Five Questions
In my role as a CFO, working with other members of the business team to grow our business and make it more profitable, I have five questions that help me focus on where we are and what we should be working on. To me, these questions provide a quick overview of the businesses performance.
Are we growing Revenue? Revenue comes from one of two places, volume and pricing. A business that continues to grow revenue quarter over Prior Year quarter is demonstrating that its offering is meeting its customers needs, and that they are rewarding the company with continued support. When revenue is shrinking, customers are pulling away.
Are we improving Gross Contribution and Gross Margins? Simply stated, Gross Contribution is the difference between what you sold something for and what it cost you to make it or buy it. Gross Margin is the Gross Contribution as a percent of the Selling Price. I like to see increases in the absolute dollars of Gross Contribution quarter over Prior Year Quarter, and I love to see the quality of that contribution increasing through a higher Gross Margin %.
Are our Fixed Costs appropriate? Fixed Costs are the costs that do not vary directly with Sales. These are the costs that are there whether you sell something or not. Examples would include Salaries and Benefits for non-commissioned Sales Reps, Marketing Expenses, Office Rent, Travel, R&D, etc. Many businesses let these costs spiral out of control on the justification that they "need" that expense to grow the Top Line (Sales). Make sure the costs are appropriate and that the timing of the expenditure supports immediate business needs or (well-justified) strategic direction.
Is our Working Capital helping or hurting? Most businesses have three main drivers for working capital: Accounts Receivable, Accounts Payable, and Inventory. When well managed, these three make good use of cash, but when badly managed, they quickly drain cash from a business.
Accounts Receivable is the money that customers have promised to pay you. When you negotiate a sale, you do it with payment terms. It might be a Cash sale, with an immediate payment term of zero days, or it might be a sale with payment in 30, 60 or 90 days, depending on what was negotiated.
Accounts Payable works the same way, except you are negotiating how long you have to pay after the purchase is made. The best situation is when your customers pay you in cash and you don't have to pay your suppliers for months. The worst situation is when you are paying your suppliers in advance and your customers aren't paying you for months.
Inventory is the third leg of the Working Capital stool. This represents what you have tied up in Raw Materials, Semi- Finished Goods, or Finished Products (including products purchased for resale). Inventory is usually measured as Inventory Days Supply, meaning how many days of sales could you support with your current inventory level. More about that in a future post.
Are we making smart Capital decisions? Businesses need to invest in assets that will help them achieve future sales. This might mean building a new plant or buying a new piece of equipment. While the capital outlay is made now, the benefits from it will be achieved over time. For new purchases, professionals generally use a Net Present Value analysis to measure the Discounted Cash Flows of the investment over time. This will produce both a quantitative result, the NPV, and a qualitative result, the Internal Rate of Return or IRR %.
Summary: This list is not meant to be exhaustive. Managing a business is a complex endeavor with many variables and competing priorities. What works well in one place may be an entirely wrong thing to do somewhere else. But this is a good place to start. Try answering these questions for your business.