Exec's Program #11: Financial Analysis Part 2

THE EXECUTIVE’S PROGRAM SESSION 11 FINANCIAL ANALYSIS FOR EXECUTIVES PART 2

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PURPOSE AND LEARNING OBJECTIVES Purpose: To continue to learn why and how top executives read financial statements to understand their company and drive growth.

Learning Objectives: To learn…

• How to calculate key ratios and margin using your financial statements • What those ratios and margins mean • To start doing it…

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AGENDA 1. Orienteering and recap 2. How to do financial analysis (cont.)

3. Breakout 4. Summary 5. Reflection and assignment

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SECTION 1 ORIENTEERING

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ORIENTEERING: STEP-BY-STEP Session Topics

If you did just one thing…

The Habits

Have a morning routine! Use your calendar.

Strategic Planning

Write down your 5-year plan.

The AMP

Write down you AMP. Look to the Left!

Governance

Have a diverse group with authority (ideally a board) to give you feedback and holds you accountable to your plans.

Set 3 “I Musts” each week and map them to your calendar.

Start with your Guiding Statements, and KISS and use it (Coffee Stains) to set your annual plans.

Strategic plan is the input. Use the AMP to set quarterly and monthly OKRs. Chop up your goals into bite-size work that ultimately becomes weekly projects and I Musts.

Ask for their feedback! Follow your own rules – set the example. Everyone is watching you.

Intro to Execution

Build your binder! “I should write that down.” Write SOPs.

Management Teams

Have an org chart and use it to organize your company.

Meeting

Run great meetings! Use them to drive execution.

Reporting

Start measuring 5-10 KPIs for your company. Weekly or monthly. As you measure it, you will see improvements.

Intro to Finance and Accounting

Close your books by the 10th and hold your finance meeting on the 15 th. DO NOT ABDICATE this work. You are the co-CFO.

Financial Analysis Part 1

Calculate your monthly TvA and ratios and do a quick common size and trend analysis. Ask Why 7 times during your TvA meeting. Observe red flags in trends and common size.

They are the treasure. Plan + Organized Team + PAs + SOPs + Battle Rhythm = Results!

Write PAs for those connected to you (your management team).

Use meetings to drive execute. Have P, O and A for every meeting.

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ACCOUNTING VS FINANCE Accounting

Finance

• About the past

• About the future

• Controls the current inflows and • Analyzes the future investments outflows of cash of capital • “Is that approved?”

• Forecasts cashflow

• Very disciplined

• “Is that a wise investment?”

• Close the books every month

• Very analytical

• KPI: Timely and accurate financial • KPI: TvA, ROE, FCF statements Look at your cash flow weekly Look at your financial statements at (daily), budget monthly least once per month; NOT only once a year 6

FINANCE AND ACCOUNTING 101 SUMMARY • DO NOT abdicate accounting and finance: You are the co-CFO. • Employ a very disciplined accountant: Their main job is to deliver accurate and timely financial statements to you every month (this is their KPI), and to control the cash in and out of the company.

• Have, read and implement the finance manual: This is the accounting and finance SOP for the company.

• Have a financial plan: The financial model (i.e., strategic plan), the budget (i.e., the numeric version of your AMP) and the 13-week CF (i.e., your quarterly OKR / Cash plan).

• Close your books every month. Ask for the financial statements.

• Hold a monthly finance meeting every month: one of your two monthly management battle rhythms.

• Enjoy reading your financial statements: BS, IS, CF - and see what they tell you.

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SECTION 2 HOW TO DO FINANCIAL ANALYSIS

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FINANCIAL ANALYSIS: BUCKETS OF ANALYSIS

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2

3

Targets versus Actuals (Budget)

Trend / Common Size Analysis (Past Financials)

Ratio Analysis (Industry Comparison)

Ask “why” 7 times: Why are we hitting our targets? Why not? Get the real answers.

Spot trends Any outliers? What are my margins?

What are the trends?

Evaluate Yourself How am I doing?

How are we doing compared to others?

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BUCKET 1: TVA

Target vs. Actuals The Accountability Metric

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EXAMPLE BAR CHART: TVA An example way to present TvA sales and profit.

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Ask “Why” 7 times.

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BUCKET 2: COMMON / TREND ANALYSIS

Common / Trend Analysis The Wise Executive 13

TREND ANALYSIS

Two-types: Do both.

– Common Size Analysis or Vertical: Compares all IS items to sales (IS account over total sales). Use to study trends in cost and profit margins. Also, key for ratio analysis.

– Trend or Horizontal: Divides all numbers by the first year’s values or month’s values (i.e., first year or month will be 1.0 or 100% for all accounts). For spotting trend analysis.

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HOW TO COMMON SIZE ANALYSIS Common Size (Vertical)

Trend Analysis (Horizontal)

1.

Create a column to the right of the figures

1.

2.

Divide all figures by sales (Use $$ to lock cell – Command T)

Have multiple years (months or quarters) of data aligned in the same rows

2.

Divide all figures by the first year/month (Use $$ to lock cell – Command T)

3.

Drag the cell across

4.

Observe the % changes

3.

Drag the cell down

4.

Observe the % - GPM, OPM, NPM

NOTE: Common size on the IS gives you your margins.

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ANALYZE DATA: TREND ANALYSIS Goes Horizontal. Spots trend or patterns over a period of time.

Common-size analysis

Mar-12

Mar-13

Mar-14

Mar-15

Mar-16

Revenue From Operations [Gross]

100.0%

83.0%

63.4%

66.4%

78.5%

Less: Excise/Service Tax/Other Levies

100.0%

92.7%

70.6%

65.7%

87.0%

Revenue From Operations [Net]

100.0%

82.2%

62.8%

66.5%

77.7%

Other Operating Revenues

100.0%

130.4%

126.6%

134.2%

140.1%

Total Operating Revenues

100.0%

82.4%

63.1%

66.8%

78.0%

Other Income

100.0%

363.7%

667.7%

327.7%

371.5%

Total Revenue

100.0%

85.4%

69.5%

69.6%

81.1%

Cost Of Materials Consumed

100.0%

80.4%

60.5%

65.4%

71.7%

Purchase Of Stock-In Trade

100.0%

91.1%

78.5%

89.6%

81.7%

Operating And Direct Expenses

100.0%

181.8%

183.0%

186.8%

181.3%

Changes In Inventories Of FG,WIP And Stock-In Trade

100.0%

23.0%

-59.6%

140.9%

-3.7%

Employee Benefit Expenses

100.0%

105.4%

106.9%

114.9%

112.5%

Finance Costs

100.0%

113.9%

109.8%

132.3%

121.5%

Depreciation And Amortization Expenses

100.0%

113.1%

128.9%

162.0%

152.7%

Other Expenses

100.0%

92.6%

83.1%

96.1%

95.7%

Less: Amounts Transfer To Capital Accounts

100.0%

105.1%

111.2%

123.3%

114.0%

Total Expenses

100.0%

87.4%

72.9%

78.8%

83.1%

Expenses:

BUCKET 3: INCOME STATEMENT RATIOS

Income Statement Ratios Performance 17

RATIO ANALYSIS Profitability Ratios (Margins) – Gross Margin = (Sales – Cost of Sales) Sales – Operating Margin = (Gross Profit – Operating Expenses) Sales – Pre-tax Margin = Earnings before Taxes

Rule of Growth Next slides

Sales – Net Profit Margin = Net Income Sales NOTE: Pull from your Common Size Analysis of the Income Statement

RATIO ANALYSIS

The Strategy Metric Gross Margin = Sales – Cost of Sales Sales

NOTE: Pull from your common size Income Statement

RATIO ANALYSIS

The Strategy Metric Gross Margin = Sales – Cost of Sales Sales

NOTE: Pull from your common size Income Statement

RULE OF GROWTH 10% Pre-Tax Profit Margin Your New Breakeven Pre-Tax Profit Margin

Rule of Thumb

5%

Your business is on life support

10%

Doing OK but has untapped potential

15%

Doing good!

>15%

Wow…But watch out. Dig the moat.

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BUCKET 4. BALANCE SHEET RATIOS

Balance Sheet Ratios Strength 22

Working Capital = Current Assets – Current Liabilities

From the Balance Sheet 23

RATIO ANALYSIS Liquidity Ratios • Current Ratio = Current Assets Current Liabilities • Quick Ratio = Current Assets – Inventory Current Liabilities

Higher the better.

Should be above 1 1.5 – 3x

Higher the better.

At least 1x

• Cash Ratio = Cash + Cash Equivalents Current Liabilities

Higher the better.

1x is good

RATIO ANALYSIS Coverage Ratios • Interest Coverage Ratio= Earnings Before Interest & Taxes (EBIT) Interest Expense • Current Liability Coverage Ratio = Cash Flow from Operations (CFO) – Dividends Paid Current Liabilities

RATIO ANALYSIS

Warren Buffett’s CEO Metric Return on Equity (ROE) =

Net Income Avg. Shareholders Equity

NOTE: When you use an IS and BS item, you need to use the average of the BS item

BUCKET 5. MARGINS

Cashflow Statement Metrics Health 27

EQUATION: THE CASH CONVERSION CYCLE

CCC = DSO + DIO - DPO CCC = Cash Conversion Cycle DSO = Days Sales Outstanding DIO = Days Inventory Outstanding DPO = Days Payable Outstanding 28

EQUATION: ACCOUNTS RECEIVABLE TURNOVER & DSO Step 1:

Sales

Receivables Turnover =

Average Accounts Receivable 365

Step 2: DSO

ADD

= Receivables turnover 29

EQUATION: INVENTORY TURNOVER & DIO Cost of goods sold

Step 1: Inventory Turnover

= Average Inventory 365

Step 2: DIO =

ADD

Inventory turnover 30

EQUATION: ACCOUNTS PAYABLES TURNOVER & DPO Cost of goods sold

Step 1: Payables Turnover

= Average accounts payable 365

Step 2: DPO =

SUBTRACT

Payables turnover 31

EQUATION: EXAMPLE

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EQUATION: SOLUTIONS

DIO = $1,500 / ($3,000/ 365 days) = 182.5 days DSO = $95 / ($9,000 / 365 days) = 3.9 days DPO = $850 / ($3,000/ 365 days) = 103.4 days CCC = 182.5 + 3.9 - 103.4 = 83 days

Read more: http://www.investopedia.com/articles/06/cashconversioncycle.asp 33

EQUATION: DELL AND THE CCC

BUCKET 6. BENCHMARKING

Industry Comparison Benchmarking 35

DEVELOP COMMENTARY & RECOMMENDATIONS Industry Comparison • Analyze the company’s ratios and margins with others in the industry. Try to find comparable size or geographic profile.

• Tells you how you are doing compared to others (apples to apples. Or as close as you can.)

• Example: Our gross margins are 30% higher than the industry average due to proximity to raw materials, lower labor and electricity prices and a shorter supply chain. Our ROE is lower due to higher costs of capital good and higher depreciation.

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INDUSTRY ANALYSIS RESOURCES 1.

BizStats (www.bizstats.com): It offers statistics and financial data on businesses in a variety of industries as well as tools to calculate business valuation and cost of goods sold.

2.

Securities and Exchange Commission (www.sec.gov/edgar.shtml): The SEC makes annual reports and other financial filings of publicly traded companies available for review at its website.

3.

Hoover’s Online (www.hoovers.com): This is a product of Dun & Bradstreet that offers a searchable database of financial information and profiles of public and private companies.

4.

Thomas Register (www.thomasnet.com): Originally published in book form, the Thomas Register is a searchable database of product information and market trends for a variety of industries. It publishes an annual survey it calls its “Industry Market Barometer” that shows where reporting companies are, where they have been and where they are heading.

Source: https://www.discoverbusiness.us/resources/business-plans/ 37

GREAT FINANCE RESOURCES • Investopedia: http://www.investopedia.com/articles/06/cashconversioncycle.asp

• Strategic CFO – 13 WCF: https://strategiccfo.com/thirteen-week-cash-flow-report/

• Accounting: https://www.accountingcoach.com/

• Accounting Podcast: https://www.accountingtools.com/podcasts/

• 13WCF Video: https://www.youtube.com/watch?v=ddNBsBnek78

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SECTION 3 BREAKOUT

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BREAKOUT DISCUSSION 1.

What do you look at and what are the pain points when you go through analyzing the statement and making decisions?

2.

What are the key components do you think you need to see and how are they presented to you?

3.

How would you communicate the information to your stakeholders?

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SUMMARY • Close your books on the 10th.

• Get the financial statements and do analysis on the 15th.

• Analyze your financial statements to understand your key performance, strength and health metrics.

• Ask “Why” 7 Times!

• Get better at forecasting (budget and 13WCF) • Cash and cash flow are key! There are 7 levers to increase cash flow, which we will cover next class.

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HOMEWORK ASSIGNMENT 1. Use your calendar (I Musts, map all your time, set aside 3 hours for ON the business work) 2. Schedule 3 hours: –

Collect your financial statements

–

Calculate your margins and your ratios

–

Email us if you want a consultation

3. Do the prep work for next class on cash flow.

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Feedback Time

Proprietary and Confidential to RENEW LLC

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Thank you! www.renewstrategies.com

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Backup www.renewstrategies.com

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TEAM EXERCISE • Time: 60 min • Goal: Try what you have learned on your own financial statements.

• Topic: Calculating margins • Discussion Questions: – What is your gross profit margin?

– What is your net profit margin?

– What is your current ratio?

– What does this tell you about your company?

– Are you paying men and women fairly?

• Report Out: Each team reports out 3 things they learned?.

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RATIO ANALYSIS Financial Leverage Ratios • Debt Service Coverage Ratio (DSCR) = Net Operating Income Total Debt Service • Capitalization Ratio =

Long Term Debt LT Debt + Shareholders Equity

• Debt to EBITDA = Total Liabilities EBITDA

THE ADVANCED STEPS Time for Growth 5.

Step 6: Clear distortions

6.

Step 7: Set the right profit target

7.

Step 8: Use labor efficiency to drive profitability

8.

Step 9: Manage the four forces of cash flow

Source: Mastering the Rockefeller Habits

Proprietary and Confidential to RENEW LLC

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STEP 5: CLEAR DISTORTIONS a.

b.

Add your salary to management expenses i.

You are an expense for the company.

ii.

Management’s job is to assign tasks to other and maximize output.

Use “Modified Gross Margin” dollar as revenue: i.

Modified Gross Margin = Revenue – NONLABOR Direct Costs

ii.

Why? NONLABOR expense are pass-through costs. “Other people’s product”

Proprietary and Confidential to RENEW LLC

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STEP 7: USE LABOR EFFICIENCY TO DRIVE PROFITABILITY a.

Calculate labor efficiency ratios i.

Direct labor efficiency (DLR) = Gross margin dollar (GM) / direct labor cost (DLC) •

Gross margin dollar = Revenue – NONLABOR direct costs

•

Direct labor spends 50% or more delivering products or services

ii.

Sale labor efficiency (SLR) = Contribution margin dollar (CM) / sale labor cost (SLC) •

Contribution margin dollar = Gross margin dollar – DIRECT LABOR.

•

If you have a dedicated sales team

iii. Management labor efficiency (MLR) = Contribution margin dollar (CM) / management labor cost (MLC) •

Labor costs that are left after direct and sale labor deducted

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STEP 7: USE LABOR EFFICIENCY TO DRIVE PROFITABILITY: THE MAGIC 1.

Calculate current labor efficiency ratios,

2.

Calculate your pre-tax profit margin = Revenue / Pre-tax profit.

3.

Set your sale needed to get to 10% pre-tax margin by holding all costs excluding direct material constant.

4.

Hit 10%, rest the target to 15%.

5.

Hit 15%. Add labor to the category you see “stress”. Adding labor can be raises or bonuses.

Doesn’t just need to be people. Pre-tax margin will drop down below 15%, temporarily. Do not drop below 10%.

6.

Drive growth back up to 15%.

7.

Repeat. Track the LERs to see which categories are doing best.

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EXAMPLE Step 1 Pre-tax Profit Margin Target Income Statement

10% $450,000

Direct cost excluding labor

$130,000

Modified gross profit

$320,000

Direct labor Contribution Margin

71.1% $90,000 $230,000

Management labor cost

$75,000

Sales labor cost

$35,000

Other operating costs Pretax profit

Step 3 15%

Step 4 10%

15%

Starting Month

Revenue

Modified gross margin dollar

Step 2

$100,000 $20,000

Pre-tax profit margin

4.4%

Contribution margin

51.1%

Other operating costs margin

22.2%

Labor Efficiency Ratios: DLR (GM/DLC)

$3.56

SLR (CM/SLC) MLR (CM/MCL)

$492,195 $534,402 $531,633 $578,919 • This is work you need to perform $142,190 $154,383 $153,583 $167,243 on your Income $350,005 $380,019 Statement. $378,050 i.e., $411,676 71.1% 71.1% will not 71.1% PeachTree or71.1% QuickBooks $90,000 $90,000 $98,333 $98,333 do it automatically. $260,005 $290,019 $279,717 $313,343 $75,000 $83,333 $83,333 • Blue is hard$75,000 entered numbers. $35,000 $43,333 • Orange are$35,000 the labor$43,333 categories. $100,000 $100,000 $100,000 $100,000 • Green main target $50,005 is our $80,019 $53,051and focus. $86,677 10.2% 15.0%These 10.0% • LERs are below. are our 15.0% 52.8% 54.3% 52.6% 54.1% performance levers.

20.3% 18.7% 18.8% 17.3% • Highlighted yellow is what we are changing. $3.89

$4.22

$3.84

$4.19

$6.57

$7.43

$8.29

$6.46

$7.23

$3.07

$3.47

$3.87

$3.36

$3.7652

STEP 8: UNDERSTAND THE 4 FORCES OF CASH FLOW Force #1 – Save for Taxes: Make sure to set aside money to pay your taxes Force #2 – Manage Debt: Debt is generally not your friend. If not carefully managed it will enslave your business. Rule of thumb: Don’t use lines of credit.

Force #3 – Hold a Core Capital Reserve: Save 2 months of operating expenses in cash.

Force #4 – Harvest Profits: Once Forces #1 - #3 are set aside, distribute profits and bonuses.

You made it!

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SUMMARY • 10% is the new breakeven • Drive your company to 10% pre-tax margin without changing costs, except direct material costs • Once you hit 10%, push to 15% • Only at 15% add costs beyond direct material • Repeat this exercise • Manage cash like a hawk: 1) Always pay your taxes, 2) always pay your short-term debt, 3) hold 2 months of opex in cash in reserve, 4) then pay dividends…you did it!

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CASH FLOW • Perform cash analysis – Analyze the Free Cash Flow (FCF) = Cash flow from Operations (CFO) – Capital Expenditures • Look at the Y-O-Y, Q-O-Q, M-O-M and CAGR growth rates • Compute FCF as % of Cash flow from Operations

– Look at the Operating Cash Flow ratio = Cash Flow from Operations Sales

QUICK FINANCE REFRESH 1) Know your financial tools: – Budget: How you wanted to do / how you plan to do for the coming months – Monthly Financial Statements: IS, BS and CF. How you did last month(s) – 13-week Cash Flow: How you must do over the coming weeks 2) Know your calculations: – Growth (MoM,YoY), Margin (GPM, OPM, NPM), Ratios (Current, ROE), & CCC 3) Collect reports – Monthly Financial Report: TvA and “why?”

– Monthly Operational Report - Dashboard: Each managers’ KPIs, which are documented in the PAs and SOPs

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RATIO ANALYSIS Profitability Ratios

Return on Assets (ROA) =

Net Income Avg. Total Assets

RATIO ANALYSIS Efficiency Ratios: Measures a company's ability to use its assets to generate income.

• Total Asset Turnover = Sales Avg. Total Assets • Fixed Asset Turnover = Sales Avg. Fixed Assets

You You should should compare compare these these with with those those inin your your industry. industry.

RATIO ANALYSIS Financial Leverage Ratios

You You should should compare compare these these with with those those inin your your industry. industry.

• Debt Ratio = Total Debt Total Assets • Debt to Equity Ratio =

Total Liabilities

Total Shareholders Equity