Written by Helen Dow
Part I: Identifying Key Financial Drivers
Summary
Good financial management is evidenced by identifying, giving attention to, and supporting the activities that drive success and achieve the goals of your business. To do this, you will need to know the performance drivers for your business, set and track progress on goals, include your partners, and get your team’s buy-in.
It includes building controls and systems to safeguard assets and increase efficiency. It’s about knowing the points to jump in and, sometimes more importantly, when not to.
This is about taking ownership of the financial management of your organization. You will need to lead the way. You must initiate, request, and insist on delivery. Like learning to drive, much attention needs to be given to the smallest of things. Once established, it is easier, and the focus can stay on the important parts of operation and navigation.
Before we start
You may call your business a firm, agency, business, shop, or organization. In all cases, it is a business that is involved in activities with intended goals. In this article any use of the term business or organization will be used generically for any type of for-profit or nonprofit entity.
This topic is broad and there are textbooks written and careers built on this subject. This series of articles will focus on what I believe are the most important financial management principles for success. I love analogies and there is none better than the use of driving for financial performance management. There are no mysteries or magical potions, but instead, it is like setting out and charting a course, deliberate and steady. Not saying there won’t be wrong turns and new adventures, yet covering the fundamentals will best prepare you to see challenges and opportunities as they approach.
Drivers
A discussion on drivers is as good a place to start the subject of financial management as any other. What are the drivers for your business? You may have heard this question before and maybe had some ideas that came to mind. It’s also very possible that there was a lot of uncertainty and a feeling that perhaps you don’t have the full picture. Why did only a couple of items come to mind? And are they even the right ones? And perhaps even a feeling that if I don’t know, what does that say?
To make sure this isn’t you going forward, let’s take the time to work this out for you right now. Grab your last set of internal financial statements, the late-night email to yourself, the early morning email to your management team, and the lists of questions in emails that you sent members of your team.
Now, let’s define what we mean by drivers. Drivers are any activity that you watch and measure to know whether your business is on track to meet its goals. It can be best practices, financial ratios, metrics, indicators, goals and outcomes. It can be as unique to your business or a common truth known to your industry. To give you some examples, it may be that you know that you need a certain number of sales calls per week, a certain number of proposals issued, or a traffic level in the store. Perhaps it is the number of in-kind donations received or a sales conversion ratio. Hopefully, you see that a driver is the measure of an activity that translates to revenue or sales, providing knowledge, influence, and volume. Inversely, it could be an indicator that impacts expenses and costs, such as employee satisfaction to turnover, accounts receivable calls to days in receivables, customer returns to product satisfaction. You can imagine how some of these would be important to your business.
Once you identify your drivers, you will want to establish goals, and track and measure them. This will give your team the focus on the specific activities that maximize your organization’s performance. As time goes by it will confirm or discredit the correlation. This time tracked knowledge can also be scenario based and forecasted for operational decision making.
Dashboards
The best tool for tracking the progress of your drivers is the dashboard. Familiar to most, this is a report in summary form on the results and balances of operations. It’s best for a first or second page to the financials. Like a car’s dashboard, in one look (or page), it should give you key indications on how you are doing. Not just your performance to your goals, but also to alert you to problems and trends.
To help translate what the dashboard should convey, there are four main areas: Safety, Speed, Inputs and Direction. There’s no right or wrong answer here, but I think of Safety as being people centered. Are you overheating or is your tire pressure low? Speed could be growth … too slow and yes, too fast. The inputs feed your engine. What is your cash availability, sales trend, margin, work-in-progress and staffing level? And lastly, Direction to me is a trend. Where are you and what are your goals? Are you on or off course to meet your needs and goals?
Conclusion
Drivers and dashboards give us a good start on setting and monitoring important components of financial management. The next issue of this three-part series will provide a “Roadmap” to establishing and monitoring a financial management system. The third and final part of this series will provide a “Rules of the Road” formula, that can be used for understanding, evaluating, and correcting the internal controls for any financial process.
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Below is a list of sample financial ratios. There are many others, but these are some common ones and discuss a little insight on what they are used for.
Appendix A – Financial Measurements and Ratios
A few samples of financial ratios that are used to indicate financial strength.
Current Ratio – total current assets divided by total current liabilities
This is a ratio that tells you how easily you can cover your current liabilities with current assets. The word current means an asset or liability that converts to cash within one year (e.g. cash, accounts payable, accounts receivable, inventory).
Quick Ratio – this is the current ratio without using inventory.
It is a more liquid (available) version of the current ratio.
Days in Cash – Total cash balance divided by daily operating costs (annual costs divided by 365)
This important metric tells you how much reaction time you will have if an operation is disrupted.
Debt Service Ratio – Net income plus interest, taxes, depreciation, and amortization divided by total debt service payments
Often used by the bank to determine how your cash earnings can cover your debt service
Funded Debt to EBITDA (Total Debt Financed/rolling 12 months (or annual) EBITDA).
Often used by banks to see the ratio of total debt to EBITDA)
Fixed Charge Coverage (EBITA +Rent)/(Curr matur debt + leases + Int + Rent)
Similar to the Debt Service Ratio, it adds rent payments to the coverage requirements
Net Assets or Equity – total assets less total liabilities
On its own, it has little meaning, but is important for its trend
Days in Receivables – average aging of receivables
There is some variation for your industry, but demonstrates the efficiency and effectiveness of collecting on receivables. The trend is important as a slowing (increasing value) can indicate economic problems with customers or not enough attention to collections.
Days in Inventory – Gross annual sales divided by inventory balance
As holding inventory has a number of costs, optimizing the days for your industry can save money
Days in Payables – average aging of accounts payable
It’s important to pay your vendors timely and this metric will tell you how prompt you are
Net Margin – net income or net operating income divided by gross revenues.
This is obvious for a for-profit business. But can be confusing for a nonprofit. it is also important to keep a positive net income number for nonprofits as most are growing and having a positive bottom line keeps the financial stability to do so.
Gross Margin – Sales less cost of sales, divided by sales.
Expense Ratios to Sales or Gross Revenues – this is an expense account divided by total sales or revenue
Many expense accounts correlate with the volume of sales. For instance credit card fees go up proportionally with sales. There are many other expense ratios that can be important to monitor. Think about compensation or any other expense that has a correlation. Often support departments are looked at. For instance the IT, finance department or a group of indirect departments.
Expense to nonfinancial metrics – this is a financial cost divided by a nonfinancial number.
This can provide insight into the cost per unit of something. For instance, sales per square foot or retail space. Or HR costs per headcount. Again, the meaning comes from the trend and benchmark comparisons for your industry.
Specialty Calculations
Bender (a fraud indicator) – a fascinating pattern of number sequences
Altman Z score (a bankruptcy predictor) – this combines a number of financial data points that have been used to indicate financial weakness.
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Helen Dow is a Director of Warren Whitney with more than 30 years of experience helping companies improve their financial performance and enhance all finance and accounting functions. She works with clients on overseeing financial analysis, improving operational efficiencies, and system implementation. Helen generally serves Warren Whitney’s clients in the role of Fractional CFO/Controller. To learn how Helen or our other consultants can support your business, contact Stephanie Ford at sford@warrenwhitney.com or 804.282.9566.
Making Potential Happen.
Data Directions Inc.