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January 01, 2007 at 02:00 AM
Shortly after the 2006 Moss Adams Financial Performance Study of Advisory Firms, sponsored by SEI and JPMorgan Asset Management, was published and distributed to more than 1,000 participants in November, we received several queries from advisors about whether we could move the numbers around within their income statements so that their firm’s performance scores would look better (See this month’s cover story, and www.mossadams.com/surveys/advisorstudy /2006htm for more information). Of course, focusing on your score alone misses the point. While we acknowledge that some surveys are designed as cheesy little tools to give people a Cosmo magazine-like score, benchmark studies are designed to provide meaningful insight into how you can be a better manager and leader of your business.
There is an elegant, linear process for comparing one’s business data to that of like businesses. The first step is to look at a macro level for key operating ratios related to profitability, productivity, and leverage. The second is to bore into the data to understand exactly what is influencing the macro statistics for your business. One helpful tool is what we call “common sizing,” in which we compare specific cost data.
One should first look at the numbers in relation to previous years. Are your sales and profit up or down? Have your current liabilities and long-term debt changed since the last time you looked at your balance sheet?
Next, convert these numbers into ratios, which are ways of evaluating the relationship between one number and another. The key income statement ratios for a financial advisory firm are gross profit margin and operating profit margin. The first metric is determined by dividing the gross profit dollars by the total revenue, and the second is determined by dividing operating profit by total revenue. Expressed as a percentage, these margins will give you important clues as to what is going on in your business, especially when you observe the trend in margins over a three to five-year period.
For example, if your gross profit margin has been declining over this period, you could be having problems with (1) how you are pricing your services, (2) how productive your staff is, or how your (3) client or (4) service mix has changed. If your operating margin is declining, this could be caused by (5) a revenue volume too low to support your infrastructure or (6) by poor expense control. In other words, these two simple measures can expose six possible problems in your business.
Key Performance Indicators
Very few advisory firms maintain a balance sheet, but we think it’s a good idea to do so, especially as the firm grows larger. The two key balance sheet ratios for an advisory firm are the current ratio (current assets/current liabilities) and the debt-to-equity ratio (total liabilities/total equity). When your current ratio is declining, this is a clue that it’s going to get harder to pay your bills.
If your debt-to-equity ratio (also known as debt-to-worth) is increasing, this means that your business is potentially becoming too leveraged, which may undermine your safety–your ability to continue in business should something happen. This is not a common problem with advisory firms, but it can be, depending on how you choose to finance your growth.
After you observe the trends on the income statement and balance sheet, it’s helpful to examine the ratios related to productivity and leverage. In the Moss Adams study, we refer to these ratios as Key Performance Indicators (KPIs). The most common KPIs are:
- Revenue/Client
- Revenue/Total Staff
- Revenue/Professional Staff
- Clients/Total Staff
- Clients/Professional Staff
There are other KPIs to consider, but if you observe the trends in these key relationships over time, you will develop insight into how your business is performing. Sometimes this is even more helpful than looking at benchmarks of other firms because you’re comparing your performance against the firm itself. In the sample ratio analysis here, we show that over the past two years, the (fictitious) firm Wealth Accumulation LLC shows deterioration in both gross profit margin and operating margin. The question is, why?
Finding Relationships
By delving into the KPIs, we can see that some key relationships, such as revenue per professional staff and clients per professional staff, have also worsened. We can see that the average AUM fees as a percentage of revenue have begun to drift. In other words, both productivity of professional staff and pricing is deteriorating, so the first step for the owner of this practice will be to address how to improve the gross profit margin.
However, this is not Wealth Accumulation’s only problem. Gross profit margin represents only a small fraction of the total reduction in operating profit. Obviously, with the increase in other staff and related overhead, this business also has a cost control problem.
Realizing this should lead the firm owner to pose two questions: Can I justify this additional overhead as an investment in my capacity to help me manage future growth, or is it possible that I cannot generate sufficient revenue volume to support my overhead? There is no clear answer here because we don’t know the specific circumstances. But this is the type of critical thinking owners of practices must apply when looking at their data.
