Judging management by its numbers

Electrical Apparatus, Jul 2004 by Wiersema, William H

How to base evaluations on figures that don't lie

YOU CAN'T JUDGE A BOOK by its cover, they say. But the performance of a company's management is well indicated by its financial numbers. What's needed is a way of interpreting the data. Various tools and analyses apply. See the examples in the accompanying box. Some of these are readily available, whereas others need to be specially prepared.

A starting point for evaluating a company's management is its financial reporting system. In order for management to stay on top of the company's performance, it must receive financial reports in a timely way, say before the fifteenth of the month. They must not only be available, but supported appropriately. Significant accounts, such as cash, must be reconciled.

The financial statements must also be accurate. One sign of inaccuracy is instability in major ratios, such as gross profit. Unexplained fluctuations may indicate errors, such as improper month-end cut-off of accounts receivable and payable. Management should also have suitable operations reporting in place. These include budgets to assure that things go according to plan.

In absence of these basic controls, management lacks knowledge of the company's financial standing. It has little basis for taking action to address these issues before it is too late. Running the company becomes guesswork.

Trends

Trends in revenue growth and decline can be most telling, as can trends in profitability. Increases in revenue accompanied by reduced profits may mean that growth is being pursued for growth's sake. Similarly, a revenue decline leading to large losses may indicate that management has not pared down its infrastructure adequately in response to economic conditions.

Measuring a trend in growth or decline is straightforward, using the first formula in the accompanying table. The base against which change is measured is prior year sales. If sales are $1.25 million this year and were $1 million in the prior year, the result of division is 1.25. By subtracting 1 from it, a growth trend of .25, or 25%, remains. Similarly, if current year sales are $0.9 million, the result is 0.9 minus 1, which gives negative 0.1, or 10% decline. A single customer or supplier may be responsible for a level of volume that is so significant as to indicate dependence of the company on it. In such cases, the company has a great deal at risk if it loses the relationship. The loss of an exclusive distributorship, for example, can be devastating to a company.

Finally, comparisons of budget to actual costs provide insight into areas of concern, assuming appropriate data is available by which to compute them. As indicated in the formula, the variance is derived by subtracting actual costs from those budgeted. For example, payroll that according to budget or plan should be $200,000, that is actually $250,000, results in a negative or unfavorable variance of $50,000. Significant negatives should prompt timely corrective action.

Accounts receivable

The most telling statistic for accounts receivable is turnover, measured as days' sales in accounts receivable. Turnover is accounts receivable divided by sales, times of the number of days sales. For example, if sales during the past twelve months are $10 million, and accounts receivable are $1 million, days' sales in accounts receivable is 36.5, assuming 365 days in a year.

Accounts receivable should turn according to terms of sale plus an allowance for customer mailing time. If a company sells on "net 30" terms, the days' sales in accounts receivable should not be more than 35 days or so. Any longer needs an explanation.

A good source for explanation is the report of aged accounts receivable. The percentage past due and amounts that are 60 or 90 days' delinquent bear directly on the credit policies and collection procedures of management. The company's experience with bad debt credit losses is also telling. Billing should also be prepared in a timely way. Doing so is a priority. Otherwise, a company invites a cashflow crunch.

Inventory

In companies that are inventory-intensive, days' cost of sales is as telling as accounts receivable turnover. In theory, days' raw materials should never exceed order quantity expressed in days' supply and a reasonable safety stock, often benchmarked as one-half usage during lead-time. The actual number of days should average half of this total. Similarly, days' work-in-process should be close to time to process items through the facility.

High levels of raw materials may be the result of over-ordering or poor inventory management. Likewise, too much work-in-process may indicate problems getting orders out.

As with accounts receivable agings, special inventory analyses further delineate how management is doing. One good measure is the percentage of inventory aged over six months. In a job shop, a key amount is the percent of the total inventory that is not associated with current open orders. In production to stock, a similar feel for performance is obtainable from percent in excess of six months' usage.