The profitability of a financial planning firm is a sensitive issue for many advisors. For some, the income of the business is a primary focus, and the balance between the financial success of the firm and its owners, and the services it provides to clients, is carefully balanced. For others, however, there is far less focus on the profitability of the firm, and more on the depth of service delivered to clients (even at the cost of profitability), especially if total income is “comfortable” to support the advisor’s lifestyle.
Yet the reality is that whether the goal is to maximize income or not, the profitability of an advisory firm matters, in far more ways than “just” the income paid out to the owner. The profit margins of a firm are also crucial to its value; in the case of a sale to a third party, it may be the difference between selling or not finding a buyer at all, and even for an internal succession plan, a business that isn’t profitable is simply unaffordable to the next generation at any price. And of course, if the owner’s exit from the business is unexpected — for instance due to disability or death — the profitability of the firm has a direct impact on whether the surviving family members receive any value at all.
But beyond the financials of the advisory firm owner, family members and successor owners, the profitability of an advisor firm matters for another reason as well: the stability of the practice helps it to retain its staff. After all, a firm that is only marginally profitable simply has no flexibility to deal with the vicissitudes of business. Like living from paycheck to paycheck, it creates an environment where even a small disruption can have major ramifications, as many firms discovered when the 2008-2009 financial crisis forced them to fire staff and reduce services to clients at the exact time clients needed them the most.
And perhaps, ultimately, that’s the real reason why running a firm with healthy profit margins matter: a firm that doesn’t have a healthy profit margin as a cushion to deal with inevitable difficult times that can occur may be unable to sustain the quality of its services to clients… or at worst, may have to cease serving them entirely.
To discuss profit margins for a financial planning firm, it’s first necessary to clarify what exactly we’re talking about.
An excellent guide on the issue is “How to Value, Buy, Or Sell a Financial Advisory Practice” by Mark Tibergien and Owen Dahl. The basic framework is captured in the advisory firm Income Statement below:
Revenue $1,000,000 100%
Minus Direct Expenses $400,000 40%
Equals Gross Profit $600,000 60%
Minus Overhead Expenses $350,000 35%
Equals Operating Profit $250,000 25% The category of “Direct Expenses” includes all the compensation paid to professional staff — e.g., the financial advisors who are directly responsible for the generation of revenue, including the owner for the work he/she does “in” the business. The category of “Overhead Expenses” includes all over expenses of the firm, from the remaining (operational) staff salaries to rent and equipment to software and IT and everything else. The percentage of revenues that are available after direct expenses is called the Gross Profit Margin ($600,000 / $1,000,000 = 60%), and the portion of revenues left after all operating expenses is called the Operating Profit Margin ($250,000 / $1,000,000 = 25%). In the context of advisory firms, the latter would typically also be analogous to EBIT — earnings before interest and taxes.
Notably, the percentages above — 40% for direct expenses and 35% for overhead expenses — are considered a good target for an advisory firm according to Tibergien. In fact, the whole purpose of benchmarking is to evaluate the way a firm allocates its expenses, between direct and overhead expenses, and down to individual line items, to better understand where the firm may be spending too little or too much, in pursuit of reasonable profit margins. In some cases, firms simply reinvest a lot of profits into future growth of the firm and may not necessarily take much out of the business, but a firm that isn’t generating reasonable profits in the first place may be signaling other problems, that can be concerning for the owner, the staff, and the clients.