A Workable Business Model Is Essential
An overall financial plan should be an integral part of your business strategy. I will not visit in depth how to price individual services or how to manage company operations, as these subjects are easily found in several other sources. I will, however, lay out the keys to creating an overall financial plan to guide you in developing your business success strategy.
In the first installment of this series ("Lessons Learned in Bankruptcy," March 8, 2004), "strategy" was defined as "managing sales, expenses and assets in such a way that your company achieves its financial goals."
I will now utilize return on investment (ROI) to help you create a strategic plan for your company. This is done by breaking ROI down into component parts so that sales, expenses, and assets can be structured to create a working strategic plan that is right for your business.
ROI can be broken down as shown in Figure 1.
Hypothetical ExampleLet's look at an example. Let's assume an HVAC company has the following statistics:
Allow our hypothetical company to reflect the following scenario: The company sells standard equipment and services a range of three counties, covering an area with a 50-mile radius from company operations. It does not provide much technician training and receives a high percentage of customer callbacks. The company uses the least-expensive equipment and supplies available, which sometimes results in warranty service calls. The company does not maintain tight controls over truck stock and shop inventories, and it lacks real job oversight and pre-job planning, resulting in lengthy job turnover.
This company's ROI would equal 16 percent. (See Figure 2.) This could be considered a poor rate of return on the company's investment dollars, considering the risks of owning a small business. Unfortunately, this is also the average ROI for many companies operating in the HVAC industry.
A Different ScenarioNow let us consider another scenario. Under this scenario, the company practices strategic execution effectively, raising annual sales to $1 million. The company's selling methods are comfort-solutions based, resulting in more sales and more profitable selling prices. The company sells higher-value comfort equipment, such as variable-speed, two-stage furnaces. This allows the company to charge a higher price, if only based upon the higher markup cost of the equipment being sold.
The company's service range was reduced to a 25-mile radius from company operations, allowing for one extra service call per day per technician. Project management improved, and with it so did job turnover. This allowed for a greater number of jobs to be invoiced over the course of the year.
In this scenario, year-end sales dollars increased $200,000 (from $800,000 to $1 million). The company's average total assets remain at $200,000.
Controls were implemented and shop inventory was monitored. Low-turnover inventory item purchases were reduced, resulting in a higher turnover of inventory on hand.
Truck stock was monitored so that overstocking and waste were reduced, and the tighter service range allowed more work to be done with the same amount of vehicles.
Accounts receivable controls were put in place, resulting in better cash flow and less receivables outstanding. However, since the company grew in sales, accounts receivable in dollar terms remained unchanged.
In this scenario, operating income is $60,000, or 6 percent of sales. Notice that net income increased by only 2 percent of sales when compared to the first scenario. The 2-percent increase in profit was due to the higher job turnover, higher daily invoicing under a tighter travel range, and increased dollar profits through solution and value-based selling, reduced warranty work due to the use of better-quality equipment and supplies, and callback labor was down.
What do these changes mean for the company's ROI? Let's take a look at the calculations shown in Figure 3.
As you can see, the company's rate of return nearly doubled, jumping from 16 percent to 30 percent. Now you are beginning to see how managing your company's sales, assets, and expenses in a strategic way can help you to achieve your company's financial goals. This is how successful business owners create personal wealth.
You can play with this equation utilizing a multitude of scenarios to devise a business model that is right for your company. The key is to balance your profits and asset utilization in such a way that you maximize your company's growth while earning a return on investment that is equal to or better than your company's costs of financing and alternative investments with similar risks.
Turnover And ProfitHave you ever wondered why vendors who always seem to have the parts that you can't seem to find anywhere else also seem to charge a higher price? The answer for their higher prices can be found in the ROI equation. These vendors have to carry a greater inventory on their shelves, which increases their assets on hand. Since those hard-to-find parts don't sell as quickly as more commonly requested parts, these vendors do not turn over their assets as quickly as the vendors who only stock high-demand parts do. If vendors who stock these hard-to-find parts are going to meet their ROI requirements, they must receive a higher profit on the units that they sell. That is, lower asset turnover necessitates a higher operating profit to meet the same ROI. (See Figure 1.)
As I previously indicated, sometimes a higher profit on your in-come statement may not be in your company's best interest. The reason is that higher profits might stifle sales growth and actually reduce your ROI. In the example above, the company earned an ROI of 30 percent. But let's assume that the reasons for your company's higher profit margins are due to higher selling prices rather than more efficient management of your company's operations. (I am not implying that you do not maintain a higher selling price than your competitors; I am implying that if your price is higher, you must provide a perceived value for the price, or you may not close as many sales as you otherwise could.)
While operating income rose an additional 2 percent of sales (to 8 percent), the company's asset turnover fell from 5x to 3x. This incurs a lower return on investment for the company, even though operating income, as a percentage of sales, was actually higher than in the previous example.
A word of caution: When putting together your strategic plan, you should have a realistic idea of what sales your company can achieve utilizing the assets it has on hand. This is known as "sales capacity." Preparing a strategic plan with unrealistic sales goals could result in your company failing to meet its ROI goals. As a guide, asset turnover (annual sales divided by average total assets) averages between 3x to 6x in the HVAC contracting industry.
Next week: Long-term cash flow can be difficult to forecast, but figuring out the minimum amount of cash your company should have on hand to maintain operations can save your business.
Roberts is owner of Roberts Commercial Lending Co. LLC. He provides corporate finance and debt consulting, business loans, and leasing services. He can be reached at 586-716-8329 or CommercialFnnc@aol.com.
Publication date: 03/15/2004