As we head into the second half of a very tumultuous 2020, your professional service firm may be asking, “Where do we go from here?” Hopefully you have been able to battle through the unexpected and sudden impact COVID-19 has had on nearly all businesses and their clients.
In the back of your mind you may be thinking, why bother planning for your business when unforeseen circumstances continue to undermine your planning? Will it really make a difference? As entrepreneurs and advisers to entrepreneurs, we know that running and owning a business is never easy, but looking ahead is always necessary. Below are a few areas on which we suggest you focus your energies.
1. Evaluate Short- and Long-term Opportunities, and Profitability
As Albert Einstein said, “In the midst of every crisis lies an opportunity.” Now is a critical time to focus on key real-time, short-term metrics that drive profitability and cash flow. At the same time, it’s important to keep your strategic antenna up for longer-term opportunities that will allow your firm to thrive as we come out of this recovery.
Internally, Cohen & Company has been focusing on “sprints” with a lens driven, initially, by evaluating daily results but then turning our focus on the weeks and months ahead in two week increments. Similarly, many of you have taken advantage of our Cash Management Model, an Excel based cash flow model to analyze your company over the next 13 weeks. If you have not used this or a similar tool to keep yourself laser focused on your cash flow, now is the time to get started. Many businesses have also used a Power BI liquidity dashboard to determine where they stand, or attempted to focus on their individual Key Performance Indicators — hopefully not still based on pre-pandemic budgets and goals.
A cash model will become even more critical as many complete the utilization period of funding provided by the U.S. Small Business Administration’s (SBA) Paycheck Protection Program (PPP) loan program. Although this program has been extremely beneficial to many businesses, don’t let it mask more significant issues in your business — which could lead to potentially unsustainable cost decisions in an effort to maximize the loan and forgiveness opportunities. For example, in a short-sighted decision, some PPP recipients may not focus on cash collections since they have the loan to use as cash flow. A loan recipient might not focus enough on employee productivity, or might keep unproductive or excess employees simply to meet the forgiveness standards.
But you may be asking, with all the numbers at your disposal, where should we focus our efforts to maximize our profitability? Based on information as provided by PSMJ Resources, Inc., which focuses on the challenges of architectural and engineering firms. Their research indicates the focus should be on the following three combined factors:
- DLM = Direct Labor Multiplier = Net Revenue Dollars/Direct Labor Dollars
- UR = Utilization Rate = Direct Labor Dollars/Total Labor Dollars
- NLOH = Non-Labor Overhead Factors = (Non-Labor Overhead + Total Labor)/Total Labor
Using these three factors in the following equation can help you determine your profitability:
Profitability = 1 - NLOH
DLM x UR
The goal is for the combination of these three factors to exceed profitability of 20% as applied to the entire firm, a division or an office. This is obviously not easy in this environment, as in many cases, the decline in revenue exceeds the decline in labor and overhead costs. The key then is to manage towards that goal and not focus on just one of the three factors, which often results in unintended consequences.
This formula results in a direct correlation to profitability for that industry and, although the factors may need modified slightly for different service firm business sectors, it can be a very good tool to guide your planning and accountability especially in a declining revenue environment.
2. Determine Your Return on Overhead (ROO)
One of the keys you will need to determine in a declining revenue environment is how to reduce the correct “break-even costs” and make sure you are making a return on the investment of those dollars spent. PSMJ again focuses on, and tracks in their annual surveys, a factor they call ROO (Return on Overhead).
ROO = Profit (defined as earnings before bonuses and taxes)
The key is to reduce costs that really matter. Consider:
- Removing mediocre or underperforming employees at all levels. This includes principals and direct and indirect costs across the firm. Although this may be emotional and difficult, if you do not reduce underperformers, you risk losing your up-and-coming and star performers that will not be there as the business cycle returns to stronger profitability and strategic opportunities ahead. This also may be an opportunity to pick up a great “free agent” from another firm as they struggle and make tough decisions of their own. This can be a perfect opportunity to improve your overall quality of your workforce. Keep the recruiting pipeline open as it is just as important as keeping your revenue and business development pipeline flowing.
- Focusing on those business development costs and people that create the greatest return on your investment in them. Don’t just focus on historical results but their ability to grow the backlog of new opportunities in your most profitable sectors. Establish criteria to determine which clients deserve your marketing investment, and seriously consider severing ties with those that do not — resulting in a win-win situation.
- Focusing on the potential return on big ticket, non-labor overhead costs that allow you to obtain reasonable ROO goals. Consider applying this to appropriate business units and divisions.
In all of this, NO SACRED COWS!
3. Remember, Cash is King
As noted before, many businesses obtained forgivable PPP loans through the SBA in accordance with CARES Act, but as a result may be masking bigger cash flow issues.
Focus on the following:
- Shortening the cash flow conversion cycle. Shortening the time from when you incur direct labor time and costs for your services until you are able to bill and collect for those services is critical. As a service business, your employees are generally your largest costs, getting paid anywhere from weekly to monthly. They expect and deserve to be paid within the agreed upon time frame. The key is to turn around that inventory of labor dollars and related costs into billed revenue as quickly as possible to shorten the cash flow conversion cycle.
- Monitoring your accounts receivable and related terms like never before. This includes conducting credit checks and enforcing terms of your purchase orders and customer contracts, which will allow those clients to continue to have you as a service provider. If someone within your organization is not tasked with enforcing collections in “normal times,” it will become even more difficult with remote workforces, yours as well as your clients; personnel cuts and general turnover.
- Not being lulled into a false sense of security. As you begin to collect on previously billed invoices and realize the benefits of your cost reduction efforts, you may be tempted to feel a false sense of security. The key is to look ahead for what is on the horizon using a 13 week Cash Flow Model or another predictive tool that gives you an indication of your cash flow needs farther out — before they become a crisis in a time of increased financing restrictions (a.k.a. no surprises!).
For times like these, the key is a short-term focus on data driven key indicators of cash flow and success with an eye towards longer-term strategic client relationships and opportunities. Keep your foot on the gas and use your internal team and external advisers to keep your business on the path to be leaner and meaner in the days ahead.
Contact Tom Bechtel at email@example.com or a member of your service team to discuss this topic further.
Cohen & Company is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law.