This article is best viewed in a PDF Format.
| |
Continuing from the situational assessment (Optician 29.10.10), which shows us where the business stands at the moment, we shall now take a look at the place and importance of money, and knowing how it works. Money is like oil in the machine of the business - it connects and enables everything, although it does not, of itself, make more money. We spend money on materials (frames, lenses, contact lenses etc), equipment and people, and then by combining these elements cleverly we add value to goods and services so that we can charge more than they collectively cost and make a profit. This profit can be either retained and accumulated, paid out to the investors, or invested in further assets which will bring more profits to the business. A clear understanding of the flow of money in a business can help enormously with prioritising its use to deliver excellence, and from that, profits.
Financial overview and ratios
In a company's annual accounts, the profit and loss (P&L) statement gives an overview of the financial activity in the business over the year, and the balance sheet (BS) gives a snapshot of the net worth of the business at the end of the year. The values in these statements can be further used to assess profitability, asset use, and liquidity of the business by using business ratios.
Profitability
Profit in a company is looked at in stages. Gross profit is the amount left when the cost of goods sold is deducted from total sales. If the operating costs such as payroll, rent, marketing and sales, light and water etc are then deducted, we are left with the operating profit, and finally, if the interest owed to the bank and taxes are deducted, we are left with the net profit, or bottom line.
The gross profit is an important number in looking at the business. It comes from the individual profits made on each product, which can be viewed in relation either to the cost of the goods, or to the final selling price. If it is expressed as a percentage of the cost price, this is called the mark-up, and if as a percentage of the sales price, this is known as the margin, as illustrated in Figure 1 for an item bought at £1, and sold at £3. The gross profit of £2 is 200 per cent of the cost price (mark-up) and 67 per cent of the selling price (margin).
Ratios which help to show the profitability performance of a business, therefore, are:
- Gross profit margin per cent = 100 x gross profit/sales
- Operating profit margin per cent = 100 x operating profit/sales
- Net profit margin per cent = 100 x net profit/sales
Table 1 looks at the profitability of CITYPRAC and RURPRAC in 2009.
Asset use
Asset use is how hard the money which is tied up in the business works. Assets are found in the balance sheet statement, and sub-divide into fixed assets, such as property and equipment which last for longer than a year and are therefore depreciated over time, and current assets, which include cash, stocks (at cost price) and debtors. It may seem strange to consider debtors this way, but in the short term, they will provide income to the business, and so they are assets. Suppliers and others to whom the business owes money in the near future, by the same logic, are liabilities. The working capital of the business is the total assets (fixed and current), less the current liabilities representing all the assets that are tied up in running the business. Return on assets quantifies the profits coming from the use of those assets, dividing the profits by the value of the assets. If the result is high, the assets are working hard at producing profits, and if low, they are not. Clearly, this ratio can be made bigger by either increasing the profits, or reducing the number of assets at work (cash, stocks, debtors). The following are measures of asset use:
- Return on total assets per cent = 100 x operating profit/(fixed + current assets)
- Return on fixed assets per cent = 100 x operating profit/fixed assets
- Return on working capital per cent = 100 x operating profit/(fixed + current assets - current liabilities)
Table 2 examines the overview of the return on assets in the two shops, heavily influenced by the profitability figures. The return on assets for CITYPRAC is certainly better than it would be if the money was in a building society account, but comparison with RURPRAC shows that it might be working much harder. The bigger profit ratios for RURPRAC undoubtedly help to improve these ratios.
Another indicator of how well assets are being used is stock turnover. Imagine that you have two items of stock, both selling for £100, one with a margin of 50 per cent, and the other with a margin of 20 per cent - it would seem obvious that the one with the biggest margin is the better one to have. However, this does not give the complete picture. Now imagine that the high-margin product takes a year to sell, and the low-margin product sells five times in a year, enabling new stock to be bought, and re-sold with the proceeds. In this example, the total profits from the low-margin product would be 5 x 20 per cent = 100 per cent for the same investment in stock. The overall effect of such fast-moving, low-margin products is to lower the gross profit, but to increase both sales and cash profits in the year. Stock turnover measures how many days the stock sits in the business before being sold to allow further rotations - the lower the number, the harder the stock is working.
Similar ratios are applied to debtor days and creditor days, which measure how long your customers take to pay you, and how long you take to pay your suppliers. They show how long money sits in the business so that it can generate profits - if your debtors pay you early, or you pay your creditors late, the money sits in the business for longer, and can be put to work.
- Stock turnover (days) = 365 x average stock/cost of goods sold
- Debtor turnover (days) = 365 x average debts/credit sales
- Creditor turnover (days) = 365 x average current liabilities/cost of goods sold.
Looking at these measures for the two practices in Table 3, stock rotation seems to be an area in which CITYPRAC shines, turning its stock over in a third of the time it takes for RURPRAC. As the sales levels in the shops are similar, this possibly comes from carrying a smaller stock, and from fitting more contact lenses, which turn over much faster than frames do. With frames, the concern from very fast turnover is that there might be a danger of limiting the selection available for the customers. The opposite of this is probably the reason for RURPRAC to have a slower turnover - they have a smaller proportion of fast-moving contact lenses, and a substantial range of frames driven by a desire to offer an excellent selection. On the other two counts, they do well, being paid faster, and paying suppliers slower, which keeps more money working in the practice.
Liquidity
Liquidity measures reflect how accessible money is in case you need it. There are two ratios that look at this - the current ratio, and the quick ratio. The current ratio answers the question, 'How easily could you pay off your current liabilities with your current assets (cash, debtors, stock)?' The quick ratio assumes that money from debtors is more quickly accessible than money from selling stocks, and so removes the latter from the equation.
- Current ratio = current assets/current liabilities
- Quick ratio = (current assets - stock)/current liabilities
Any number higher than one indicates that, should your creditors suddenly demand payment of your bills, you should be able to pay them. Anything lower than one means that in a crunch, you would have difficulties. A bigger stock increases the current ratio, but not the quick ratio, whereas more creditors has the opposite effect, increasing the size of the denominator. This is reflected in the two practices, where despite poorer profitability, CITYPRAC has better liquidity ratios than RURPRAC, coming from its smaller stock.
Operating ratios
While these general business ratios give an overview of the business, and tell us where to look for trouble, closer examination comes from other ratios. We started by looking at the absolute sales value for each product range and service offered as a percentage of the total to see where sales were concentrated, using:
- Per cent of sales = 100 x sales from product or service/total sales
The use of gross profit and margin is more applicable to industry or retail, where the great bulk of revenue comes from goods being bought and sold. We asked the two shops to supply the average margins they use for each product range, and from this we were able to calculate and rank the total profits from each product range
- Product sales x product per cent margin = gross profits from that product.
In an optical practice, however, a good deal of the income is or should be coming from services, and so we looked for an equivalent to apply to services. We asked the shop owners to estimate the percentage of time in each practice spent on each of the services. We applied this allocation to the total costs of the services, defined as the sum of payroll, depreciation and equipment leasing costs to get the gross margin for the services. We were then able to work out a margin for each service derived from the allocated costs and the actual charges. Dispensing fees were an allocation of product charges to the customer, and we allowed for this.
- Profit from a service = charges for the service - allocated costs
- Service margin per cent = 100 x (charges - costs)/charges.
This information enabled us to tabulate the profits for each product range or service, and its percentage of the total profits.
Finally, to work out how hard the assets in the practice were working, we divided the profit (or loss) for each product by the average stock held, and for each service by the allocated cost of the service to give us a return on investment (ROI).
- Product ROI per cent = 100 x profit/average stock
- Service ROI per cent = 100 x profit/allocated cost.
The breakdown from all these calculations is shown in Table 5, with relative strengths shown in green, and weaknesses in red. Both shops do very well from their dispensing fee allocations. RURPRAC is more profitable on fees than CITYPRAC, mainly because it makes its examination fees pay through a graduated fee system for different levels of service, and through tight control of appointment time and significant use of assistants to do pre-screening. CITYPRAC loses in this area from a longer appointment time, and more gaps in appointments, which suggests a need for tightening time management, and for activities to bring in more customers, including upgrading the decor of the practice.
CITYPRAC gains in from having a higher proportion of contact lenses, which are lower margin, but whose stock turns over so rapidly that there is a very high return on investment which brings significant amounts of cash into the business. RURPRAC derives less income, profits and ROI from contact lenses, at least partially from its older client profile, but also from a weaker emphasis on these products. It also has a low ROI on frames, probably from high stocks with a low turnover. In the area of ancillary sales (contact lens solutions, sunglasses and accessories), better margins, and stock control and turnover in CITYPRAC again yield advantages in ROI. Improvements here from RURPRAC can be expected by extending the client base into younger age groups, and by finding stock management improvements (Table 5).
As a final exercise, we consolidated the figures for fees and products for glasses, contact lenses and sunglasses for the two shops (Table 6). Here it can be seen that in both instances, contact lenses yield the highest return on investment in the practice, although they represent a significantly bigger proportion of the profits in CITYPRAC. In both cases, appointment time allocation is a somewhat higher percent than the profit gain, but in both cases, they bring in the highest return on investment, bringing in high amounts of cash for the time and stock invested.
So what next?
The two practices need to set themselves financial targets for the coming year, including figures on sales, profitability, and then relevant targets related to products and services. CITYPRAC needs to address its profitability as a matter of urgency, and to balance its income from fees and products. RURPRAC needs to control its stock, which is the weak point in an otherwise strong business, and as sales have been flat for the last few years, to increase sales by expanding its customer base into younger customers, as discussed in the previous article on the situational analysis.
In both instances, the shops have spent less than £5,000 on marketing in a year, representing less than 1 per cent of sales in each case. The challenge would be to double this spend, but to ensure that it is spent effectively, which we shall cover in the section on marketing. Another area which we would advise to increase is staff training, as the professionalism in a business comes from the people. CITYPRAC will need to devote some spend to upgrading its decor.
All these expenditures need to be laid out in a table which can be under the headings found in the detailed P&L accounts. All increases and reductions in costs need to be anticipated and put in, and any capital equipment or refit requirements need to be built in - where there are several, they should be prioritised and scheduled over the next two to three years.
Any additional expenditure needs to be covered by sales, and there is a simple way to calculate what extra sales will be needed to pay for any such expenditure, using the gross margin for the business. Let's say that we want to spend an additional £10,000 on marketing and training, and our gross margin is 65 per cent. The additional sales required are calculated from the formula:
Additional sales = costs/margin
In the example,
Additional sales = £10,000/0.65
= £15,385.
Any such extra expenditures should be compensated by extra sales to pay for themselves - if they are capital expenditures, this might be spread over several years - and this should be built into the financial targets. These additional sales are then built into blank P&L table into which the costs have already been put. If the sales number as a result of additional costs is obviously too high, then prioritised cuts in costs have to be made to bring them down, with corresponding sales reductions using the above formula until a realistic balance is reached.
Finally, once the numbers are all in place, it is a good idea to put them away for a week or two, and then come back and look at them with new eyes to see if they make sense. The numbers will then be divided up month by month to set sales and cost targets, which can then be compared with actual figures during the year to ensure that the financials are on track. We shall be looking at how to measure different aspects of the business, including sales and costs, under different headings in the next articles. ?
? Ross and Claudia Grant are founding partners of ToolBox Training and Consultancy, based in Zurich, Switzerland. Both have worked for many years in the optical industry - Ross is an optometrist with a track record in research, professional services and business, and Claudia is an economist and psychologist who has worked in field operations and brand management