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Accounting for costs = preserving profits

I have thought often about the need to say something about cost accounting because of its importance in creating a profitable business, but I knew the mention of the term would put even most accountants to sleep. So rather than talk about cost accounting, a few words about capturing profits might be worth a few minutes of your time. Chapter 8 of my book goes into the topic in some detail, but perhaps the summary points at the end of the chapter will whet your appetite to delve just a little deeper into the subject. After 14 pages of terminology, examples, and definitions, these are the key take-aways that close the chapter on capturing profits through manufacturing:

  1. Cost accounting is about protecting and growing gross profit by understanding and managing the details of the cost of sales, i.e., the costs incurred in producing the revenue.
  2. Knowing the costs and gross profit margins on each product a company sells is a critical tool for managing overall gross profit. This is true for all kinds of businesses, but it’s more challenging for a manufacturing company because of the complexity of the business.
  3. Cost accounting is possible only when detailed production costs are collected at the source, on the shop floor, where workers are honestly recording what they are doing.
  4. Understanding how costs behave is key to controlling them. Tools such as standards, budgets, and classifications such as “controllable,” “variable,” and “direct” help us to do that.
  5. Variance analysis is the way managers use standards and management by exception to reduce variation from predicted outcomes.

Actually it was that last point that first drew me to write this post, because variance analysis is a poorly utilized tool, in my experience. Any financial report that shows a variance from what was expected is not, as it is often used, an opportunity to offer a reason why it didn’t matter or an excuse why it should be ignored. It’s a call to action. Every variance – well, material ones anyway – requires a conscious decision by management to do one of three things:

  • For a negative variance, make a change to prevent it from happening again,
  • For a positive variance, explore what is needed to keep it from disappearing next month, or
  • Acknowledge that the expectation was incorrect and ensure the creator of that expectation has the information to avoid making that miscalculation again.

Of course, each potential decision presumes that management has first asked and answered the question “What caused the variance?” Without that answer any decision is a management guess that will sooner or later manifest itself in lower profit margins and a reduction in the value of the business. Anyone still sleeping out there?

We are Your CFO for Rent.

Yield Curve – Who Cares?

Pick up any business newspaper today and someone will be opining on the interest rate yield curve. Is it going up, going down, reversing, inverting, or just resting quietly? You’re busy running a business that isn’t a bank, so what’s that all about? Why do you care? What should you do, if anything? This post – longer than most – is the what, the why, and what to do about it.

First, the what. The yield curve is simply a chart that plots at given points in time the interest rates of bonds of equal credit quality but differing maturity dates. Typically it is US Government debt that gets talked about, because that drives interest rates for much of the mortgage debt and bank lending in the US. In effect it’s the benchmark from which lenders determine the interest rate on the money they lend to you and me.

Why do you care about this curve? It impacts the interest rate you will pay on borrowed money. Short term lines of credit, real estate mortgage, long term loans. All lenders pay attention to the yield curve because it reflects the interest rate trends they expect to see over time, which will impact their profit on the money they lend you today. Since most banks get much of the money they lend out from short term commitments of their customers – savings accounts, CDs, and the like – they take a risk in lending that money for a 30-year mortgage that sometime in the future they’ll be paying more for those savings than they’re earning on your mortgage. That’s their risk of borrowing short and lending long. Normally the yield curve expectation is that rates are higher for long term lending than for short term lending (because of the higher risk that comes with their longer commitment). So maybe you can get a 1-year credit line for 4% but a 10-year term loan may cost you 5% or more to compensate the lender for that risk of waiting to get their money back.

So what if the yield curve “inverts” or shows that long term rates are lower than short term rates? The experts will tell you that means trouble ahead – perhaps a recession or financial crisis that will result in a lowering of demand, followed by a lower of rates – driven by the Fed typically – to help the economy by encouraging borrowing. Banks these days try to alleviate their risk by doing more lending at variable rates that will adjust to the market periodically. This has happened notably in the mortgage market where options include both fixed rate and variable rate loans, with the variable rates starting lower because the lender has more security that they won’t be caught with a losing loan down the road. Your 10-year loan at a variable rate could start at 5%, creep up over time to 6% or 7%, but have a built-in provision that it will never go below the 5% that it started with. Either way, bank wins, you lose.

OK what should you do about it? First you need to have a sense of your capital needs, ideally over the next 5-10 years. (Yes, that means a plan!) Next, how much of that will come from retained profits, from new equity investors, and how much will need to be borrowed. Is that borrowing going to pay back in a short period of time or is it about long-term capacity that will pay off handsomely but not tomorrow? That thinking should drive your borrowing strategy.

Money borrowed today will cost historically low rates to start. Based on today’s yield curve you should borrow your long term money at rates as close to fixed as you can get, e.g. bonds, meaning that you keep today’s rate for as long as you can, and the reset benchmarks are as infrequent as you can get, because resets down the road will cost more, based on today’s yield curve. Now, will the curve stay normal or invert during the term of your loan? Well, if you can answer that, you should start a bank.

We are Your CFO for Rent.®

Helping Your Board Look Ahead

For those privately owned companies that have had the foresight to have boards of directors or advisors in place prior to the pandemic, it’s been a busy time for them but a welcome source of guidance and support for you, the CEO, owner, or the family management team. And the worst is hopefully behind us. Now what?

Boards have traditionally had the role of helping their company’s management look ahead, to be on top of how tomorrow will impact their business, but with the short-term focus of the past year or so, that need may have slipped by the wayside in board thinking. So I’m offering some ideas from Private Company Director magazine for getting your board refocused, probably best discussed in a board meeting with company management present and involved in the discussion.

  1. Is the board curious, cautious or complacent? Does the board have an intellectual curiosity about the business – especially outside directors who don’t live it every day? Do meetings focus on a packed agenda of reports or do they take time to ask questions beyond the report line items, even when the business is doing great (as they almost certainly do when it’s not so great)?
  2. Are board members great at listening and learning? Gathering views of current and prospective customers – is that incorporated into your thinking? Do you simply accept your previously formed ideas about how things are, or do you keep an open mind that will recognize and value information that challenges your preconceived notions about the business?
  3. Is the organization as flexible, agile and resilient as it can be? How do you contribute to a flexible thinking approach that is willing to pivot in times of need (like the pandemic) or when the world around you suddenly changes? Even in a capital-intensive business or one with long-term commitments, this is an ever-present need in every board.
  4. Does leadership development have a future-proofing focus? This is often most demonstrably needed in family-owned businesses. Is there a concerted effort to challenge the rising stars to prepare for the future? This doesn’t happen by having them just occupy a seat at the table – they need to have leadership opportunities that will challenge their thinking in ways that will build for the future.
  5. Are the board and management unleashing the potential of the business? Do you ever even ask that question at board meetings, or have you had that dialogue in collaboration with management? One of our clients has expanded their bricks and mortar business to ecommerce in order to broaden their market from regional to national in scope. That happened because someone asked “What if?”

How does your board’s practices stack up against my short list? Who on the board is enthusiastic about this kind of thinking and who sits quietly during such discussions? If you’re thinking of forming your first board, how do these questions figure into your recruiting? We are Your CFO for Rent.

Shortcuts to tracking your company’s business health

So, maybe you saw my post from January 14 – “Business Planning is Crap” – and you believed it, perhaps without reading beyond the title. No budget, no financial plan and you like it that way. One day at a time.

We actually have a couple of clients like that. And most of them are still doing well. How do they do it? One thing they don’t do is track their business’s health by simply checking the bank account each day (OK, they probably do that too). That’s for the corner candy store.

While we always urge clients to adopt a formal planning system, if that isn’t going to happen the business needs a Plan B.

Ours is tracking Key Performance Indicators (KPIs) – those metrics that are tailored to each business and are the sensitive pieces of information that eventually lead to sales and profits, or at least prevent losses. Some can be tracked monthly; some should be tracked weekly or even more often.

Here are 10 of my favorites, and a quick description of the kind of business – as a minimum – that should be tracking each. (You can find a more in-depth discussion of these in my book.)

KPI label The kinds of companies that need to always be aware of this
Days Sales Outstanding Sell B2B on credit, especially when average invoice amount is significant
Accounts Receivable Aging Sell B2B on credit, especially when customer payment patterns vary widely
Inventory Turnover Rate High inventories, especially limited shelf life or market value items
Gross Profit Margin (GPM) Every company should track this and mind the trend over time as well, because Gross Profit pays for everything else and is the source of profit
Marketing Cost per Sales Dollar Marketing spend is high and key to sales, e.g., ecommerce, mail order sales
Debt Service Coverage Ratio Any company with a bank loan (almost always in loan covenants)
Late Order Backlog Custom manufacturing, made-to-order, drop shop model
Order Processing Time Complex order processing system; customer has alternative sources
Sales per Customer Retail trade, especially where extras and upsell options are plentiful
Sales per Employee Retail trade, especially where employee interface is key to the sale

 

This is a short list, and it’s not intended to be all-inclusive; so we urge each CEO/CFO to develop a list that is relevant for their company – no less than 5 nor more than 10 such factors – tailored to the business and tracked as often as needed to keep it from getting out of control.

For example, Late Order Backlog and Order Processing Time should likely be monitored weekly to enable timely corrective action and avoid lost sales. All of these should be tracked and reported over time, so that a favorable trend can be reinforced or an unfavorable trend reversed before it becomes the norm.

Want to “take a shortcut” but not sure where to start? Call us at 310.645.1091.

The tax man cometh – for you!

If you have been considering selling your business, or any other asset that will generate a handsome long-term capital gain, Consider this – compliments of Janas Associates, an investment banking partner of ours:

“The Biden Administration has indicated a plan to increase taxes. For Long-Term Capital Gains (“LTCG”), the proposal is to increase the rate from 20% to 39.6%. New rates are unlikely to apply through the end of 2021 and possibly into the first quarter of 2022. Income tax laws are generally not retroactive. Under current tax law, the federal tax for each $10.0 million of LTCG on sale of your business will be $2,000,000. Under the proposed new rate, the federal LTCG tax would be $3,960,000, reducing the net cash to owners at transaction closing of $1,960,000 per $10.0 million of LTCG.”

That’s a pretty big chunk of any gain you might achieve on the sale. Regardless of what you might think of the tax policies of former President Trump or President Biden, it would be wise to avoid a hit of that size if possible. While it’s not a certainty that the proposed rate increase will pass as proposed, you might be wise to avoid the risk if you’re in a position to take your profit this year. If you’re ready to sell and you need to understand the process and ensure you have a solid team of advisors, think about this:

Virtually any sale of a a business takes the better part of a year from decision to close, and that’s if everything is in great shape. If not – and for most privately owned companies the answer is usually “not” – the timeframe could already be too short. If your balance sheet needs a cleanup, if your path to a sale is unclear, if you don’t know what should be fixed and what won’t much matter, I suggest you call us today. Or you could take your chances. It could all work out just fine. Or not. We are Your CFO for Rent.

 

What Drives the Value of Your Business?

As 2020’s challenges resulted in a significant drop in M&A activity, deal flow is expected to pick up big time in 2021 and 2022 because of the suppressed workings of supply and demand. There’s a lot of money on the sidelines waiting to be put to work. There are a lot of business owners who were close to the decision to sell in 2019 – remember our earlier articles on the demographics of business owners – and are now very ready to retire. So my question: If this is going to be a seller’s market for the next year or two (or three?), how can you drive the value of your company so that you get the best possible price, even in the face of other business owners equally anxious to sell? Remember, a seller’s market means the average prices paid for good businesses could be higher than any time in the past decade. In our research, here are the key factors that we favor to drive value:

1. Asset Quality: Are the assets that the business depends on of good quality and long life so as to avoid the need to recapitalize the business in the near future? This applies to physical assets – equipment, facilities, etc. – but also intellectual property, the secret sauce that drove your success to this point.

2. Human Capital: Do your people have the skills and tenure to keep the business growing? Is the morale of the team strong enough to ensure retention when you’re no longer there?

3. Depth and Quality of Management: How good is the leadership team you will leave behind? Can they run and build the business without you? Do they have the knowledge of your processes, the relationships with your customers and suppliers, and the leadership abilities to carry on without you?

4. Financial Performance: Is the company’s history of profitability appealing to the next owner? Not just in admiring the profits you created, but in recognizing the presence of trends that will continue to deliver positive top and bottom line results into the future.

5. Scalability: Is it clear the business model can be scaled up without a major retrofit? Is the market there? Is what you sell valuable enough to have appeal to that market into the future so that the business has an inherent ability to grow and a market that will continue to want what it has to offer?

6. And finally, Risk: Is there inherent risk in your business that could negate the value of some of those factors above? Are you in bricks and mortar retail as ecommerce takes a greater and greater market share in the years ahead? Is it particularly susceptible to visible trends that exist today – climate change, consumer tastes, international competition, etc.?

That’s my list. If you have some thoughts on what else should be on the list, or removed, I’d love to hear from you. And let me know if we can help. We are Your CFO for Rent©.

Do you really have enough cash?

Do you really have enough cash? Let me be more specific: Do you really have enough cash for some unexpected horrific event in your industry? Hertz Corporation, a household name for decades to business travelers, filed for Chapter 11 bankruptcy last year when the travel industry collapsed. They were already short of cash in an attempted turnaround of their business when the pandemic hit, and they had nowhere to turn. What about your business? Can you say with certainty that you will not face a sudden, unanticipated event that would suddenly cause your revenue to drop by 40, 50, or 75% or more? Such events, even for a few months, can easily cause the death of a company if they don’t have the resources to see it through. For example:

  • You operate a chain of restaurants and two of the units in your chain are hit with shooting incidents from unknown (and uncaught) shooters, causing regular customers to stay away fearing the unit they favor will be next.
  • You manufacture parts for an airplane that has just crashed for no known reason – sorry, Boeing – and orders for those parts, which make up 50% of your business, stop cold. The FAA will likely take a year or more to clear the fix.
  • You’re a SaaS business or web services company and a wave of hugely successful hacks from some bad actor has suddenly made internet connectivity unsafe for virtually every one of your customers. So they sign off for 6 months or more until they’re convinced it has blown over.

Whether you’re the company’s CFO, or its CEO, or a member of its Board of Directors, it’s your responsibility. And the only thing you have reasonable ability to control is access to the one commodity that can tide your company over – cash. That doesn’t mean your company needs to have a closet full of money sitting collecting dust, i.e., .02% interest. It simply means you need to have a way of accessing enough cash to pay the company’s fixed costs for an extended period of time. How much is that? That all depends. One thing is sure: If you don’t know what your fixed costs are, if you don’t have access to a bank credit line or easily accessible cash reserves or saleable investments, or if your lifestyle demands that you take most of the cash home every quarter as ownership distributions, then how much doesn’t matter because you won’t have it. This is where your finance team comes in. They need to provide the answers to these key questions:

  1. How much money do we need to have each month if our revenue goes to zero?
  2. How much money can we access quickly to cover that number, and for how long will it last?
  3. If the answer isn’t good enough, what are the recommendations to make it better?

If you think it can’t happen to you, let me introduce you to the (former) CEO of Hertz.

Vaccine regulation change in CA – Use Caution

FOR CA EMPLOYERS ONLY – NOT FINANCE RELATED BUT IMPORTANT IF YOU HAVE ONSITE EMPLOYEES

An alert compliments of Greenberg Glusker:
The California Department of Fair Employment and Housing (“DFEH”) has updated its COVID-19 guidance (effective 3/4/21, replacing its previous version from 7/24/20).

Use Caution If You Are Considering Making Vaccines Mandatory

The DFEH now says employers may require employees to receive a Food and Drug Administration (FDA)-approved vaccination. We suspect that many employers will be misled by this guidance because many COVID vaccines are available and being administered to many people. The new guidance relates only to FDA-approved vaccines. Currently available COVID vaccines are not FDA-approved; they have only received emergency use authorization (“EUA”) at this time.

How Does Your Accounting Department Stack Up?

In the job of managing a company, the owner/CEO has many tools available to help decide when a department is functioning effectively or not. Some are easier to use than others. Managing the sales department may be among the easiest, because you have sales numbers to use, sales vs. quota, sales vs. prior period, sales of most profitable products, etc. Production departments can be monitored by the percentage of goods produced timely, labor and overhead rates, etc. But what about your administrative functions, and in particular Accounting? OK, you eventually got your monthly P&L statement. Is that it?

We recently got a survey report commissioned by Airbase, an expense software management company, that attempted to create some benchmarks by asking nearly 800 US-based companies of various sizes what they do to get their accounting jobs done. The results, while not earth-shattering insights, are useful as a way to develop some metrics for your company. For purposes of this post, I’ll focus on companies that reported total headcount of 100 or less, representing 98% of the businesses in this country. Here are a few highlights:

  • Nearly 2/3 of these companies realized the need for improving processes by adding new systems and techniques to reduce manual operations. Does your accounting leader regularly look at the possibilities in this area? Best single path to improving productivity, in my view.
  • Half of these companies said they need to improve their control over budgeting – meaning get them to work better for what they’re intended, which is to focus spending. How’s your budget process working for you? Do you even have one?
  • 75% of these companies don’t have a CFO, while the other 25% outsource their CFO support. For companies with less than 100 employees perhaps not having a full-time CFO to oversee their financial affairs is understandable, but not having any CFO support at all when there are many fractional CFO resources out there does not make sense to me. Yeah, I genuinely believe we’re the best, but we’re certainly not the only resource out there. What’s that about anyway?
  • The vast majority of these firms use QuickBooks for accounting, despite its limitations beyond basic accounting, perhaps related to the complaints about the amount of time spent in manual processes. The reality is that basic accounting software can’t handle very much beyond the basics. If you manufacture anything and your books are on basic software like QuickBooks, you’re going to either have lots of manual processes or poor visibility into the financial side of your business.

To that we would add one fundamental metric. Your monthly financial report should be ARTistic, that is: Accurate within reason, Relevant, meaning formatted to your needs and level of understanding, and Timely, which means you can count on it being on your desk within X workdays after the end of the prior accounting period.

We are Your CFO for Rent®.

What if it doesn’t work out as planned?

To all who made a well thought out plan for 2020: sorry about that, glad you’re still there. To all who despaired of any ability to create a plan for 2021, this blog’s for you.

We have three big reasons for developing annual plans (for this article, think both written plans and budgets):

  • to properly and thoughtfully allocate our limited resources to best use,
  • to be prepared to take advantage of opportunities that present themselves to us, and
  • to be prepared for any bad things that might come along and hurt the business.

I think you can agree with me that avoiding any effort to plan would be a risky idea and inconsistent with effectively managing your company. The problem is doing it in an environment where the unknowns are larger than normal, the length of undesirable events can’t be predicted – yes, even into 2021 – and your resources have been strained just to stay viable and safe, not to mention visible to your market.  So how to begin? Centage, a maker of financial analysis software, presented a short list of reasons to not only do a budget but develop what-if scenarios to attempt to avoid being blindsided by what you don’t know. I liked it, so decided to share their thoughts. Here’s the cliff notes version:

Be Prepared. One of the primary reasons companies create what-if planning scenarios is to be prepared to adjust to a variety of unknown situations. It can also prepare you for any situation or potential change in the market. Foreseeing how these changes will have an impact on your business will give you an advantage over your competition, as you can adjust your business accordingly. Think Blockbuster vs. Netflix.

Manage Risks. Managing risk isn’t just about knowing when and what changes to make should something bad happen. It’s also about thinking and planning for various possibilities to see if your internal systems can handle a situation, or if operational changes need to be made. Think of this what-if planning like a stress test for your financial health. Think Lehman Brothers in 2008.

Identify Key Business Drivers. Similar to KPIs, knowing what these are is always a good idea, from planning the future to assessing the past. As you start to work these interest-drivers into your planning, some will emerge as the most meaningful to you and therefore also to the company’s success. Measuring them, trending them, paying attention to them is essential to success for any business.

Understand the Effects of Big Business Decisions. Big business decisions are both frightening and ubiquitous for a company’s leaders. While a what-if scenario won’t make you a fortune teller, it can make clear what the business could look like after the success or failure of a given decision. This information can then arm you to make informed, data driven decisions.

Let me know if we can help. We are Your CFO for Rent.

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