements of Business
Breakeven Percentage draws together the four key elements of business: a) sales, b) overhead c) gross margin (gross profit) and d) asset funding need, into one universal Benchmark / Key Performance Indicator.
The lower the breakeven, the better the relationship, in each case. The higher, the worse. With the threshold between 'strong' and 'weak' company at around 75%. Per table above.
Margin 'Leverage'
As will be known "Gross-Margin improvement" exerts considerably more 'leverage' in "getting breakeven down" than "overhead cost-reduction" (which tends to cut resources - for product / service / market development).
'Resources' in P&L Account, not BS
'Resources' in modern companies lie in the Profit & Loss Account, in the form of 'overheads', not the Balance Sheet in the form of capital expenditure.
Margin / Volume Trade-off
Improving gross margin percentage from say 25% to 30% produces 20% gain in real income (5/25%). The cost-cutting alternative requires 20% cut in overheads to achieve the same ends.
Note that turnover can fall by up to 17% before the benefit of the stated '5%' margin improvement is wiped out.
Most Frequent Cause of Company Failure
The most frequent cause of company failure is where management teams are either unaware of this critical price/margin dynamic or ignore it and head in the wrong direction (particularly in response to a sales downturn), making matters worse.
For instance by "cutting prices" to "get more sales", management can end up generating less £ gross margin income in total, on higher turnover and therefore higher funding needs, weakening the operation further. [You might like to work out how much increased volume is needed just to compensate for a reduction in gross margin from say 20% to 15%. Yes, your figure is right - and most unlikely to happen of course, intensifying likelihood of failure.]
Experienced Management Approach
Experienced management teams tend to aim in the other direction, firming up margins and being relatively relaxed about turnover easing back (with the added benefit of lower funding-needs and greater productive-capacity-availability, for the same or less overhead). The acid test is: does breakeven reduce by more than the fall-off in sales? If so, the operation strengthens. The favourable gap between breakeven and sales widens. And of course, worryingly, vice versa.
Knowledge Shortfall
As mentioned, inadequate knowledge, by management teams, about this particular dynamic is one of the greatest causes of sluggish company performance; and company failure.
Only by specifically knowing about the issues can companies avoid falling into the same trap. Conventional management information tends to be largely silent on such matters; leaving management teams unbriefed about the dangers. An unbriefed too to on the considerable profit opportunities available from moving in the reverse direction.
Dell Example
If you were not adequately aware of this 'dynamic' you are apparently in good company. Some time after the above was written the Financial Times reported on 12th August 2005, under the byline "PC pricing mistake hits Dell revenues": "Kevin Rollins, chief executive, blamed the revenue shortfall in part on more aggression in its pricing than was strictly necessary." "Dell could have made up for much of the shortfall if it has added $10-$15 to the price of each of the 9.1m machines it sold during the quarter." "Frankly, we executed poorly."
The FT comments: "the admission marks a rare slip at a company that has risen to the top of the computer industry on the strength of a relentless low price business model that has relied on close attention to detail".
If it can happen to Dell, it can happen to anybody. The above price/volume trade-off calculations will help you avoid the problem. (The Mini is another example - the car not the skirt - which eventually brought down what might otherwise have become one of the world's leading car manufacturers, on par with Toyota.)
Pricing / Costing
Breakeven can play a seminal role in all pricing and costing decisions, for all sizes of company, sole trader to multinational.
Sole-trader
A sole trader can readily calculate how many productive hours are needed, at present fee levels, to cover overheads. If more than 40 hours a week, clearly the operation is on a hiding to nothing.
Because a sole trader has so many other calls on his/her time (marketing, administration etc), fees need to be pitched at a level where costs are covered by no more than say 10-15 fee-earning hours per week. Leaving the remainder for profit, plus non-fee-earning activities.
Larger Companies
And similarly for all other sizes of company. The overall gross margin / overhead balance can be assessed across the whole broad spectrum of products, prices, markets, subsidiaries and outlets.
Multinationals
Companies like Phillips, Hewlett Packard, Rentokill and others have at one time or another gone through 'thin' periods as a result of insufficient insight in this area.
Flexibility of Approach
Breakeven is a Universal 'Dynamic' benchmark. 'Dynamic' in automatically adjusting to changing conditions as they happen. 'Universal' in being an accurate benchmarker for all types of and conditions of company - the Holy Grail of Standard Setters.
Such measures automatically help companies maintain and where possible enhance, for instance gross margin income through good times and bad. At the very least helping maintain continuity of income; or not allowing it to fall away too unacceptably.
IV CREDITOR (PAYABLES) STRAIN - the extent to which suppliers are kept waiting beyond agreed settlement terms; and whether the overall timescales are getting longer (worse) or shorter (better). Measuring financial Strength / Weakness. In more familiar terms 'SOLVENCY'.
'Days' Measurement is straightforward. Trade Creditors are compared to annual (gross margin) purchases after adjusting for VAT. 'Other' Creditors (Overhead creditors) are more tricky. A good rule of thumb is that 6 weeks overhead comprises the 'norm'. Anything in excess is 'strain'. With days calculated accordingly.
For full effect, any amount by which the overdraft is over/(under) the limit should be added/(subtracted).
The total provides a reliable guide to whether 'strain' is getting better or worse. And if / when the crunch will come. Regularly done, considerable early warning of looming problems becomes available (months at least, sometimes much longer). Which should of course immediately feed back into all business plans and budgets - whilst there is still time to remedy the situation.
Many companies have been helped in this way. Creditor-strain, undetected creditor-strain, is one of the biggest killers of growing companies. It happens on an extensive a scale and is, very largely, avoidable.
It is also one of the biggest killers of companies falling into difficulties due to external factors like market downturn. Detected and addressed early enough, again there is much that can be done. As hopefully has been shown.
"Balance Sheets can't show Funding Strain"
Balance sheets balance, so cannot show, or detect, funding strain (another of the paradoxes of business) which can therefore all-too-easily remain hidden, deep within the company. Management remaining unaware of its existence. Or significance.
Remotely Buried
Buried in the most remote and obscure part of balance sheets is a Note that analyses 'creditors' (a not easily understood term incidentally - the Americans use the much clearer term 'Payables'). Within this Note a 'Trade Creditors' figure is given (payments owing to suppliers for purchases that go into the gross margin); and 'Other Creditors' (several, often) relating to overhead, capital, etc expenditure.
'Strain'
Any of these figures may contain - hidden - 'strain' elements (overdue payments), which unfortunately get 'lost' in the overall figures. Unless the 'strain' element is specifically isolated from 'normal' creditors (amounts not yet due for payment) management team members are likely to remain unaware of what is happening; with very real dangers of unidentified, and unanticipated, cash crises developing.
Becomes Apparent Too Late to Save the Company
When the strain gets so bad it does surface, it is often / usually too late to avoid the consequences - leading either to growth becoming ever more severely curtailed; or outright company failure, which seems to come 'out of the blue'.
Wrong to Blame Management
Investors then blame management for 'concealing the truth from them'. And introduce comprehensive corporate governance and other regulations to try and make management 'more forthcoming' in future.
Everyone Wrongfooted
Whereas the reality is that management team members themselves are likely to be as much in the dark, and wrong-footed, as investors and others are.
Solution
The solution lies making the necessary enhanced information available to management.
Regulatory Mismatch
Much compliance legislation thus seems directed at a mistaken target, with a high probability therefore it will not achieve its aim, despite the considerable extra work and management distraction of time and effort involved.
Fraud and Error
Similar comments apply on the question of fraud and error; including (inadvertent) errors in public statements. Ordinary management team members don't have the means of detecting it - so again are more in the dark than the outside world believes; or realises. (See Section V below for the solution to this particular problem.)
"Undetected Time-Bomb"
Creditor Strain is like an undetected time-bomb sitting at the very heart of your company, primed to go off at the worst possible moment (as the company tries to expand).
"Holed Below the Waterline"
Business schools use the analogy of a leak in the hull of a ship, many decks down, unknown to those on the bridge - until too late.
"Fractured Foundations"
Or an undetected fracture in the foundations of a building, which widens, and suddenly gives way, with little or no warning, when more floors are added.
Measure, Measure, Measure
Creditor Strain needs incorporating in all strategic thinking, business plans, budgets and monitoring procedures. [You will know whether this applies in your company. If not, be concerned.]
Detectable from Audited Accounts
In the first instance, like breakeven itself, the build-up of creditor-strain can usually be at least generally detected from publicly-available audited accounts, forewarning of the growing dangers. [Nearly all companies exhibit some degree of creditor strain - how does yours fare?]
Key Aspect of 'Internal Control'
Detection and elimination of creditor strain needs to be made an integral part of the company's Internal Control procedures and Strategic Planning exercises.
Test
You can test for yourself whether such features appear in your own management and audited accounts. If not, however carefully prepared, your existing information can not be relied on to reveal growing dangers and weaknesses within the business.
Or conversely, enable management to get the very best out of the operation - the main aim of course.
V DETECTION OF FRAUD AND ERROR - 'PATTERN DETECTION'
Fraud and error (whether intentional or inadvertent) need to become readily apparent to all members of the management team, as a routine part of their day-to-day work.
As will be known, 'pattern-detection' is the standard way of detecting say credit card fraud.
PATTERN-DETECTION IS AN INHERENT FEATURE OF DYNAMICS AND AUTOMATICALLY AUTHENTICATES ALL INFORMATION PRODUCED
Failure to unearth expected patterns invariably means something is wrong, setting in train search for the cause. Which must continue, however laboriously, until the information is 'clean'.
Gross Margin Assessment
This applies especially to gross margin assessment. Dependent in turn on stock assessment.
Can be Frustrating & Onerous Task
Often, at least in the first instance, it can be an onerous task. But a company can not be reliably run without this extra dimension. Nor can dependable profit etc statements be made, internally to management and auditors, or externally to the outside world.
Example
A good example of 'error' detection recently occurred when dynamic analysis - 'pattern-detection' - was applied to a five year sequence of audited accounts. Debtors (receivables) appeared to be running at around 20 days and work-in-progress at over 100 days ('days' is of course a 'dynamic' measurement).
Internal procedures however indicated that work-in-progress was unlikely to be more than a month, but debtor collection could take up to 90 days or more.
This immediately highlighted the fact that a large element of 'debtors' must be included in wip. The combined figure was accurate, but - for management purposes - re-grouping was desirable to reflect reality on the ground (reality on the ground of course being the final arbiter of how costs should be grouped). Making it possible, in ensuing months, to tighten cash-flow control considerably.
VI SOUND-BUSINESS DESIGN FEATURES
Other business-design features include:
1) Stocks, debtors (receivables) and creditors (payables) need to be tightly controlled to pre-determined targets (percentages of annual sales and 'days'). And to Total Net Current Asset Percentage (enabling the Turnover-Related-Funding-Need to be rapidly calculated).
2) Gross Margin Percentage needs to exceed Net Current Asset percentage (calculated assuming no Creditor Strain, which would otherwise understate the overall funding need).
3) After-tax profit retention needs to be sufficient to support whatever borrowing becomes necessary as the company grows (banks tend to lend against 'balance sheet strength' - rate of growth of shareholders funds)
4) Capital expenditure should not be excessive
5) Profit distribution should not be excessive (at least until sufficient equity base has been built up)
6) New forms of cash planning and monitoring are needed, which are briefer and simpler, yet:
- More accurate
- Faster to produce
- More meaningful to the management team
VII WORKING CAPITAL ASSESSMENT
As the downturn begins to bite, accurate planning and control of working capital has become ever more vital. Applicable Benchmarks are 'days' and '% of turnover'.
A company operating 30 day terms for debtors ('receivables' from customers) has a debtor funding need of ~ 10% laboriously annual turnover.
30 days (sales) is 1/12th or 8.3% of a year. Debtors contain VAT. Sales do not. Adjust to compare like with like, 8.3% x 1.175 = 10% in round terms. Producing a funding need of £100,000 for every £1m of turnover.
Allow debt collection to slip to 2 months and £200,000 per £1m of turnover is needed.
A customer unilaterally extending payment terms from say 21 days to 3 months, throws an added funding burden on the supplier equivalent to 25% of turnover.
A £10m turnover company overnight needs to raise an extra £2.5 million just to stay in business.
1) with bank borrowing becoming ever more difficult to obtain and 2) absence, in many cases, of a sufficient equity base within the company to support additional borrowing on a 1:1 basis, company failure in many cases becomes only a matter of time (months often). Is that really in anyone's best interests, least of all the customer's?
Looked at another way, 1 day's sales for a £100 million turnover company is around £300,000. One hour's sales around £40,000.
Simplifying to illustrate the point, an extra hour's delay in issuing invoices requires another £40,000 to fund the company. A day late, £300,000. A week £1.5 million.
Similarly, carrying an extra day's raw material stock, or an extra day's work-in-progress, or finished goods and another say £100,000 - £250,000 is needed.
If ever there was truth in the saying 'time is money' it lies in the planning and control of working capital.
BDL uses special techniques to plan and control working capital to very high degrees of accuracy (details available on application).
VIII NEW FORMS OF GROSS MARGIN ASSESSMENT ARE HELPFUL - 'VALUE-ADDED-PER-HOUR'
New forms of gross margin-measurement, like value-added-per-hour (rate of generation of gross margin - directly measuring Productivity) allow 'variable' or 'differential' costing and pricing to be introduced, often substantially improving gross margin income - and therefore profit and cashflow generation; and profit retention (balance sheet strengthening).
Improved Competitiveness
laboriously is nearly always improved in the process, in both specialty ('niche' products and services) and volume ('commodity') markets.
Offshoring
It can also make offshoring less necessary. Or not necessary at all.
IX MANAGEMENT TEAMS' PERSONAL VULNERABILITY
There have been notable examples of incorrect information being released, eg to markets, without proper awareness it is faulty.
Test
A hint is provided when management accounts (and audited accounts) show something different from what management have been expecting.
Does this happen to you? If so, the team will sense they do not have full control of the business. Either their own knowledge of what is happening is incomplete, or the accounts are not reflecting events sufficiently accurately (or clearly) enough. Either way, the disparity must be eliminated before the company can be considered adequately, let alone 'well', run.
Present Regulation does not Address Problem
Unfortunately, 'tightening internal controls' viz: Sarbanes-Oxley, does not, as such, deal with the problem (such tightening merely makes all concerned more at risk and vulnerable). The form of information first needs refocussing (as above). Without such change those involved (usually unknowingly) remain vulnerable.
B. C. J. Warnes MA (Oxon) Natural Sciences (Physics), FCA, FRSA
Managing Director
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