The ideal income statement and how to use it
Practice Management / Business Intelligence / Business Growth / 31 May 2017
Are you a financial adviser or a business person in the business of financial advice?
From a core purpose perspective, we are not in the business of financial advice, we are in the business of getting paid for financial advice.
As established in April’s article (“The future belongs to the professionally managed”), I believe professionally managed firms will carry the day, going forward. Part of being professionally managed is knowing your business’s numbers and ratios extremely well. Let’s unpack this more.
Information is power
Most firms can produce loads of what they call management information, but in my experience what they actually produce is loads of sales statistics. It becomes management information only when the data tells you something useful about your business, and helps you make better decisions for the future. This is particularly important if things are not going quite as you would like. So what are these key ratios and numbers?
One way of obtaining greater insight from the numbers is to convert your financial information into ratios. These allow you to examine various aspects of your business, compare your firm with other firms, and see if your actions are translating into better business performance. Your top line revenue growth tells you none of this, yet this is what most advisers quote when asked if their business is going well. Key ratios can be broken down into the following:
1 | Profitability ratios
2 | Productivity ratios
3 | Client selection ratios
Let’s consider and examine each.
1 | Profitability ratios
Profitability is a metric with which many firms seem to struggle. When asked what their profit is, most principals I speak to can’t tell me. You should be able to define, measure and articulate profitability in your business. How else will you work out if you are doing well or poorly, or being efficient or inefficient? There are three headline measures to consider:
Direct expenses: These are the costs of making a sale or providing advice (whichever terminology you prefer). All costs associated with sales people in your business are recorded here. For example, fee or commission splits paid to advisers or, if they are on wages and salary, their salary package (all inclusive). If you pay to introducers from the fee or commission earned, this is also counted as a direct expense. Direct expenses shouldn’t exceed 40 per cent of gross turnover for the firm. It will become obvious why shortly.
Other overheads: This includes all other business expenses (para-planner wages, administrator wages, rent, telephone, technology costs, printing and stationery, marketing, etc).
Other overheads shouldn’t exceed 35 per cent of gross turnover.
Net profit: Whatever is left, after direct expenses and overhead expenses, all becomes net profit.
If direct expenses are 40 per cent of gross turnover, and other overheads 35 per cent of it, then that leaves a net profit of 25 per cent. This is the return to which you are entitled for the risk you undertake as a business owner. (Clearly, financials need to be normalised, to adjust for reasonable owner’s compensation, to provide accurate output).
By considering these headline measures, you can glean a lot about your business. For example, if you pay more than 40 per cent of gross turnover to the advisers in your firm, you will struggle to make a 25 per cent net profit. Keeping other overhead to 35 per cent of turnover is not easy, so paying away too much for ‘sales’ is going to squeeze your bottom line. Making less than 25 per cent net profit puts your personal income and the business at risk, particularly in difficult times (such as the GFC).
Most firms don’t achieve this profit benchmark and, accordingly, in difficult times the owners often have no choice but to reduce their income to cover the other running costs of the business. This is crazy. Also, with rising business costs, and the risk that you take as a business owner, if you don’t make a genuine profit (after you and everyone else is properly paid for what they do) you may start to question why you don’t just go and get a job as an adviser in someone else’s firm and let them take the risk.
In a more mature business, if your other overheads are greater than 35 per cent, you can instantly glean that you have an inefficient back office. You may not know why this is the case and what to do about it, but you be assured it is inefficient. If this area of expenditure is too high, you will also struggle to hit your 25 per cent net profit benchmark.
It might be different if your business is youngish and in the earlier investment stage of its growth, but don’t hide behind this for too long. My experience is that, in many cases, firms that struggle with managing the cost vs. profit equation early in their development still do so years later. So be careful. If you are new, I would give yourself three to four years of leeway, and
in year four I would be looking to be close to these ratios.
2 | Productivity ratios
Productivity ratios include:
- Revenue per FTE (full-time equivalent employee)
- Revenue per adviser
- Clients per FTE
- Clients per adviser
- Net profit per FTE
- Net profit per adviser.
You can probably see for yourself that analysing these aspects of your business will give you tremendous insight into how productive it is. For example, if you have a revenue/FTE ratio (i.e., total revenue divided the number of FTE staff) of $160,000, and a peer firm has a ratio of $230,000, there might be some lessons you could learn from them about how they have structured their business processes.
Obviously, these ratios need to be looked at in context, rather than in isolation, but they start to shine a laser on the areas of your business that need improvement.
Productivity ratios, in particular, are often neglected completely by firms, and this shows up as poor profitability and a difficult working environment (for you, your staff, or both).
Most adviser-owners are front-office, client-facing (finder or minder) types who don’t have strong skills in designing or implementing better business processes. However, without a focus on this area, you will struggle to break through and achieve your potential. You must find time to work on your business, and if you don’t or can’t, get someone to do it for you.
3 | Client selection ratios
- Revenue per client
- AUM per client
- Gross profit per client
- Net profit per client.
Improving client selection over time is the third lever you can lean on to improve profitability. Improving the client quality, and therefore revenue per client, is a powerful way to boost adviser and business profitability. By benchmarking against peers and tracking various ratios quarter by quarter and year by year, you can see the impact of the choices and decisions you have made.
These ratios allow you to track progress, even if there are major changes to your business, such as an acquisition, or re-structuring. If you are not focused, these changes can hide a multitude of sins.
Growth-by-acquisition strategies, in particular, can allow a business to believe it is growing and performing better when, in fact, underlying performance might be deteriorating. Using client-selection ratios can help you see through this.
In fact, if you are contemplating an acquisition or disposal, you can even model the likely impact on your financial ratios before you proceed. Just to be sure the right trends are likely to show up after the transaction.
The data that matters
Identifying the management information that matters is a key part of running a successful business, rather than a practice. If you have been in business a long time but still feel like you haven’t fulfilled your potential, this may be an area that can help you break through. Remember, financial information becomes management information only when it provides insight.
These ratios can provide some real insights for you. But how many advice businesses have this data at their fingertips monthly? How many have the systems in place to produce it consistently, predictably and effectively month after month? Perhaps this is another reason the future will belong to professionally managed advice firms.
If businesses want to grow, they will need to separate the technological needs of running the business from those of producing client advice.