"Measuring and Managing the Financial

Health of a Professional Services Business"

Institute of Management Consultants

Meeting(September 12, 2005)

Howard Wasserteil

PrincipalWasserteil Consulting, LLC

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Purpose of Presentation

To review certain financial tools that will help you manage and improve the financial health of your professional services firm – leading to increased sales and profitability

To help you better serve your clients

To motivate you to action!

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Financial Terms to be Used

Profit and Loss Statement (P&L) recaps sales, expenses, profit (loss) in $’s and margin %’s

Balance Sheet (B/S) recaps current and l-term assets, liabilities and profitability; equity

Equity recaps your net worth

Cash Flow Statement recaps how cash is used: operations, financing and investment

Accounts Receivable (A/R) recaps sales booked but not yet collected

Accounts Payable (A/P) recaps what you owe to venders, staff (payroll), gov’t agencies,.

etc.

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RMA Ratios

RMA -- “Risk Management Association”

Nonprofit, professional association that advances the use of sound risk principles in the financial services industry

Has 3,000 institutional members -- banks of all sizes and non bank financial institutions

Annual Statement Studies provide reliable

benchmarks on private businesses, including “Financial Ratio Benchmarks”

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RMA Financial Ratio Benchmarks

Helps banks assess credit risk for bank loan applications; set loan covenant ratios if approved loan covenant ratios – key financial ratios banks require

borrowers to maintain over the loan term; failure to do so can result in loan defaults

Sorted by Assets and Annual Sales (ranges)

Data broken out by reporting period, # of statements and statement type

Ask your banker – it’s free

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RMA Financial Ratio Benchmarks (cont.)

What kind of data dominates the ratios? Balance Sheet – not the P&L! Of the 16 ratios listed, 18 of

the 32 numerators and denominators are off the B/S Value of knowing your RMA ratios:

Provides information on “bankable” competitors: operating results (P&L) assets; liabilities and equity data (B/S)

Provides operating benchmarks you can use as guidelines to manage the financial health of your business

Ask your banker for these ratios (with SIC code) when you don’t need a bank loan – it increases your credibility as someone who recognizes the need to manage using key metrics

Resource: (“Understanding Your Financial Statements”) – Jim Schell

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The “Z Score”

Uses statistical techniques to predict a company's probability of failure, using 5 financial ratios off the P&L and B/S

as with RMA ratios, the data is primarily off the B/S -- 8 of the 10 numerators and denominators

The Z-score, can also be used to predict the opposite of a company’s potential failure – its financial health.

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It’s Not Just the P&L!

RMA ratios and Z-Score: it’s the B/S , not the P&L, that provides the better overall picture of financial health

Many businesses file for bankruptcy after having just completed their most profitable year -- being profitable does not necessarily translate to sound cash flow management!

Where does cash and cash related business activity (A/P; A/R, etc.) show up? The B/S and “Cash Flow Statement” (not the P&L)

“Profitable” Companies can run out of cash because

A/R collections cycle longer than A/P cycle over-investment in equipment (capitalized over time) excessive debt (loan principal paym’ts are not expensed on a P&L) excessive cash in inventory; if it’s slow moving or unsalable, the

cash invested is not available to pay operating exp’s

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It’s Not Just the P&L! (cont.)

Unprofitable Companies can be cash flow positive (in short term)

A/R is collected faster than A/P is paid high “non-cash” items (e.g. depreciation) high prepaid deposits for long term projects can generate lots of cash,

but the income is allocated over the life of the work (e.g. 12 – 18 mos.)

MAJOR POINT #1: There are 2 objectives in successfully running any business: (1) being profitable; and (2) generating cash (most employees don’t know the difference between the two)

the B/S tells the “complete story”: current/past profitability, cash, debt, equity – it tells you if a business is “sick”, and has a “fever”

P&L’s help staff understand their role in helping a business be successful; and, help the owner understand, track and manage what needs to be done to be profitable and generate cash

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Examples of What the B/S Tells You that the P&L (alone) does Not

If the Z-Score’s 5 ratios help predict financial health, each provides insights as to what is right, or wrong, with a business:

Equity/ Liabilities excessive debt

Net Working Capital/ Assetsinsufficient cash

Retained Earnings/ Assets insufficient cum. profits

EBIT/ Assets insufficient profits

Sales/ Assets insufficient sales A professional service firm not large enough to employ a

controller/CFO,and needs help in using its financial statements to effectively

manage itsbusiness, should have its CPA do quarterly reviews of the P&L, B/S

andCash Flow Statements

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How Understanding Financial Health Can Help You Better Serve Your

Clients Consultants’ primary mission: to serve their clients any way that helps them be successful: within, or outside of, their expertise

We all ask our clients from time to time “how are

things are going?” The next time they respond: “We are doing great! We are going to apply for a bank loan in 6 mos.

to purchase new equipment/ open a new location…” , ask them if they have their RMA ratios. If not, suggest that they do ASAP. Proactive action will impress their banker, help them properly prepare for the loan application, and have some valuable financial benchmarks

“We are profitable and yet we continuously run low on cash, and don’t

know why.” Ask them if they review and use the info on their B/S and Cash Flow Statements (w/ their P&L). Again, suggest their CPA help!

bank credit dep’t analyses are a great resource too -- again, free!

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Managing Your Critical Numbers! MAJOR POINT #2: Professional service firms have

specific “metrics” they need to understand, track and manage on an ongoing basis in order to be profitable and generate cash

learn how each component of your business impacts profitability and cash -- most key metrics are not found on the P&L or B/S

develop metrics specific to your firm, that, if managed properly, will produce a profitable, cash generating company – it takes discipline!

teach your employees why each of their jobs are important; it

helps create teamwork and helps keep them focused. And, set up systems to make them accountable

Track metrics as often as needed, displaying them for all to see – not just key managers!

financial statements need to be completed by the 10th of the month for them to serve as an effective management tool -- accrue re-occurring expenses that come in after the 10th

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Managing Your Critical Numbers! (cont.)

learn how each component of your firm impacts profits and cash

example: retailers whose employees greet an incoming potentialcustomer with “have you been here before?” generate 10% - 16%more sales than stores whose employees ask “hello, may I helpyou?” (Gerber – “The E-Myth Revisited”)

By quantifying over time everything having to do with yourfirm, you learn what numbers are, and are not, important

develop metrics specific to your firm, that, if managed properly, will help produce a profitable, positive cash flow generating business

Financial Statements need to be completed by c. the 5th of the

month for them to serve as an effective management tool

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Managing Your Critical Numbers! (cont.)

Most key operating metrics are not found on the P&L

Examples of key metrics for Professional Service Firms *

“Realization”: Avg. billing rate/hr. earned = Total $ Fees / Total Hours

“Utilization”: Avg. # billable hrs per Emp = Total # Billed Hrs / # Emp’s

“Productivity”: $ Fees $ Fees Hours

_____ = ______ x ______ Emp Hour Emp

(Realization) x (Utilization)

* “Managing the Professional Service Firm” (David Maister)

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Using Key Metrics in the Budgeting Process for a

Professional Service Firm MAJOR POINT #3: Budgeting is a valuable financial management tool when done methodically, and with a purpose:

“Bumping” current year’s sales and exp’s by 4% (CPI) is not a conservative way nor right way to budget. It assumes sales and expense results were “acceptable” and well managed in the most recent year, rewarding inefficiencies, and it does not factor changes in the competitive marketplace that have, or may, occur

Budgeting sales: Professional Service Firms must make

assumptions about their key metrics: “realization” and “utilization” (subject to “best guesses” about future economic conditions). Ex’s:

how much can hourly rates be increased? how many units can be sold for current and new products and

services, on a month to month basis?

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Using Key Metrics in the Budgeting Process for a Professional Service Firm

(cont.) MAJOR POINT #4: Consultants’ Most Valuable Asset is their Time

more billable hours (“utilization”) drive higher sales and profits how you budget, manage, use time is key in achieving financial

goals

Budgeting Sales is all about Budgeting Time annual net income goal drives req. # billable hours (based on

billing rate) for sole consultants who only “sell their time” -- know your # billable hours goal per week (incl. holidays/ vacations..)

“tool kits”: in addition to hourly consulting (billable hours), you must calculate each profit center (program) individually, based on historical data that you track, in order to properly budget sales

you also have to budget time for mktg (networking, attending industry events) and admin duties (accounting and cash flow, managing others…)

the time you desire for family and loved ones also has to be budgeted!

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Using Key Metrics in the Budgeting Process for a Professional Service Firm

(cont.) Budget expenses using a “Zero Based Approach”

(line by line)

what would you have to spend if you were starting the business over tomorrow?

don’t consider what you have been spending; develop budgets for what should be spent

for fixed expenses, budgeting a c. 4% (CPI) increase can be OK

as with sales, there are key expense metrics, tracked over time, that will help you manage your financial health

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How “Managing Financial Health” Integrates w/ Two Prior IMC

Presentations Budgeting Key Metrics are part of the Bus Plan Process

Jim Horan’s “One Page Bus Plan” ™ (Vision; Mission; Objectives; Strategies; Plans) mandates a “vision” and “mission” before setting financial goals

vision (what kind of co. are you building?) mission (why does the co. exist – what is your “passion”?) strategies and plans to support financial objectives follow…

Effective Business Networking Impacts Sales, Profits, Budgeting Kathie Nelson’s “Networking for Busy People” ™ programs

empower clients to

make best use of their time (your most valuable asset) when networking

“zero in” on their passion (“mission”) – needed for the business plan leverage their strengths, improving sales, profits, financial

health

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Major Points (Recap)1. There are 2 objectives in successfully running any business --

being profitable and generating cash B/S reflects overall financial health; P&L whether you make $’s

2. Professional service firms must develop, track and manage key

metrics on an ongoing basis to be profitable and generate cash

3. Budgeting is a valuable financial management tool when done methodically, and with a purpose

key metrics are used to develop budgets, line by line recent financial performance helps, but is only part of the process

4. Consultants’ Most Valuable Asset is their Time Budgeting Sales is all about budgeting time

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Misc Points Re: Financial Health Budgeting: any numbers are better than no numbers!

Per “The Great Game of Business” (Jack Stack) missing a metric once is “OK”; missing 3 mos. in a row is a neg. trend imp’s come in fractions (of %’s); surprises come in whole percents! at any given time, a co. generally has to focus on one “critical number”

that has the most impact on how it’s performing and where it’s heading

P&L’s show you where you can make more money, by showing you where you’re losing it

Importance of Proactive Communication During Tough Times contact your key suppliers and bank proactively, telling them

what’s wrong and why your plan to fix it what support you need from them (ext. terms; loan ratios temp. waived) communicate regularly during the process; and deliver what you promise!

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Misc Points Re: Financial Health (cont.)

Spending Policy have one! limit # people authorized to spend $’s require a 2nd set of eyes to review proposed expenditures require two people to sign checks people authorized to spend your $’s must view their spending

decisions as if it is their money -- it’s VERY EASY to spend the owners’ $’s!

Other Sources for Financial Benchmarks (besides

RMA’s) Industry Trade Associations seminars, white papers, surveys, etc. Non-competitors in other markets - industry mtgs such as CONFAB

The Difference between High Performing Companies and Average Ones: they Manage Many Different Areas Just a Little Bit Better!

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Ignoring the Financial Side of your Business” (Inga

Arendt)“Your business exists to make money. Don't neglect to learn about and keep tabs on this important part of your business.

The number one pitfall I see over and over is that the owner does not payenough attention to the financial side of the business. Many owners seem tofeel that as long as there is cash in the bank, they are doing well, and theydon't look beyond that. These are the owners that are usually surprised whenthey go to the bank to get financing and find out that they are not doing as well as they thought, or may be surprised at the end of the year that they didmuch better than they thought and are scrambling to come up with themoney to pay their taxes….. finally, it is very difficult to position a companyas a competitor in the marketplace if the owner does not have a good feel for the pricing structure needed to stay competitive, yet still cover their costs andgenerate a good return.”