Consider an Expense to Revenue Ratios Report for Spending Decisions

An idea for more easily monitoring spending (expenses) and making more timely decisions about future spending is using a rolling expense to revenue ratio report.  Create a report that will show the current quarter’s expenses to revenue ratios for your expenses.  On the report, also present for the previous four quarters, the expense to revenue ratios.  Include an average of those four previous quarter ratios on the report.

Now use the report to determine how the current ratios (the just concluded quarter) compare to previous quarters.  The comparison should alert you to those expense to revenue ratios that are unexpectedly increasing, decreasing, or staying the same.  Think about the unexpected changes, or lack of change, as to the causes, the implications, and what actions (decisions) might need to be taken.

Such a report can be fairly easily created in the accounting system QuickBooks using the profit & loss standard report that is modified to show the percentage of income for each line item.  This report can easily be exported to Excel.    Create similar reports for the previous quarters and export those to a different worksheet in the same Excel file.  Be sure that all line items, including line items with zero activity in some quarters, are included in the QuickBooks profit & loss reports.  Using Excel's special paste feature allows copying and pasting so that current and previous expense to revenue ratios line up on one worksheet, from which comparisons can be made to previous quarters.

As a new quarter ends, update the saved Excel file with the new quarter’s data.

Rather than using traditional budgets, for quarters and longer periods, numbers which can quickly become irrelevant as conditions change, consider the rolling expense to revenue ratios report described above as a substitute for monitoring expenses.  The process should be easier.  Better decisions might be made in a more timely fashion.

The Equipment Effective Percentage Can Be Useful for Equipment Evaluation

Computing the actual percentage of time that a piece of equipment is in use compared to the total time that the equipment piece is available for use can help to evaluate the equipment piece's effectiveness.  Evaluating expensive equipment effectiveness can be useful for making better use of the equipment, in making purchase and sale decisions, and probably in other decisions related to the equipment.

The purpose of this blog is to provide an example of computing an equipment effective percentage.  Suppose a company has 2 concrete drills with different characteristics.  Drill #1 is less powerful but requires less maintenance time than Drill #2.  Drill #1 requires 4 hours of maintenance after 19 days of use, whereas Drill #2 requires 24 hours after 19 days of use.  However, Drill #2 is easier to operate, demanding less time the operator needs to take a break from using the drill.  The operator only needs a 5-minute break per hour for Drill #2.  For Drill #1, the operator needs a 15-minute break per hour.  The company has sufficient need for both drills to use them eight hours each day of the work year (240 work days; 20 days a month for 12 months).

The equipment effective percentage is a ratio of the actual use of the equipment divided by the available use (expressed as a percentage).  The available time for each drill is 1,920 hours per year (240 work days times 8 hours per day).  The actual use time for Drill #1 (from the facts above) is 1,392 hours per year [1,920 hours less 48 hours maintenance (4 hours per month times 12 months) and less 480 hours operator’s rest time (15 minutes per hour for 1,920 hours)].   The actual use time for Drill #2 (from the facts above) is 1,472 hours [1,920 less 288 hours maintenance (24 hours per month times 12 months) and less 160 hours operator’s rest time (5 minutes per hour for 1,920 hours)].

Knowing the actual use times for Drills #1 and #2, the equipment effective percentages (EEP) can be computed.  For Drill #1, the EEP is 72.5% (1,392 hours divided by 1,920 hours) and for Drill #2 the EEP is 76.7% (1,472 hours divided by 1,920 hours).  So, Drill #2 is in actual use more than Drill #1.  This may be surprising since Drill #2 has a much higher down time due to maintenance.  However, its much less down time due to operator’s rest time more than makes up for the higher maintenance time.

The equipment effective percentage is a way of evaluating equipment that can provide insights about the equipment use that may not be expected.  And, therefore, better decisions might be made.  The equipment effective percentage analysis can be applied not only to equipment but other assets that are in use.

Computing the Quantity Flow Through a Company Process Can Be Useful for Planning

Estimating an expected quantity flow through in a company process can be useful for effective planning.  A few examples of quantities that flow through a company process are customers, inventory, and requests.

If the flow rate of the quantity flowing through the process and the time of the process are known, the quantity that will flow through the process can be computed.  For example, how much inventory is needed (the flow quantity) for a future sales period?  If the flow rate (the sales rate) and the process time (the time during which the inventory will be sold) are know, the needed inventory (the quantity flow – the amount that will be needed during the process time) can be computed.    The inventory flow rate (the number of inventory items sold per period) can be based on historic values.  If during the previous 12 weeks, the average inventory flow rate (sales per week) is 10 items per week, then the expected quantity flow (amount of inventory needed) over the next 6 weeks would be 60 items (10 items per week times 6 weeks).

The equation for this computation is: Quantity Flowing Through the Process (QF) = Flow Rate (FR) times Flow Time (FT) or QF = FR x FT.

Although applying this equation to inventory (the quantity flowing through the process) and sales (the process) comes readily to mind, the equation can be usefully applied to many other company processes.  For example, suppose you want to estimate the number of sales orders (the quantity flow) that can be responded to over a period of time.  Knowing the past respond (flow) rate, an estimated quantity flow (number of sales orders) that can be responded to for a future period can be computed.  Some other examples that come to mind are the number of sandwiches that might be prepared per hour given a prepared rate and the number of patients that can be seen per day knowing how long it takes to see a patient.

A previous paragraph shows examples of computing quantity flows (QF) where flow rates (FR) and flow times (FT) are known.  But, the equation can also be used to compute either FR or FT, when the other two variables are known.  For example, if the inventory on-hand at the beginning of a period is known, the rate of sales (the flow rate, FR) can be computed in order to use up the on-hand inventory.  Or, how much flow time (FT) that will be necessary to sale a quantity on-hand (QF) at a given flow rate (FR) can be computed.   Another example is computing the number of guests arriving everyday (FR) at a bed & breakfast where the average stay is 4 days (FT), the bed & breakfast has 20 beds (FQ), and the bed & breakfast is always fully occupied.  Using the equation FR = FQ/FT gives FR equal to 5 (20/4) guests arriving each day.

Although a simple equation, QF = FR x FT has many useful applications for estimating quantities, rates, and times, from which more effective planning can be accomplished..

Ideas Matter – Focus on Generating Good Ideas

Generating more value in a company (e.g., positive cash flow) requires the right company projects.  And, the right company projects require good ideas.  This was a concept reinforced in a Coursera (click here for information on Coursera) course I recently completed (Introduction to Finance; taught by Dr. Gautam Kaul, a Professor of Finance at the University of Michigan).  Professor Kaul, an outstanding teacher, stressed over and over that value is initiated only with good ideas that lead to successful projects.

Small company owners that associate themselves with idea generation report better company success (growth and profits).  In a study done by Shelley M. Farrington, at the Nelson Mandela Metropolitan University, 383 small company owners returned a survey with answers that revealed their personality characteristics and their perceptions on their company’s success.  A statistical analysis by Farrington indicated the personality characteristic, openness to experience, “… is strongly correlated with perceptions of performance, and enhances firm performance.”  “Openness to experience” is a personality category, used by psychologists, and characterized by having such traits as originality, open-mindedness, and likely to seek out new ideas.  To read this study, click here (PDF file).

In a recent analysis that I did, I found that gross profits and research and development expenses correlate in the chemical industry.  The analysis was done because of an interest in examining the concept that a company's R&D expenses can represent how well a company’s “good” ideas (with R&D expenses reflecting such ideas) correlate with how well a company generates value.  The assumption is made that if there is such a correlation, than the R&D expenses as a percentage of revenues would show a correlation with gross profit margin percentages (GPM %) for a series of chemical companies.  I believe that the analysis that I did shows good correlation between research and development expenses and gross profits.  And, if so, good ideas, represented by research and development, are associated with company value generation (gross profits).  Click here to read more about this analysis.

A small business owner should be opened to and accepting of new ideas.  New ideas do not need to come only from the owner – the owner should not expect to be the only generator of company ideas.  Besides employees, look to outside “consultants” – accountants, information research specialists, marketing specialists, and others for ideas.  Attend conferences and network events for the purpose of generating new ideas.

Use the Small Business Owner’s Personal Credit Score to Judge the Business’s Credit Worthiness

The credit score company Experian has found a correlation existing between the personal credit scores of small business owners and the credit worthiness of the owners’ business.

Evaluating the credit worthiness of a small company can be difficult.  Because perhaps the business has only been in existence for a short time, and for other reasons, little, or no, data is available to judge the business's credit worthiness.  However, the owner may, often does, have a long personal credit history.  Based on Experian’s findings, an owner’s personal credit score correlates well with the owner’s payments of his/her business bills.   This gives vendors (other small companies) a good opportunity for being able to judge a small business credit risk, when no other data exists.  Ask the owner of the small business you are selling to for a copy of his/her personal credit score and use this data to evaluate the risk of selling to the person’s company. 

Experian’s correlation conclusions were based on a study of thousands of its records dealing with small business owners.  You can read more about this study by clicking here (Section III) (PDF file).

Four Suggestions for Helping Your Company Grow

Presented below are four suggestions for a small company owner to help his (her) company grow.  These suggestions are based on Professor Edward Hess’ Coursera course entitled “Grow to Greatness:  Smart Growth for Private Business, Part II”. (https://www.coursera.org/course/growtogreatness).

1.   A key to growth is the owner.  The owner sets the tone for the company on all matters.  The owner needs to lead by example; what the owner does is important in influencing how employees follow.  Recognize that what the owner says, does, and shows (e.g., by body language) will have an influence on the employees and others connected to the company.  The owner will create the company’s culture.  In order for the company to grow, the owner needs to also grow.  The owner (leader) needs to go from being a “doer” to being a leader/mentor/coach.  And, the owner (leader) needs to go from being a “doer” to a delegator.  Delegation is not natural and requires skill and practice.  The leader (owner) needs to work at being a successful delegator.  Delegation is not giving orders, but demonstrating, coaching, and suggesting.  A good leader (owner) is: humble; seeks opinions and feedback; shares; and is fair and consistent to everyone.

2.  A second key to growth is making employees happy and successful.  Happy and successful employees lead to happy customers.  Employees’ happiness depend upon the owner (leader).  Do not try to control employees but to assist them in doing their jobs and in doing them better.  Recognize that employees are the most important asset of a company.  Allow employees to contribute.  Everyone wants to contribute – by contributing, people feel better about themselves, something everyone wants.   Do not give orders to employees but delegate; encourage them, guide them, suggest how you would do the task.  Go from concentrating on “me” to concentrating on “them”.  Be sure employees are adequately compensated and rewarded.  Not all people hired work out as planned.  Recognize as soon as possible when an employee is not right, explain this to the employee, and let the employee go quickly.  Work hard to have the right people.

3.  A third key to growth is excellent execution.  Focus on continuous improvements in processes done, and products and services provided.  Stress in improvements the importance of employees and the leader continuously growing.  Concentrate on the most important process for company success.  Make the necessary changes for improvements in this process.  Then move on to the next most important process, and so on.  Provide lots of training.   Set up a schedule of training and ensure that all receive the needed training.  Set up measurements to monitor desired changes in processes, products, and services and implement needed reporting to show and understand these measurements.  Reward employees when the results of these measurements are positive.

4.  A fourth key to growth is to focus on a common sense, doable list of strategic goals. Put these goals in writing and review them periodically.  Set up measurements that show success or failure on goal accomplishments.  Have strategies that relate to the company being successful, including success in other than simply making money.   Be sure that all employees and processes are in alignment with achieving the goals.  Be able to summarize the goals in a 30-second presentation.  Change the goals as needed.

Cash Investments are Critical for Growth – Make Them Wisely

Cash investments are critical to a company’s growth.   Cash investments can lead to increased revenues and/or decreased costs, leading to higher profits, and growth.  So, decisions about what investments to make are critical to your company’s future.

This blog suggests using a quantitative approach to making decisions about how to invest cash for growth.  Think in terms of the affect that the investment will have on profit by increasing revenues or decreasing costs.   Quantify these changes in revenues and costs in dollars and than divide these changes by the dollar amount of the investment made.  The result will be the return on the investment.  Have in mind a minimum return on investment percent (e.g. 5%, 10%, or greater) that you will required before you will make the decision to invest.  Use your financial statements for support in making investment decisions.  Consider each line item on the profit and loss statement for where increases or decreases can result from investments.   Accept that too low a return is not worth the effort.  Rather look for other investments with sufficient returns.

Return on investment calculations need to be based on reasonably accurate estimates of gains (the increased in revenues less costs) divided by reasonably accurate estimated costs.  Too often the return on investment determination is flawed, because the estimated gains and costs are incorrect, leading to a wrong rate of return. The return on investment concept for decision making should only be used when there is a clear amount of investment and a quantifiable gain and cost that clearly and unambiguously results from the investment.  Otherwise too much uncertainty exists about how the investment correlates with the gain.

Accounting systems such as QuickBooks and QuickBooks Point of Sale can be used to determine the return on the investment for each item of inventory that is sold.  Reports in these software packages can show total costs (investments) and total profits (gains) form the inventory item sales.  From this data, investment returns can be calculated showing those inventory items that are most profitable.   Investment return percentages give a more pronounced picture of the differences in gains from sales than gross profit margin percentages and, in that respect, can be useful for decisions related to inventory investments.

Besides inventory investments, investments in creating new products or services, in marketing, in adding personnel (where the personnel can be clearly tied to increased revenues, such as sales personnel), and projects with clear, directly-related costs are likely investments for return on investment decision-making analysis.  Remember, be as accurate as possible in estimating these gains (benefits) and the costs of the gains. And implement only the investments with sufficient returns.  Where limits on investments exist, choose the investments with the best expected returns.

Other factors need to be considered in addition to the percentage rate of return of an investment, not the least of which is the risk associated with the investment failing to meet the expected gain.

Try to keep in mind that computing investment returns in your business should be straight forward, not unduly complicated and complex,  and fully understandable by you.  Although good estimates of gains and costs are important, absolute accuracies are not so critical such that determining the estimates become a lengthy, complicated, painful, and costly exercise.  Rely on good judgments and common sense in estimating the gains and costs.   Whether the return is 15%, higher, or even lower, the decision to make the investment in your business will help your business.  What is important is to be in the right ball park, e.g., the result that the return is above your lower limit for a return, rather than in the wrong all park, meaning there is no return, and therefore a bad decision.

Lots of information can be found on the Internet about returns on investments, their calculations, and other factors about there use.  Finding this information is relatively easy, and from the information you can begin your education about using returns on investment for decision making.