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/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?
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.
Once you’ve converted the numbers to ratios and observed the trend in each KPI over a period of years, you will want to compare your ratios to the benchmark of your peers. As in previous years’ studies, we have segmented advisory firms by business model and size so that advisors can slice and dice their data in a way that is most helpful to them.
In this example, we compared Wealth Accumulation LLC to other Market Dominators. At first glance, many of the ratios appear to be in line with the industry averages. But our belief is the only time you want to be average is when you are above average. And for this firm, that is clearly the case.
For example, it’s interesting that the sample firm is generating more revenue per staff, per professional staff, and per active client, yet its profit margins are lower than its peers’ profit margins. For organizations that possess more of a producer culture, the top line metrics may be more exciting. But for business owners, the comparative ratios in profitability are far more telling and important. If you were the owner of Wealth Accumulation LLC, which questions would you ask in order to uncover why your margins are lower than those of your peers? Why are their margins higher even though some of the KPIs related to your productivity are above theirs?
Is it possible that your advisors are not handling enough relationships? Or that they are over-servicing their existing clients and not creating new opportunity? Or, if they have the power to negotiate pricing, that they are discounting fees in order to “buy” the business?
From a management perspective, is it possible that you may have hired too far ahead of the curve? Or that as you became bigger, you lost discipline over cost management? Are you getting good information from your accountant or bookkeeper, allowing you to manage both overhead and direct expense correctly? Is your compensation plan aligned with your goal of achieving greater profitability?
Donuts to Dollars
In benchmarking one’s practice, there is a tendency to look just at percentages and not understand the true implications of negative variances. This can be a problem when the percentage differences appear so small. But as a practice becomes larger, one percentage point for any number can be quite substantial. One way to evaluate the magnitude of the problem is to do a financial impact analysis. By this we mean convert the negative variances into dollars.
For example, the gross profit margin for Wealth Accumulation LLC is 52.5%, meaning that for every dollar of revenue, the firm produced 521?,,2 cents of gross profit to cover its overhead and produce a bottom line. The average gross profit margin of its peers is 57.3%. By taking the difference of 4.8% and multiplying it times the firm’s annual revenues of $5,945,000, we see the financial impact is significant. In this case, by not achieving the same level as its peers, the firm is leaving $285,360 on the table!
Taking just the negative variance from the previous year of .5% still means the firm made $29,725 less than it should have. Obviously, the problem seems large when dealing with large numbers, but on a relative basis, the numbers will also be large for smaller firms. What could you do with the money you didn’t make because your services were not priced right or because of slippages in productivity?
For the manager of the business, the challenge is how to repair those margins. Can you align your compensation plan to create incentives for improving pricing, or productivity? Can you reward staff for finding ways to create greater efficiency in your business so that you don’t have to lay out so much in overhead? Should you be more disciplined about client acceptance and enforcing your pricing strategy?
On-line tools and other benchmarking surveys can be fun and interesting ways to compare your business to others, and obviously it’s more entertaining when your numbers are better than your peers’ numbers. But in the long run, the challenge for each owner of an advisory firm is to look behind the numbers to determine what the Key Performance Indicators are saying about the business. Each line in the benchmark report gives you multiple ways for you to translate your vision into a profitable, thriving, and valuable enterprise.
Obviously, if running a business were easy, everybody would be doing it. By using this data as a benchmark for how you are performing, you can make meaningful, informed decisions about how to optimize your own return on investment.