Here’s how to learn whether your company is trending positive or negative in key performance areas.
In my last blog, I told you about a family-owned business I counseled. The firm appeared to be doing well, but had no way of knowing whether its performance was trending positively or negatively. My assignment was to give company officers a means of gaining that insight, through the use of key performance indicators.
The company mentioned is a Web-based business that takes orders through the Web into its system. I first needed to learn how many product lines the company offered. Once I learned that, I identified three different measurements that we would need to help us gauge the cost of producing the revenues that flowed from those lines.
First, we had to determine the direct costs, or in other words, the cost of goods sold. Second, we had to determine the employee cost, split out including payroll tax and temporary help. Finally, we had to determine all other overhead.
Using the revenue from the product lines, we knew the consolidated revenue for the company. From that number we could calculate the average unit selling price. Next, I determined average unit cost for each of those three areas: direct, employee and overhead cost, and came up with total unit cost per period.
When we arrayed all the indicators, we had a lineup of direct costs per unit, summarized for the year. Those costs were clearly coming down. We then looked at the employee cost per unit, and compared that to the average selling price per unit, and that relationship was trending positively. The same was true when we compared overhead per unit with average selling price. We could also determine from those numbers what the unit gross profit was for the company.
Simply put, once we had the unit measurements in each area, we could plot and compare them period to period. Those plot lines revealed trends, and just as quickly, we knew the trends were positive. That knowledge made possible a discussion with management as to why those trends were occurring.
Whether your company is generating reports, offering consulting services, or selling gallons of oil, key performance indicators can determine important trends.
There is a way to measure the company’s performance using two ingredients: the number of employees on staff, and your output.
If you would like assistance in determining and tracking key performance indicators, please contact me. I offer a 100 percent guarantee on my work. I take on only clients I can help. Call me and let’s talk about your business. My phone number is 630-269-7646.
Key performance indicators that offer important insights into your company
Recently, I assisted a $10-million-a-year, Chicago-based, family-owned company that was anticipating significant growth. The company’s problem was that managers did not know what data they should be tracking to illuminate their operating trends and performance.
The firm’s officers also did not feel they had a handle on their key financial indicators. Once inside the company, I determined that we should look first at the performance indicators, and secondly at the financial indicators, to gauge how well the firm was performing in terms of productivity.
The company was at a point where the second generation had begun to assume leadership. The son, who had a track record of success, had been brought in to learn the business, so he could eventually take the reins.
However, his background did not include finance. The business was starting to grow rapidly due to the son’s efforts. I found the firm had a clean operation, but wasn’t sufficiently sophisticated to try to compile these performance indicators.
Firm managers knew they were doing well from a cash-flow standpoint, but had no measurement system to see if they were better or worse vis-à-vis the previous quarter or previous year. In short, because they didn’t know what trends were taking place, they didn’t know if the firm was trending positively or negatively.
In measuring key performance indicators, you first define the indicators you want to gauge. Some indicators can be compiled in relation to sales, others in relation to employees. Then you line them up quarter to quarter, and month to month, and have a year-to-date measure as well. This way, you learn whether the indicators are moving positively or negatively year to year, and within years.
Back at that company, I asked for the last three years of financial statements and operating statistics, to learn how much was being sold to create the revenues, margins and profits. Having ascertained that what was being sold was reports, I needed to learn the volume of unit sales, and simply concentrated on the number of reports sold. I thought about what happens from the time a customer orders their report to the time the report is issued.
The numbers helped me put together some key indicators to start measuring the company’s productivity and efficiency. As a result of identifying these key performance indicators, the company managers were now well informed, and the indicators showed their company was trending positive.
Here’s the takeaway from this success story. In a fast-growth environment, you must understand what you’re measuring, and what it means.
That’s what key performance indicators provided for this business, and what they will provide for yours. Next time, I’ll show you, again through the example of this company, how to generate and track key performance indicators.
The media reports we’re experiencing the most unusual economy in 40 years. Interest rates are low, however banks are reluctant to lend; hence stalling the contribution of our nation’s small businesses. A growing percentage of home owners are upside down on their mortgages and struggling to find the motivation to pay their debt since there appears to be no benefit to them. Education costs are exorbitant and our students are saddled with school debt. Unemployment is 11%. Although these trends have been developing for years, businesses and consumers alike ignored the facts and continued to spend freely. What is there to learn from the wisdom of 40 years ago and how can we apply it to the reality of today’s situation?
What is there to learn from the wisdom of 40 years ago and how can we apply it to the reality of today’s situation?
Altman’s Z-Score Insolvency Predictor
Edward Altman (1941 – ) presently Max L. Heine Professor of Finance at the Stern School of Business, New York University created the Altman Z-Score in 1968. Professor Altman combined a set of 5 financial ratios to determine, with tremendous accuracy, which businesses would flourish and which businesses could be headed for bankruptcy.
The Z combines a set of five financial ratios. It uses statistical techniques to predict a company’s probability of failure using eight variables from a company’s financial statements.
The Z-Score formula can be applied to publicly traded competitors, acquisition candidates, suppliers, customers, and other companies of interest. The Z-Score may also be useful for establishing trends in the financial condition of your own company. Sometimes a Z-Score analysis is needed to convince management and board of directors of the seriousness of a company’s condition so that turnaround efforts can be initiated.
Here are the 5 ratios and their respective weight factors:
|A||Net Sales/Total Assets|
(simple measure of capital turnover using annual sales)
|B||Earnings Before Interest and Taxes (EBIT)/TotalAssets|
(referred to as return on capital employed, this ratio incorporates all capital employed, both debt and equity)
|C||Working Capital/Total Assets|
(the difference between current assets and current liabilities divided by the total book value)
|D||Retained Earnings/Total Assets|
(this ratio is lower for younger companies since retained earnings accrue over the lifetime of a company; this penalty for youth reflects the higher probability of failure among younger companies)
|E||Market Value of Equity/Total Liabilities|
(stock market capitalization for all classes of stock is used in this ratio)
Each ratio is then multiplied by its weighting factor and summed to calculate Z:
Z = (1.0)A + (3.3)B + (1.2)C + (1.4)D + (.6)E
Scores below 1.81 indicate a high likelihood of bankruptcy. Scores above 3.00 indicate a low likelihood of failure. Scores in the middle of this range are not clear indicators, but they are less likely to be associated with failure than low scores.
Repeat the analysis periodically and plot Z scores for companies of interest on a graph with Z scores on the vertical axis and time on the horizontal. Significant downward trends in Z scores signal a potential problem, and even if the Z score does not fall below 1.81 the source of the problem should be identified and evaluated. Look at trends within the component ratios to see why the Z score is falling and decide whether it represents a serious problem.
For Privately Held Companies
If you want to analyze a company that is not publicly traded, you will not be able to compute ratio E for the Z score formula. Many companies use smaller suppliers and sell to smaller customers that are privately held. Although Altman did not extend his study to these companies, the other 4 ratios can be computed from D&B reports and a partial Z computed by dropping E. The resulting measure will tend to be lower than the standard Z score. It is best used as a long-term tracking device, with significant declines considered a flag requiring closer scrutiny.
Interested in a Z-Score analysis for your company, customer base, public or privately held competitors, or potential acquisition target? We can conduct an analysis, allowing you to make informed decisions for a reasonable flat rate. Please give me a call at 630.778.7646 or email me at firstname.lastname@example.org discuss.
The Wisdom of Henry Hazlitt (1894 – 1993)
It is exports that pay for imports, and vice versa. The greater exports we have, the greater imports we must have, if we ever expect to get paid. Without imports we can have no exports, for foreigners will have no funds with which to buy our goods.
The clearing house for these transactions is known as foreign exchange where, in America, the dollar debts of foreigners are cancelled against their dollar credits. In England, the pound sterling debts of foreigners are cancelled against their sterling credits.
This mechanism does not differ essentially from what happens in domestic trade. Each of us must also sell something, even if for most of us it is our own services rather than goods, in order to get the purchasing power to buy. Domestic trade is also conducted in the main by crossing off checks and other claims against each other through clearing houses.
Among the arguments put forward in favor of huge foreign lending one fallacy is always sure to occupy a prominent place. It runs like this. Even if half (or all) the loans we make to foreign countries turn sour and are not repaid, this nation will still be better off for having made them, because they will give an enormous impetus to our exports.
It should be immediately obvious that if the loans we make to foreign countries to enable them to buy our goods are not repaid, then we are giving the goods away. A nation cannot grow rich by giving goods away. It can only make itself poorer. No one doubts this proposition when it is applied privately.
If this proposition is so simple when applied to a private company, why do apparently intelligent people get confused about it when applied to a nation? The reason is that the transaction must then be traced mentally through a few more stages. One group may indeed make gains—while the rest of us take the losses.
The U.S. government has been engaged for years in a “foreign economic aid” program the greater part of which has consisted in outright government-to-government gifts of many billions of dollars. What conceals the truth from many supporters of the program is that what is directly given away is not the exports themselves but the money with which to buy them. It is possible, therefore, for individual exporters to profit on net balance from the national loss—if their individual profit from the exports is greater than their share of taxes to pay for the program.
The real gain of foreign trade to any country lies not in its exports but in its imports. Its consumers are either able to get from abroad commodities at a lower price than they could obtain them for at home, or commodities that they could not get from domestic producers at all. Outstanding examples in the U.S. are coffee and tea. Collectively considered, the real reason a country needs exports is to pay for its imports.
— Paraphrased From Economics in One Lesson (1946)