Aug 14, 2020 | Analytics, Management
You will not hear the term ‘normalising’ the P&L very often. When you do, it is often an indication that the business is in a frame of mind open to change.
It is a common starting point of valuing a business, a process that has two basic buckets:
- Financial value. This is where any valuation process will start, with the numbers.
- Strategic value. Far more qualitative than the numbers, a potential buyer will set out to put a value on such things as market share, customer profiles, geographic location, cultural fit, and so on.
Valuing a business is a complex exercise, particularly valuing the contents of the ‘strategic bucket’.
Creating a financial value is much better understood, and almost always starts at the same place: EBITDA. Earnings Before Interest, Tax, Depreciation, and Amortisation.
EBITDA is a construction of the profit and Loss account, which reflects the trading results. Usually the P&L is completed on a monthly basis, and so long as the classifications of the expenses remains consistent, can be used for comparisons over time to give a good picture of trends.
However, the P&L can also be the repository of all sorts of costs and activities that bear little relationship to the competitive trading health that determines the value of a business. Therefore, an exercise to arrive at a value will seek to remove from, or add back, items that reflect more accurately the trading health. The usual term is to ‘normalise’ the P&L.
This is particularly relevant in the sale process of a private company, less subject to the rigors of governance that apply to listed companies with professional rather than family management.
The common items to be ‘normalised’ I have seen are:
Related party revenue or expenses. Purchases from, or sales to another business related in some way to the one being investigated, that are above or below market value. A common practise is for the owner of a private business to have their superannuation fund own the premises from which the business operates. The premises are then leased back to the operating business at a rate not reflective of competitive market value.
Owner bonuses and benefits. Often the owner of a private business will pay themselves and family members more than the market value of their contribution to the business. It also works in reverse, owners are sometimes the worst paid staff members, working longer hours than anyone else, just to keep the wheels turning over. These anomalies need to be ‘normalised’
Support of redundant assets. Every business has redundant assets that would be jettisoned by a new owner. This stretches from old inventory still carried on the books, to premises not utilised, to the country retreat used occasionally for a sales conference, but usually for the summer holidays of the owner. These do not realistically impact the performance of the business, and a new owner, unencumbered by the past, and by costs not associated with the trading position of the business, will remove them from the P&L.
Asset and expense recognition. Treating an expense as an asset, ‘capitalising’ an expense is a common practise that will boost short term profitability by moving items from the P&L to the balance sheet. While this practise is subject to the scrutiny of tax and accounting rules and independent audit, it is pretty common. It is particularly common in the treatment of repairs and maintenance. As with many items, the accounting treatment can be used both ways to ‘manage’ short term profitability.
One time costs. Items such as litigation, insurance claim recoveries, one-off professional fees, even charitable donations, that are not a normal part of trading operations need to be identified and ‘normalised’ to build the picture of repeatable trading outcomes.
Inventories. Every business has inventories, for many it is a significant item. Manufacturing businesses have physical inventories in raw material, Work in Progress, and finished goods, while service providers have projects in various stages of completion. The method of valuation of inventories is subject to all sorts of shenanigans, and the amount of inventory, subject to mismanagement, sloppy processes, and a host of other curses. Aggressive and consistent inventory valuation is a vital part of understanding the working capital needs of a business, and it often the most contested piece in the valuation puzzle.
When you have all that out of the way, you should be able to calculate a reliable figure for the free cash flow generated, or consumed by the business. A further vital number, and the one upon which many acquisition/divestment decisions have been taken.
As a consultant, looking to help businesses improve their financial and strategic performance, I often quietly do a ‘normalisation’ exercise on a clients P&L. This process almost always offers up those difficult questions that need to be asked and answered before an improvement process can be truly effective.
Header cartoon credit: Dilbert and Scott Adams again capture the idea.
Aug 10, 2020 | Analytics, Management, Strategy
Data is inherently tactical, just numbers without intelligence. It takes structure, capability development, and governance to turn it into a useable asset that adds value. In the absence of a structure that is designed to enable the identification, analysis, and leveraging of that data, and to turn it into useable intelligence, it will remain just data.
To go about that task, ask yourself a number of questions:
What are the data flows?
Through the enterprise, who uses the data, how do they use it, and to what outcome?
Where are the interconnections that occur, to what extend are they compounding positively? Data can also compound negatively, usually because it reinforces an existing confirmation bias that is flawed.
Data is functionally agnostic, should be readily available to all, and the outcomes of use transparent so they can be built upon and compounded.
Who ‘owns’ the data?
Too many times I see the IT department generating data, and keeping to it themselves. Similarly, the finance department is guilty, as are all functions. This is usually not malicious; it is just reflecting a lack of cross functional collaboration. It is becoming more common that marketing is driving a large part of the data agenda, enabled by digital tools, but few marketers have the capability to do it effectively.
Often, there is an expectation that ‘digitisation’ of the enterprise will change the way data is used. Not so, it is no more than putting a new coat of paint on the building, unless the internal structures are changed as well, nothing really changes, you just get a few press releases and nice photos for the annual report.
What data is used?
Piles of data is generated, often collated, and distributed, or made available, but never put to productive use. Usually the missing ingredient is curiosity. Those who are curious approach the data with a ‘why’ and ‘what if’ attitude, they ask questions which identify holes in the data, drives them to be filled, and seeks new sources.
Where does the data add competitive value? Competitive value is a two sided coin. On one side is the need to keep up with what your competition is doing, to leverage the opportunities for productivity and not fall behind in your customers eyes. The second is to find ways for data, and more specifically the knowledge that comes from analysing data, to give you a competitive edge. If a proposed investment does not do at least one of these two things, why would you proceed?
How well do the data outcomes reflect alignment with strategy?
Having data and the analyses that goes with it that leads to conclusions that are inconsistent or divergent from the stated strategy must cause you to question the data, its analysis, and the strategy. In these circumstances, it makes sense to deploy the scientific method, create a hypothesis, test it, collect more data and rinse and repeat until you have alignment between the strategy and its supporting data.
Where are you on the digital adoption curve?
Data is just another asset, it requires explicit actions to build the capabilities necessary to generate, use and fund it. There has to be explicit policies and priorities given, or the investments in data development and the capabilities required, or it will not happen. There needs to be a clear picture of the structures of data domains, from engineering, finance, marketing, sales, and they need to be prioritised and organised to deliver the best return in the long term.
The tools being used to accumulate, process and analyse data are just tools, no different to the hammer that drives a nail. It is how we use them that make the difference. Tools everyone should have are those that ensure the data is both clean and robust. Decisions based on data that fails either of these ‘sanitary’ tests will be sub-optimal at best.
We have entered the digital world. Data and its organisation, funding, leveraging and governance are rapidly becoming the key to competitive survival.
How well are you, and your enterprise placed?
Header cartoon: courtesy Tom Gauld at tomgauld.com.
Jun 15, 2020 | Management, Operations
Metrics at their best deliver game changing insight and wisdom. At their worst, they are misleading , irrelevant and a pain in the arse to collect.
So, what are the two characteristics that make a great metric?
The metric is a leading indicator.
A Leading indicator is a reliable measure of what will happen.
For example, if you have the data that shows that for every lead you generate, you convert 5% at an average purchase price of $50, and those customers buy twice a year for an average lifetime of 3 years, you can calculate with some confidence what each lead is worth to you. In this case, it would be: 100 leads X 5% X $50 X twice a year X 3 years = $1500.
The metric is causal.
The most common mistake I see, is metrics that confuse cause with correlation. There are many things that correlate, despite the fact that there is no relationship between them. One does not cause the other.
For example, there is a correlation between ice cream sales and drownings, which on a graph looks identical, but there is no causation between the two. Look deeper, and you might see that on sunny days, more people eat ice cream, and more people also go to the beach, swim, and therefore risk drowning. There is also a close correlation between ice cream consumption and a shark attack. This second correlation would also suffer from very ‘thin’ data, which make any sort of causal relationship even further from the truth. However, a glance at a graph, which takes on some credibility as someone has actually created a graph, would suggest there is some causation.
For a metric to be of any real use, it has to be the catalyst that changes behaviour, and delivers a predictable result. It is not always easy to sort the causal from the correlative. When you need some experienced wisdom, give me a call.
Jun 12, 2020 | Governance, Management
Preparing forecasts is an integral part of most jobs these days, even if it is just how much available capacity there might be on the machine tomorrow, and how best to fill it.
Most forecasting I see is based on the financials, and is one of two methods: The ‘spreadsheet method’, where 4.5% is added across the board, and bingo, a forecast. Easy. The second method is driven by numbers of a different sort: the Net Present Value equation, the present discounted value of forecast future cash flow, which is more often than not driven by spreadsheets with hurdles imposed.
Neither is much good by themselves.
More recently, a range of pretty sophisticated modelling tools have become generally and cheaply available, which despite their sophistication, still have to be fed data and assumptions to spit out an answer.
Effective forecasting takes in a range of qualitative factors, some of which can be massaged into the algorithms, with the caveat that they then have some sort of relative weight applied.
- A realistic assessment of the resources required to reach an objective. Of increasing importance in this calculation are the capabilities of the people required to deliver the outcome.
- An assessment of the strategic, competitive and regulatory environment in which the forecast lives. Generating forecasts without due consideration of a range of factors external to the business, over which they have little if any control, becomes little more than wishful thinking.
- An assessment of the impact the successful initiatives will have on the external environment, particularly competitors. I see way too many forecasts that ignore the simple fact that competitors will not sit still while you eat their lunch. Failure to adequately anticipate and accommodate their reactions in the tactics to be deployed, and their forecast outcomes, is just plain dumb.
- A continuous and rolling After Action Review process. This process ensures the impact of tactical actions can be assessed, and the lessons applied to following forecasts. A forecast should be a ‘living’ document, something that accommodates, adjusts and builds on the facts and changing circumstances as they emerge.
Back in the day when I ran large marketing departments, forecasting was a key part of any project plan. When product managers came to me with their forecasts, I was not so much concerned with the numbers, as I was with the assumptions included and the relative weights of those assumptions. I also insisted that any forecast had three components, a best case, worst case, and forecast case, prepared separately, with different weights allocated to the variables. This gave us a range with which to work, and importantly, ensured some thought had been put into the implications of the ‘pear-shaped’ outcome.
The disturbing thing was always how inaccurate our forecasts were, no matter how hard we worked. This does not mean we did not try hard enough, simply that telling the future is a challenging task, not to be undertaken lightly.
Once again, my thanks for the header to Scott Adams and Dilbert.
May 18, 2020 | Governance, Leadership, Management
Are you a day trader or a marketer?
It is a paradox to me that we treat investments in capital equipment for our businesses and various financial instruments for our own wealth generation, as items on a balance sheet. By contrast, we treat marketing investments, and particularly those made in various forms of communication, as discretionary items recorded in the profit and loss account as an expense.
Nothing is more critical to the long term commercial health of an enterprise than the investment in marketing. Identifying, communicating, creating transactions and building relationships with customers.
There are 3 basic strategies considered by financial investors
- Index investment. This is a low risk strategy, sticking to stocks that reflect the particular index against the performance measures that will be applied. The most usual are the reserve bank interest rates, and the top 200 stocks.
- Arbitrage investment. Essentially this is a short term strategy that assumes the investor is smarter than the market. It involves a lot of buying and selling of stocks, essentially bets that the short term is higher or lower than the current. Over the long term, there is plenty of research around that indicates that the performance is around the major stock indices. This is also a high cost strategy, in that the constant trading incurs transaction fees, usually not included in the published performance metrics.
- Value investment. Investing for value is a strategy that involves taking a long term view of the businesses in which you invest. This means you engage deeply, not just with the numbers, but with the management and culture, as well as taking a view of the marketplace in which they compete. It is a ‘filtering’ strategy, one where a lot of research boils down the potential targets to a very few, in which you take a significant position. It is a focussing of resources at the specific points where you see there is long term returns available, and are prepared to accept the vagaries of the short term focussed market gyrations.
If you apply a similar frame to the manner in which businesses make investments in marketing, there is a remarkable similarity.
- Index marketing. Doing what everyone else is doing, being average, a follower, and risk minimiser. It also ensures you do not stand out from the crowd, which in a cut-throat marketing world means nobody notices or cares about you, so perhaps you should save your money.
- Arbitrage marketing. Those following this strategy are just applying tactical actions to situations they see, there is no underpinning strategy, just advertising and promotion, usually driven by a budget that has to be spent, and KPI’s that measure the activity, not the harder to measure outcomes of that activity. The driving word is ‘campaign’. A string of tactical activities will be seen as a campaign, and usually there is little flow from one campaign to another. This tendency has been accelerated to stupid proportions by digital, where the cycle time of a campaign, limited as they are, has reduced from months to days. No longer are we looking for the ‘big idea’ that will engage and motivate customers over a long period, we are looking for 10 ideas for the Facebook and Instagram posts in the next 24 hours.
- Value marketing. Successful marketing requires a solid strategy, well executed with a long term perspective. Over time, you will fiddle with the details as you become more familiar with the minutiae involved, and you fine tune the application of funds as you learn, but it is a multi-year commitment, not a short campaign, and certainly not a few ‘cat photos’ on Instagram. Such ‘cat photos’ may be a tiny part of the tactical execution, but are never a component of the strategy. This takes time, resources, and most importantly, a laser focus on what is important to the selected group of primary customers. Over time, you communicate your value proposition that defines why they should do business with you rather than someone else, and do so at a price that delivers you a premium return, while delivering them premium value. Then you retain their business, increasing your share of wallet, innovating, reducing customer churn, all of which delivers sustainable returns.
If any of the above arguments hold true, then it must be that the measures we use to make decisions about our financial selves should be able to be adapted to the investments we make in marketing.
Step one is to see it as a long term investment in prosperity, and not a short term expense to be reported and forgotten, hidden in a monthly P&L.
Step two is to have a robust, well thought out, and agile strategy.
Step three is to implement relentlessly.
None of this is easy, there are no templates of any value around that you can just download and apply. The requirement for success is the wisdom that comes with long and deep experience, not some superficial knowledge of the advertising algorithms in Facebook.
Header cartoon credit xkcd.com
May 8, 2020 | Governance, Management
directors; do you understand your rights and obligations?
There are a lot of SME’s around that are now in unexpected and unplanned financial trouble. For some it will be terminal with a potentially huge impact on personal assets, as well as those of the businesses they run.
Many owners of SME’s do not fully understand their rights and obligations, often despite having an accountant that does their compliance and advises on financial structuring.
In particular, many owners of SME’s do not understand the obligations they have under the Corporations Act as directors of their company.
This was brought home to me in a conversation yesterday with a casual acquaintance who I thought would be pretty well informed.
Following is a simple checklist, if in any doubt, ask your accountant the question. now is not the time to be dodging asking those questions because of the cost.
Insolvent trading.
It is illegal to trade while insolvent, and doing so risks personal and criminal liability. It is a black and white test: ‘Are you able to pay debts as and when they become due’? For manufacturing businesses the answer is often tangled up in the valuation of inventory, and the state of your debtors ledger and revenue forecasts.
Can you collect what is owed to you, what can you reasonablly expect to sell, and how much cash do you have on hand.
Solvency is based on the expected cash flow, the result of these calculations. If you are not solvent, you are, by definition insolvent.
Directors duties.
As a director, which most will be, there are duties imposed by the Corporations act, and ignorance is not a defence.
You are required to act in good faith, with due diligence, and not improperly use information gained as a result of your privileged position. When solvency is in question, you are further required to look after the best interests of creditors.
In order to carry out these duties, you need to be fully aware if the financial position of the business, and have a management plan that addresses the problems. If in any doubt at all, ensure your accountant is completely informed and able to offer their expert advice.
What to do?
If your conclusion is that you are, or may be insolvent, a voluntary administrator can be appointed. The effect of this is to voluntarily relinquish control of the financial management of the business to an outsider, whose responsibility is to ensure creditors, in a defined order are paid. It does however, limit the liability of the director after the day of the appointment. This option leaves you with more options than a wind up order instigated by a creditor, or group of creditors.
Premature appointment of a voluntary administrator is sometimes a temptation, so there has been recent changes to the Corporations act to allow a ‘Safe harbour’ which offers directors protection against personal liability of an insolvent trading claim. There are conditions attached to such protection:
- Tax records are up to date.
- All employee entitlements are up to date.
- There is a concrete, stress tested plan to trade out of the difficulties, that does not include optimistic forecasts and hopes that ‘something’ will turn up.
From March 25th as part of the governments response to the Corona induced problems, the ‘Safe harbour’ provision have been extended. You are now allowed to incur debts in the course of ordinary trading for the next 6 months, and the thresholds for issuing statutory demands have been increased. This is not a ‘get out of gaol’ card, simply a recognition of the reality of the current situation, and other director duties are not impacted. For details talk to your accountant.
The plan.
As noted, hope and rosy projections do not constitute a plan. There has to be specific actions taken to stabilise the financial situation, that will necessitate some challenging decisions about asset disposal, restructuring of operations and perhaps personnel, and managing the manner in which further costs are incurred. Together these should offer a concrete pathway to rebuilding the financial capacity of the business to trade its way out of insolvency.
The obvious elements of the plan will be:
- Assessment and reordering of the cost base. Removing, reducing and deferring as much cost as possible, both fixed costs like rent, and discretionary costs like planned capital investments, and revenue generation activities that do not have a short term payoff.
- Ensuring you have accessed government and provider assistance
- Communication with all stakeholders. Employees, funders, suppliers, regulators, landlords and key customers.
- Aggressively managing your cash conversion time by extending by agreement, payment terms to creditors and chasing debtors, early, politely, and often. This is just managing your working capital. The cash flow forecast is the essential tool for doing this. every change you make should be reflected in the cash flow forecasts.
The key ‘takeaway’ is to manage your cash.
