The best managers follow these steps to benchmark their firm's success.

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).

Step 5: Calculate the financial impact of negative variances.

As an example, when we look at the 2016 Financial Performance Study of Financial Advisory Firms produced by IN Research and sponsored by Pershing, we find a stark difference between top-performing advisory firms and average advisory firms in several key categories. The average firm shows opportunities for improvement across all categories.

The top-performing firms showed a gross profit margin of 68.32% and an operating profit margin of 39.16%. By comparison, the average advisory firms showed a gross profit margin of 62.15% and an operating profit margin of 24.71%. Both ratios show material gaps between the top-performing firms and the average. Instead of being discouraged by the difference, how can you translate this negative variance into corrective actions?

Based on the average advisory firm revenue of $3.8 million, improving your ratios to the level of top-performing firms means your practice would generate an additional $240,000 in gross profit and $562,000 more in operating profit (multiply the variance by the revenues). Your mission, should you choose to accept it, is to decide how to approach your efforts: by addressing gross profit variance first or operating profit first. You also must examine whether your disciplined approach can achieve this progress in one year or if the improvements will need more time.

Don’t Overrate Overhead

While one might think to cut overhead expenses first, consider what is included in overhead: rent, utilities, compliance, support staff, technology, marketing, management. Could you cut any of those costs quickly as a practical matter? Would these cuts improve the gross profit margin?

The answer is “no.” That’s not to say that expense management isn’t a good place to start, but ask the question: “If we cut too far, will it make it even more difficult to improve our gross profit margin?”

Using the example above, the difference between the gross profit margin of a top-performing firm versus the average is 6.17%. Assuming each advisor manages 48 client relationships, spends only 40% of their time on client service and generates $20,000 a year from clients on average (with $5,000 being charged to the lowest-value relationship and $50,000 to the highest-value relationship), which changes could you make to close that gross margin gap: the number of relationships, the productivity of advisors, the fees you charge or the clients you keep? Could you make these changes without cutting overhead expenses and still improve profitability?

Advisors may be tempted to compare numbers rather than analyzing what the numbers mean to their firms, especially those within a percent or two of the benchmark. As advisory firms get bigger, incremental differences can have a profound impact on the profitability of the business. Once you understand the levers of profitability you can take action to change the outcome. Much like how you fret over expense ratios for the investment products you use, managing the cost of doing business can make a giant impact on the return realized for a firm.

Perhaps more than any other dynamic I’ve observed in the 25 years I’ve been doing these types of studies is the fact that more advisors are generating a reward for their ownership in addition to a reward for their labor. The profession is maturing. Last year, for the first time, we saw more non-owner advisors in advisory firms than owners. In the coming years, we will see many advisory firm owners generating more on income from the business than from the clients they personally manage. Use benchmark studies to analyze your business, and then make the improvements needed to rise to the level of the top-performing firms.

— Read 5 Sink-or-Swim Metrics for RIAs in 2017 on ThinkAdvisor.