ProfiTabiliTy analySiS THE SIX KEY AREAS

Financial advisers only

Money is a subject that seems to be ever-present in the mind of the business owner and anyone involved in the finances of the business. We talk about it; we think about it; we worry about it. We plan for what we’ll do when we have plenty of it, and we reveal our fears, frustrations, and resourcefulness when we don’t have enough of it.

The ‘profitability analysis’ process consists of six key areas: 1. your accounting system 2. financial statements that make sense 3. your basic operating budget 4. your cash plan 5. business control systems 6. financial strategies to set you on the right path

1. your accounTing SySTeMEvery business should have an efficient accounting system to collect all the financial information, classify and organise it, and summarise and present it in the form of financial statements and reports. These reports are used for decision-making by you, as the business owner, any managers in your business, and people outside your business, like investors and successors. Accounting systems in all businesses have a lot in common, but can also be tailored to meet the characteristics of your business.

key coMPonenTS of your accounTing SySTeM:

• forms generated by your ongoing business activities with details about every transaction (source documents). • a record of all financial transactions in one central place (general journal). • an organised, numbered list of all the ways money is used in the business (chart of accounts). • all transactions sorted into their proper categories and stored for later use (general ledger). • your view as to what’s really happening in your business (financial reports).

benchMarkS for geTTing your accounTing SySTeM in order

Evaluate your current fi nancial statements and

reports

List any questions you have

Meet with your accountant

Implement and monitor your accounting

system

Revise your chart of accounts

Defi ne standards for source documents

Evaluate your current general

journal and general ledger

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The financial backboneIf you are an owner of a financial services business, you may know only too well that dealing with the unexpected and the unpredictable is a simple fact of business life. The ability to guide a company through times of uncertainty is an asset well worth cultivating.

Great leadership requires the ability to control what is in your power to control; to give people clarity, direction, and a sense of security, to chart a course, and set goals your team believe are attainable. A strong accounting system may prove to be the backbone of a renewed understanding of one of the most important and fundamental systems in your business. Your accounting system can be, and should be, the place you turn to and rely on for safety, certainty and reliability. It’s one of your most potent starting points for decision-making and action.

2. financial STaTeMenTS ThaT Make SenSeMoniToring The viTal SignS of your buSineSS Financial statements are more than an accounting exercise; they provide an accurate, objective picture of your business. Everything in your financial statements is a reflection of something real in your business. The two most important financial statements are your balance sheet and your income statement.

Your balance sheet describes the financial health and value of your business at a specific point in time. It is a snapshot of: • your assets – what your business controls • your liabilities – what your business owes to others • the owner’s equity – what is left for the owner and investors after liabilities have been covered.

Your income statement shows your business’s revenues and related expenses during a specified period of time, usually a month, a quarter, or a year. It describes the financial performance of your business.

The financial trends of your business are the changes over time of the various components on your balance sheet and income statement. In addition to reviewing your financial statements regularly, you should also track specific financial indicators to give you better insight into the financial health of your business. This is known as ‘ratio analysis’. Ratio analysis combines various line items of your financial statements in the form of ratios, fractions, or percentages. It adds depth to your understanding of your financial dynamics.

financial indicaTorS

To carry out ratio analysis, start with the following basic ratios. • Return on revenues (%): It is a measure of profitability. Return on revenues = net income/revenue. This is measured over periods of time. Another measure of profitability that can be used is Net Margin = (Net Profit/Revenue) x 100. Net Margin is measured as a percentage

• Contribution margin ratio (%): This ratio calculates how much change there will be in the contribution margin and net income, with a change in sales revenue. In

essence, contribution margin = sales – variable expenses. Contribution margin ratio = sales – variable expenses/sales or contribution margin/sales

• Break-even revenues (calculated with a simple formula provided in this process): The break-even point is the level of sales at which the company’s net income is zero. It is also the point at which total sales revenue is

equal to total costs, and (more importantly, from a breakeven calculation point of view) where total contribution margin is equal to total fixed costs.

Break-even revenues = total fixed expenses/contribution margin

• Operating expense ratios (%): This is a measure of what it costs to operate an asset compared to the income that asset brings. Operating expense ratio = (operating expenses/operating income) x 100.

• Working capital (%): The working capital ratio, also called the current ratio, is a liquidity ratio that measures a firm’s ability to pay off its current liabilities

with current assets. The working capital ratio is important to creditors because it shows the liquidity of the company. Working capital ratio = current assets/current liabilities

3. your baSic oPeraTing budgeTcreaTing The Tool ThaT MoveS you Toward your financial goalSA budget is a forecast of future revenues and expenses. It is the financial reflection of your expectations for business operations in the near future. Budgeting is one of the most fundamental tools of good business management. The budget format can be anything that works for you, but it most commonly takes the form of your income statement projected into the future.

The ‘budget horizon’ is the time period covered by the budget, usually one year, presented in monthly intervals. Companies new to budgeting often start with 3- or 6-month budgets. Budget reviews are normally done monthly using ‘budget variance reports’ to compare actual operating results with budgeted forecasts.

Budgeting is the bridge between today and the future. It keeps your attention focused on current issues and operations while still keeping you on track toward your strategic objective. This is explored further in the Future Fit business planning module.

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key PoinTSThe heart of budgeting is making reliable forecasts of revenues and expenses. Budgeting starts with a clear idea of what profit you intend to generate. Then, starting with revenues, you forecast your budget, planning each line item separately, keeping your profit objective in mind. You may have to go through several iterations before arriving at a realistic budget.

The best forecasts are a two-step process. 1. First, project past trends into the future. 2. Then make predictions based on your knowledge of your business, your budget,

your target markets, and the likely course of events.

Use those predictions to modify your projections.

forecaST = ProjecTionS + PredicTionS Budget variance reports are key to understanding your business’s performance and its progress toward your strategic objective. They are also a prime source of clues to problems-in-the-making and opportunities ready to be seized.

Typical budget format

MONTH 1 (%) MONTH 2 (%) MONTH 3 (%)

Value % Value % Value %

ReVeNues

Gross revenues

Less lapses and comms discounts

Net revenues

VARIABLe COsTs

Total variable costs

CONTRIBuTION

Total contribution costs

FIXeD eXPeNses

Total fixed expenses

OPERATING PROFIT

NON-OPeRATING INCOMe AND eXPeNses

Total fixed expenses

NET PROFIT

4. your caSh PlanManaging the lifeblood of your business. • Cash is money – currency on hand and deposits in the bank. • Cash-flow is the receipt and disbursement of cash – the movement of money into and out of your business. • A cash-flow statement shows the actual cash-flows of your business for previous periods, usually months. • A cash plan is a cash-flow statement for the future, including forecasts of receipts and disbursements expected in upcoming months. • A cash plan variance report shows, for a month in the past, the planned and actual cash-flows, and the differences between the two.

key PoinTSMore businesses fail for lack of cash than for lack of profit. When your business runs out of cash, it stops. Cash-flow is not the same as profit. In describing cash-flow, we speak of receipts and disbursements. Profitability is measured in terms of revenues and expenses. Cash comes mainly from three sources: sales, accounts receivable, and non-operating or occasional sources.

The cash planning process

Forecast cash disbursements

Calculate net cash flow

Calculate ending cash position

Identify beginning cash position

Forecast commission, trail fee

and advisory fee receipts

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5. your buSineSS conTrol SySTeMS Business control systems, sometimes called ‘internal controls’, help you move money into and out of your business effectively. They help

your business run smoothly, free you to concentrate on other important aspects of your business, and form the information link between your business activities and your accounting systems.

Business control systems are focused on moving and controlling the money that all your other business systems need in order to function.

Moving money to the right place at the right time

Business control systems for MONeY IN: Business control systems for MONeY OuT:

Sales Purchasing

Accounts receivable Accounts payable

Collections Payroll

Process for getting your business control systems in order:

6. financial STraTegieS To SeT you on The righT PaTh

Making effecTive financial deciSionS To geT your houSe in order

A small business owner has two sets of financial objectives related to the business. The owner’s personal financial objective is to optimise the long-term payout from the business. This includes the long-term stream of personal income from salary, benefits, dividends, and other payouts plus the market value of the business. The owner’s financial objective as chief executive is to maximise the value of the company. Maximising company value depends on balancing ‘money in’, ‘money out’ and ‘value added from business systems’.

Managing the lifeblood of your business.

• The general strategy: – maximise company value

• supporting strategies: – optimise owner’s investment – optimise revenues – optimise borrowing (leverage) – maximise value added from business systems – minimise expenses – minimise taxes – minimise vulnerability to ‘wild cards’

Formalise flow of information to your accounting system

Monitor effectiveness of the systems Train staff Gather written

documentationCreate source

documents

Use worksheets to identify key components

www.oldmutualinternational.com Calls may be monitored and recorded for training purposes and to avoid misunderstandings. Old Mutual International Isle of Man Limited is registered in the Isle of Man under number 24916C. Registered and Head Office: King Edward Bay House, King Edward Road, Onchan, Isle of Man, IM99 1NU, British Isles. Phone: +44 (0)1624 655 555 Fax: +44 (0)1624 611 715. Licensed by the Isle of Man Financial Services Authority. Old Mutual International Isle of Man Limited is a member of the Association of International Life Offices. Old Mutual International is registered in the Isle of Man as a business name of Old Mutual International Isle of Man Limited. Old Mutual International Ireland dac is regulated by the Central Bank of Ireland. Registered No 309649Administration Centre for correspondence: King Edward Bay House, King Edward Road, Onchan, Isle of Man, IM99 1NU Tel: +353(0)1 479 3900 Fax: +353(0)1 475 1020.Head Office Address: Hambleden House, 19-26 Lower Pembroke Street, Dublin 2, Ireland.VAT number for Old Mutual International Ireland dac is 6329649S. Registered Office: Arthur Cox Building, Earlsfort Terrace, Dublin 2, Ireland.Old Mutual International is registered in Ireland as a business name of Old Mutual International Ireland dac.

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For more information on Profitability analysis, please contact your Old Mutual International Area Sales Manager. Further Future Fit training modules are available on www.oldmutualinternational.com/futurefit

The information contained in this document was developed in collaboration with Masthead which is a network for independent financial advisers. Masthead is part of the Old Mutual Group which is helping advisers develop their business models.