Managing by the Numbers: Customizing Your Growth Strategy

When I introduced the first benchmarking study of financial advisory firms in 1991, I observed three things:

• Most advisors were running lifestyle practices.

• Advisors tended to have only a general ledger and not a proper financial statement.

• Profit was regarded as a reward for hard labor, not something you could manage to.

Today, much has improved about the business of financial advice, including the average size of advisory firms, the evolution of professional management as a career path and better data on what defines success. Let’s take a look at the critical challenges that remain:

• Balance sheets are widely ignored, perhaps because this business is not viewed as capital-intensive.

• Larger advisory firms have introduced a new level of complexity into the business.

• Advisors who use benchmark data view it as a score, not a source for insight on how to more effectively manage their enterprise.

On the plus side, today’s challenges are viewed through the lens of business success instead of pondering whether an independent advisory firm is even a viable business model. I expect firms to continue to get bigger, with a large number becoming dominant regional firms and perhaps a few even becoming national firms. Owners of advisory businesses will need to understand several key dynamics in this new marketplace.

Understanding Your Balance Sheet

First, managers must grasp how the balance sheet can help them make critical decisions. A balance sheet indicates one’s ability to pay the bills and withstand adversity. It shows what you own (assets) and how you fund what you own (liabilities and equity). When assets — such as real estate, furniture and fixtures, accounts receivable or pre-paid fees — grow along with the business, so too does the need for funding. Some firms use leverage to fund these assets, thus the increase in liabilities. Others use equity created through new capital infusions or retained earnings. When the current ratio (current assets ÷ current liabilities) gets out of whack, you have a liquidity problem. When the debt/equity ratio (total liabilities ÷ equity) increases, you have a growing safety problem. Without a balance sheet that accurately reflects these dynamics, many advisors may not be aware of the financial risks they are taking with their business.

Second, managers must understand what the income statement reveals. Many tend to look at the top line to see if it’s bigger and at the bottom line to see what’s left over to distribute to owners — but what happens between these lines is even more important. Just as an EKG, MRI or blood test can measure sources of illness, so too can effective financial statement analysis expose unhealthy economics in your firm.

Every advisory firm has six levers of profitability: pricing, productivity, service mix, client mix, expense control and volume. If your gross profit margin is declining or below your benchmark, this could signal that you are not charging enough, you are overly diversified, your advisory team is not focused on the right things or you are taking on too many of the wrong clients. If your operating margin is declining, it may mean you are not adequately managing the dynamics of your gross profit, or it could reveal that you have an expense control problem or insufficient revenue to support your overhead and infrastructure.

Lastly, managers must compare the income statement to the balance sheet and other variables such as number of staff, number of clients and number of advisors. Balance sheet and income statement ratios are lagging indicators, meaning they show where you’ve been, but the ratios that compare other data tend to be leading indicators. For example, if you see revenue-per-client declining each year, this may indicate a need to improve your client acceptance process or raise your minimum fee.

Analyzing a Benchmark

Benchmark data can be tremendously helpful. The best managers use a linear process to gain insight into what the numbers are telling them.

Step 1: Compare the numbers themselves to your plan and to previous years.

Step 2: Convert the numbers into ratios.

Step 3: Observe the trend in these ratios over multiple periods (optimally three to five years).

Step 4: Compare the ratios to benchmarks (using either industry studies or your own best year).