Chances are you feel perfectly healthy. But it’s still a good idea to go to your doctor for regular check-ups. Why? Well, for one thing, things can go wrong with your body that you can’t detect. More importantly, your doctor will run tests that can spot potential problems in their early stages before they get more serious.
Most likely, your doctor will make these health-saving diagnoses by comparing your current test results with one of two “benchmarks,” either results from previous tests, or established “norms” for most people. In fact, health science has come so far in its understanding of the human body that many healthcare professionals consider not getting regular physical exams akin to playing Russian roulette.
The same can be said of your practice. Like your body, your practice changes, and hopefully grows, over time. Yet many of those changes are taking place below the surface, where they are out of sight–at least, until something goes seriously wrong. Usually, advisors are happy to see revenues and assets under management grow, rarely asking the more penetrating questions: “At what cost, and for what benefit?”
That’s why we recommend that advisors give their practices regular health checkups. Like a physical, a practice-health checkup also is best performed using benchmarks: standards of industry norms or prior performance against which you can compare your practice to see how healthy it is today.
To gain this insight, we recommend that you regularly measure your practice against benchmarks in four areas: financial performance; operating performance (productivity); client satisfaction; and staff selection. These four data points are at the heart of every business. For example, it’s possible to grow the top line (revenues) while at the same time eroding cash flow, profitability, and balance sheet strength. Conversely, it’s possible to grow the bottom line (profitability) while undermining client satisfaction. Or, you might grow your client base but at the cost of your capacity to serve new and old clients. But by keeping an eye on your practice in these four areas, you’ll be able to spot and correct these potentially disastrous trends.
When measuring financial performance, business analysts calculate many ratios, but there are four at the core of advisory firms:
- Gross Profit Margin (Gross profit divided by total revenues)
- Operating Profit Margin (Operating profit divided by total revenues)
- Safety (Total debt divided by equity)
- Liquidity (Current assets divided by current liabilities)
For most practitioners, financial statements are used as a score sheet rather than as a management tool. Here is a straightforward process for using them to evaluate your firm’s financial performance. First, calculate the dollar amounts of key numbers (gross profits, operating profits, etc.). Then convert those dollars to ratios; track these ratios over several years; and compare the ratios to a standard such as data from the annual FPA Financial Performance Study.
For example, look at how we might apply this analysis to the practice described in Table 1 below. Notice that even though the firm’s revenues grew from $680,000 to $730,000, its operating profits fell from $95,000 to $65,000. Faced with this scenario, most advisors would take steps to cut their costs to restore profitability. But when you look at Table 2 (next page), you see that the margin gets squeezed not in overhead expenses, but in a declining gross profit margin (which fell from 53% to 48%), and which is then simply stated again in the operating profit margin. So even if you reduced overhead, you still would have a deteriorating gross profit margin, and therefore, lower profits.
If you observe that your gross profit margin is declining, there are several potential causes: changes in pricing; client mix; product/service mix, and productivity are the most common. If your operating profit margin is declining, there are three potential reasons: a declining gross profit caused by the factors just mentioned; insufficient volume to support overhead; or poor cost control.
Once you start gathering and analyzing this information, you’ll find that you have added a practical and powerful management tool. In this case, the benchmark was the practice’s previous year’s results. It would also be interesting to compare the ratios to the firm’s own best year, and to the FPA study results to see how it stacks up to industry averages. For instance, if this were an ensemble firm, then the industry’s median gross profit margin is 54.8%–slightly higher than the early figure, and quite a bit higher than the present one.
Your practice’s balance sheet is also an important source of insight. The two areas you want to observe are liquidity, i.e., the ability to pay your bills, and safety, your ability to withstand adversity.
In service businesses, when the business grows, the asset side of its balance sheet also grows. To fund that growth, management typically uses debt or equity. The only way to grow equity is through new capital or retained earnings, both of which the typical practitioner is reluctant to provide. In advisory firms, then, asset growth is funded by debt, usually through a line of credit.