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My objectives for today

1. Discuss non-financial and financial drivers

2. Help you understand the link between these drivers and your business’s financial health

3. Provide a framework to quantify and measure these drivers

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Not my objectives for today

1. Tell you what you should measure

2. Make you believe that measuring is all that it takes to be successful

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What is a driver?A value driver is an action that affects business performance in the short and long termimproving the financial health of your business. (it adds to the business value)

Example of a traditional value driver:Introduction of cost controls to manage short-term earnings and cash flow.

Example of an action that does not add value:Introduce cost controls that cut short-term costs at the expense of product development or maintenance of the company’s physical assets.

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Are value drivers basically the same?The answer depends on your business fundamentals.Value driver - Improving customer loyaltyIf brand makes a difference…yesIf cost is what matters….no

The answer also depends on your business strategy.Value driver – Low PricesWal-Mart….yes7-Eleven….no

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Non-financial driversOn-time deliveryProcess cycle timeCash cycle timeNumber of unqualified leadsNumber of qualified leadsWin rateProposal rateProcess improvementsCustomer satisfactionEmployee turnover

Market shareShare of customer walletNumber of new productsNumber of new servicesCustomer attritionService calls per customerNumber of defectsLabor efficiencyMachine utilization

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Financial driversSales growth by customerSales from new productsSales from new servicesCustomer profitabilityProduct/Service profitabilityCost per unitCost per customerBreak even pointRevenue per employeeIndirect cost as a percent to sales

Working capital efficiencyAsset efficiencyReturn on assetsCash flow ratiosRisk ratiosLiquidity ratiosReturn on equityIncrease in business value

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How to develop value drivers:5 Steps

1. Understand the link between operational actions and businessvalue

Value Driver Tree (Manufacturing or Construction)

Value

Growth

Cash Flow

Market Share

Share of Customer

New Products

Revenue per Unit/Product

Line

Revenue per Customer

New Customers

Customer Retention

Cost per Unit

Overhead as a % to sales

Days Sales Outstanding

Inventory Turnover or Year Supply

Average Cash Cycle

Sales Force Effectivenes

Direct Cost per Unit

Unabsorbed Overhead

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How to develop value driversValue Driver Tree (Service)

Value

Cash profit per

Customer

Number of Customers

Share of Customer

Staff per Customer

Customer Acquisition

Cost

New Customers

Retention Rate

New Services

Service cost per customer

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How to develop value drivers

2. Identify the value drivers with the highest prioritiesHow material is the driver: “biggest bang for your buck”

Example: Reducing customer acquisition cost

3. Can you impact the driver?Does your organization have the skill set or capabilities?Do you have room for improvement?

If you are already running very efficiently, can you really improve?

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How to develop value drivers?4. Consider all of the consequences

Value Driver: Sales volumeConsequence: Reduce costs; increase product availability; increase the

investment in long-term equipment, space, inventory, and the resulting impact on cash; risk (debt) in the future

Value Driver: Increase the number of customers Consequence: Reduced ability to service current customer base

5. SustainableOne time value versus consistently increasing valueExample: Cost reductions as a result of a re-organization or acquisition

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Example of a Value Driver in action:Continental Airlines

• 1994, lost $619 million, which was an improvement considering it had lost an average of $960 million the previous four years.

• Ranked dead last in almost every Department of Transportation performance measure

• Multiple bankruptcies• Gordon Bethune named CEO• Calculated that late and cancelled flights cost Continental

$6 million per month

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Example of a Value Driver in action:Continental Airlines

• He’s quoted as saying, “Customers want to get safely from point A to Point B on-time with their underwear”

• He set a goal, “Rank among the top three airlines for on-time performance in any month.” If met, he would split half the $6 million with all non-executive employees (about $65 per employee)

• The very next month they were ranked fourth, the next two months they were ranked first

• 1995,1996, 1997: Continental earned $215 million, $319 million, and $383 million respectively

• Share price in 1994: $5.00, in 1995: $65.00

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Continental Airlines1. Understood the Link between operations and financial

performance2. Developed a strategy

Fly to Win - Shut down unprofitable routes, develop hubs to win back business travel

Fund the Future – selling off non-strategic assetsMake Reliability a Reality – on-time performance, less lost luggageWorking Together – remove mistrust between management and

workers3. Measured performance

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How to measure success in dollar terms

Determine the increase in the value of your business

Dependent on the following: • Cash Flow• Cash Flow Growth • Cash Flow Risk

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Business Value 101Cash Flow

Free Cash Flow(Profit after tax +/- Change in working capital – CAPEX)

Cash Flow GrowthIncrease in free cash flow from year to yearHistorical and prospective

Back 3 yearsForward 5 years

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Business Value 101Cash Flow Risk• Past performance• Management depth• Customer concentration• Vendor concentration• Industry• Geography• Debt

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Business Value 101

ExampleAssumptions

Annual Free Cash Flow: $150,000Cash Flow Growth: 1% above inflationDiscount rate: 16%

Value Calculation$150,000/(16%-1%) = $1,000,000

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Business Value 101

ExampleNew Assumptions

Annual Free Cash Flow: increase 10% or $165,000Growth: 2% above inflationDiscount rate: 15%

Value Calculation$165,000/(15%-2%) = $1,269,00027% increase in business value

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Cash is the lifeblood of your businessIn the past we could lean on the money tree…• Eager bankers• Understanding families• Hungry equity partners• Home Equity• Air Ball

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Cash is the lifeblood of your business…Today, and probably in the future, we can’t

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Seven Cash Drivers1. Sales2. Gross Margin3. Sales, General and Administrative4. Working Capital

Accounts ReceivableAccounts PayableInventory

5. Capital Expenditures6. Shareholder Distributions7. Taxes

As separate items these are pretty obvious, the key is managing all of the drivers together (Cash Cycle)

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Cash Drivers and the Cash CycleTypical Cash Flow Cycle Jan Feb Mar Apr May TotalCollect Sale 100 100 Purchase Material (25) (25) Direct Labor (10) (10) (20) Vendor (10) (10) Overhead (7) (7) (7) (7) (7) (35) Total Disbursements (17) (52) (7) (7) (7) (90) Net Cash Flow (17) (52) (7) (7) 93 10 Accumulated (17) (69) (76) (83) 10

AccountingSale 100 100 Cost of Goods Sold (55) (55) Gross Profit - - 45 - - 45 Overhead (7) (7) (7) (7) (7) (35) Operating Profit (7) (7) 38 (7) (7) 10

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Cash Drivers and the Cash CycleCashflowability versus Profitability

-$60-$40-$20

$0$20$40$60$80

$100$120

Jan Feb Mar Apr May

Cash FlowsAccounting

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Cash Drivers and the Cash Cycle

Cost of the Cash CyclePresented in a way your organization might understand if cycle is

repeated 12 times in a year

Interest Cost $8Profit on Sales 10%

How to make up the interest costAdditional Sales $80 (approx 1 month sales)Reduction in Overhead 85%

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Create a Cash-Flow CultureBusiness owners often understand the need for cash flow

at the gut level, but sometimes aren’t very good tracking it and living it.

Focus on Cashflowability versus Profitability1. Organization Development

Teach management and employees the link between what they do and how their actions impact cash flow

• Limit it to the items that are really important• Value tree• Ask “What are the things that you do that influence cash flow?”Use IncentivesNot always necessary to make them monetary incentives…..but it

helps

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Create a Cash-Flow Culture2. Measure What Matters

Non-financial• Determine what non-financial measures will drive your value• Measure quickly and often• Communicate company wide

Financial• Understand what happened in the past, but spend more time on

what you see in the futureInstitute a 12 week rolling cash flow forecastIntroduce a 12 month rolling Sales, Gross Profits, Expenses, Working

Capital, Capital Expenditures Forecast• Benchmark your actual performance to your forecast• Calculate annually the change in business value

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My objectives for today

1. Discuss non-financial and financial drivers

2. Help you understand the link between these drivers and the your business’s financial health

3. Provide a framework to quantify and measure these drivers

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Not my objectives for today:

1. Tell you what you should measure2. Tell you that measuring is all that it

takes

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Questions?

jeff@jsmcpa.com