- go back to the shareholders to ask for a loan or infusion of cash for the business.. - Use debt to fund the balance sheet, not to cover losses on the income statement. - In addition, match funding to the useful life of an asset. - Recognize that equity can come from only two sources and that, for both emotional and financial reasons, it’s prudent to retain some earnings in your business to help fund your growth.. - Analyzing the Statement of Cash Flow. - Once you understand how this statement of cash flow is constructed, the analysis of cash flow becomes fairly straightforward. - The most helpful cash flow ratios to observe are:. - Operating cash flow to revenue ! Operating cash flow to total assets ! Operating cash flow to equity. - Operating cash flow is often referred to as free cash flow because it’s the amount available to the owner before investment in fixed assets and before funding from outside sources. - Free cash flow is a familiar concept in the valuation of an advisory firm because it’s more relevant than applying a multiple to operating profit or revenue. - To determine whether the business is actually producing a return, you need to know if the business is producing positive cash flow from operations. - Knowing the ratio of operating cash flow to revenue, to total assets, and to equity makes you better able to evaluate the real financial returns in your business.. - Operating cash flow to revenue. - Much like the concept of oper- ating profit margin (operating profit ÷ revenue), the OCF-to-revenue ratio tells you your cash flow return on revenue. - Operating cash flow to total assets. - The OCF-to-total assets ratio is significant because it helps you to evaluate whether you’re producing cash flow as a result of an investment in balance-sheet. - If this num- ber is declining, it means that you have invested too much in fixed assets or that you’ve lost your focus on managing to a better bottom line and more efficient balance sheet.. - Operating cash flow to equity. - This ratio is a variation on the return-on-investment concept, using the most relevant measure of return—cash. - Typically, one would not find a large amount of equity in a financial-advisory firm, but to the extent it exists it should, like any investment, be generating a positive and increasing cash flow return on equity.. - It’s helpful to compare your cash flow returns against industry benchmarks. - But it’s even more important to establish a baseline number for your practice and observe whether these cash flow returns are improving year to year.. - When you understand the magnitude of the problem, you’re better able to focus on the solution. - In reality, a 1 percent variance can have a significant effect on the financial performance of your practice. - This may be a benchmark derived from the FPA Financial Performance Study, or your firm’s best year, or even an arbitrary number. - The point is to compare your firm’s number with the num- ber to which you aspire. - Based on the industry benchmark, that means you’re. - $150,000 short of the amount appropriate for your firm.. - So how do you use this information? Now that you’ve uncovered the magnitude of the problem, you can go back to your analysis and focus on the causes of low profitability—namely, a low gross profit margin, poor expense control, or insufficient revenue volume to sup- port your overhead. - But let’s look at things in perspec- tive: if you’re not making enough to get the firm on the road to financial independence—plus provide a sufficient return to invest in your practice so that you can serve clients better—then you’ve already begun to damage your business. - For the purists in the financial-advisory business, “productivity”. - has a negative connotation because it conjures up images of the old brokerage environment. - With declining profitability, the firm has less to reinvest in the busi- ness, which it needs to do to maintain quality service for clients.. - it’s about enhancing client service and the firm’s reputation as a business.. - Indeed, evaluating productivity is an essential part of a firm’s financial management, and there are a number of ways to assess it:. - In isolation the ratios don’t tell you much, but by evaluating the trend over a period of three or more years in each of these catego- ries, you can observe what’s happening to the business. - To be effective in delivering services to the core client base, the core client relationships must be profitable and productive.. - As a general guideline, in an up market, it’s prudent to add staff before you are at full capacity. - in a flat or down market, it’s best to wait until you’re at or over capacity before adding staff. - Of course, one of the other factors driving this decision will be how the additions to staff are paid—either variable amounts (commission) or fixed amounts (salary).. - H OW DO YOU translate the rules of financial management into practical applications for your business? Let’s look at a few of the most com- mon strategies advisers use to create business—referral agreements and joint ventures, practice acquisitions, and investments in new initiatives.. - Referral Agreements and Joint Ventures. - Financial advisers love joint ventures and referral agreements. - In a referral agreement, whether it’s a formal joint venture or not, two parties formally combine their strengths to shore up each other’s weaknesses and systematically capture more business. - Usually one of the entities generates new business and the other provides expert services. - Ideally the parties to the agreement would bring both strengths to the table, but that’s rarely the case.. - The referral-agreement model works best when both parties share in the risk and return, have an explicit commitment to each other to support the initiative, and have a clear vision of what they’re trying to accomplish with the model. - As with any new strategy, when considering a referral agree- ment, you must first clarify how this method of sale will build on the strengths of each firm, differentiate your firm from those competing for the same type of clients, be responsive to a specific market, and match your definition of success. - For example, you may be an adviser specializing in very high-net-worth individuals with complex financial needs, especially in the tax management and estate-planning areas. - Can you package these strengths in a way that makes their delivery more cost effective, or efficient, or integrated than what’s currently available in the market? Is the proposition a compelling one for your target clients? Can you realistically pro- ject business through such an affiliation? And is the agreement the most effective way to allocate your resources?. - Once you’re clear about the type of client you’re going to pursue and serve through the referral agreement, you’ll need to define the functions each party will perform and determine who is accountable for each one. - Who will be accountable for each step? What will the final product or service look like? How will you ensure quality control? How will you report back to the other parties on what is happening with specific clients? How will you resolve conflicts? How will you distribute the proceeds?. - In joint ventures and referral agreements each side of the rela- tionship should also have someone whose mission is to manage that relationship. - That’s why it’s essential to understand the economics of your own business.. - One adviser, for example, asked us to provide guidelines on the compensation structure for a joint venture he planned to set up with a CPA firm. - The plan called for the CPA firm to refer its clients to the advisory firm through a joint venture, which would expand the adviser’s offering and bring in incremental revenue. - According to the accountant, the rule of thumb for the industry was a 25 percent payout on all revenues in perpetuity. - Like all rules of thumb, this one took on a life of its own—whether or not it was logical or in the best interest of the firm providing the professional services.. - We tried to help this adviser understand that a referral fee is part of direct expense, not part of overhead—in other words, a cost of goods sold. - Direct sales and professional service outside of the joint venture or referral agreement are also direct expenses. - So if, as in this example, an adviser pays 25 percent of total revenue from a client to the joint venture partner in perpetuity, that leaves only 15 percent to pay for the analysis, consult- ing, and implementation of the client’s plan. - This may be acceptable the first year, but it certainly is not acceptable in subsequent years because eventually the client bonds with the adviser and puts more demands on the firm. - It’s hard to justify more than a 10 percent ongoing trail (perhaps with 20–25 percent up front). - If you pay a high referral fee in perpetuity, eventu- ally you will have to ask if it’s prudent to try to build your business around the low value clients these referrals become. - Do you return the calls from the full-fee clients first or the calls from the clients for whom you’ve discounted your fees under the referral agreement? Do you provide the same degree of service to clients from the joint relationship? Which clients are you most concerned about losing? At some point, as your firm reaches capacity, you might, in fact, hope to lose some of those clients, because the. - Ultimately that outcome is not in the best interests of the client or the venture.. - In other words, they build a service-delivery model around the economics of the relationship.. - If your firm is using a joint venture or referral agreement to gen- erate incremental business and that agreement is not integral to your firm’s overall vision and strategy, the arrangement is probably not a good idea. - Eventually you’ll find that managing the relationship siphons off your time and you risk acquiring less-valuable business.. - Sellers will almost always rely on a rule of thumb—a multiple they read in the trade press or hear at a cocktail party. - Your responsibility is to define the economics of the target practice—as we have shown in chapter 9—with charges to both fair compensation for the owner as well as all overhead expenses.. - In financial terms, value is measured by projecting cash flow and discounting it at an appropriate risk rate (or required rate of return).. - To simplify this process, you can apply a capitalization rate to current free cash flow to come up with a value. - others find there is insufficient cash flow from the practice to support the terms of the buyout and still have enough left over to pay themselves adequately for their time invested. - Clearly, the “greater fool theory,” which says that there will always be a buyer regardless of price, lives large in the advisory world. - Many prac- tices, especially those that depend on commissions, have already consumed the lion’s share of the income in the form of front-end loads and insurance commissions. - The question is not how much revenue the client base has generated in the past but rather how much it’s likely to generate in the future.. - There may be a little bit of the good stuff left at the bottom,
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