Today Michael talks to us about the power of using numbers to drive the growth and strategy of your business, and the opportunities available for advisors to business in relation to this. Michael is also introducing us to a new software they developed, which makes financial modelling more accessible to small businesses.
- Recognising the opportunity to differentiate with financial analysis
- It’s not the size, but the mentality that counts
- Start understanding some basic accounting
- Biggest hump for business owners and accountants
- Look at the drivers of your business
- Numbers can get hidden amongst other numbers
- Financial modelling for service businesses
- Don’t throw away understanding
Recognising the opportunity to differentiate your business and practice
I think the opportunity is recognising that the financial analysis that you’re doing isn’t just a necessary part of your compliance. It’s recognising that it’s a huge part of getting things done and growing.
We’ve been building financial models for companies since we started in investment banking back in 1999. But we started building strategic planning models for companies back from 2002. What we’ve seen over the last 15 approaching 20 years is a direct correlation between the companies that grow and succeed and the ones that actually proactively take their financial analysis seriously and really treat it as a skill that they take pride in rather than one that they actually get frustrated by.
You look at so many companies to this day and they have these disjointed messy processes where you’ve got effectively like a poindexter nerd, almost perceived to be a poindexter nerd in the background that’s doing their accounting and their bookkeeping.
They almost align their actual financial reporting with their bookkeeping when in actual fact what you really want to be doing is saying let’s look at historical data, process it, do some projections and look at different scenarios and use that information to empower us when we make decisions.
As a lot of younger people that are more tech savvy than the people were 20 years ago are coming through into CFO and COO roles, I think more and more of this is happening. But there are still a lot of companies out there that when we go to them and ask them for some type of clarity on their numbers, they won’t have it. It’s quite extraordinary because they generally only feel like they need it when they need something from a third party.
We deal with companies, huge companies that are looking at selling to home offices or Chinese investors and they are companies that are turning over 10, 20, 30 million dollars. Until they have a sales event come in and they want to give numbers to a third party, they don’t really build a proper financial model.
They spend millions on accounting packages and they have someone sitting there reconciling numbers the whole time, but they don’t have anyone that can tell them what’s our exposure to for example exchange rates in this area and quickly and easily be able to run a scenario and how would that affect valuation if we floated or listed tomorrow or sold this business.
That’s stuff that they still rely on advisers for that, which is fine. You need advisors ultimately to get deals done. But you should have more of a hand hold on it before the advisors are called in. That’s the opportunity I think a lot of companies are taking now that’s differentiating them.
It’s not the size, but the mentality of the business that counts
I’ve always joked around about financial modeling as equivalent to seeing somebody naked. It sort of becomes a question – how far into a relationship do you go before you actually want to see the person naked. I always want to see them naked pretty quickly.
In a small business, your cash flow is unbelievably important to keep you going. Right from a small size you should be doing some basic planning.
I would answer that question by saying the smaller businesses are when they start doing this stuff, the faster they grow. I’ll give you an example of that.
Back in the day, we did a lot of work with Grill’d. Now when grilled started they had like 8 or 9 stores. They were a small company. A couple of guys started it, and basically they started rolling out these burger chain. They basically started opening new stores but they really wanted to understand – where do we open new stores, why are some stores profitable and some not, and basically what times of the week in the year do we make more or less money selling which types of food.
So those guys started doing really detailed analysis of where their business made and spent money and they used that to guide their growth really early on. They start off with basic spreadsheets they built, then they evolved into working with us to build quite sophisticated models that got bigger and bigger and bigger. Then they eventually got to a point where they couldn’t use spreadsheets to grow anymore which is when you start paying millions for proper accounting packages and forecasting tools that are outside of Excel.
We still work with companies that turn over billions of dollars that still have a strategic planning model that sits in Excel that they literally massage on a daily basis.
I think the answer to that more is it’s not about size it’s more about mentality.
Start understanding some basic accounting
The first thing to start doing is start understanding fundamental basic financial statement analysis. Why does a balance sheet exist? What is working capital and how can I minimise my working capital risk in the business, and maximise my cash flow position? Obviously, using your financial accounting package to do more than just do your tax return.
Accounting firms treat bookkeeping as effectively at times as if it were just some horrible task they have to do which is where they make their baseline revenues. But a lot of them don’t realise that the bookkeeping is the foundation for a lot of analysis.
Even myself with my business, when I was traveling last year I realised that I haven’t looked at my Xero accounts for one of my entities for quite a long time. I went in looked at it and just realised that I wasn’t practicing what I was preaching. So we had to actually reinstate all the data in a way which enabled me to really easily export it into a financial model in Excel.
The biggest hump for business owners and accountants
We actually find the biggest hump that people have is going from looking at the what is often the horror of a Xero account and looking at converting that into a beautiful driver based categorised set of forecasts for an actual business.
The first thing you need to do is start understanding some basic accounting and that doesn’t mean going doing MBA. It just means look at Xero. Go watch some of my videos. Learn about what the PNL is, how it’s different from the balance sheet and cash flow.
The next stage is start looking at the areas of your business. Where do you make money? Where you spend money? Start working through the drivers in your business and then start looking at whether your numbers in your accounting package are actually reflecting the way your business works as opposed to just your tax position.
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Look at the drivers of your business
A really obvious example is when I was over in London. I got a call from a VC, completely randomly. He said “We’ve been watching your business and we really like what you’re doing. We even tried the system and we love it.”
They are a couple of ex investment bankers that are now part of a VPE firm and they basically came to me and said “Listen. Can you give me a whole lot of data about your churn on your software subscriptions and basically which customers have been most sticky?” So they start to give me all these metrics that I realised are really powerful that I haven’t been doing.
For example, they said to me what’s the average life of your monthly subscription holders versus your annual and in different countries. They were saying to me what they wanted to see was the larger company subscribers were increasing their subscriber numbers and also that they were surviving with the software for more than three years.
He said the big risk with software services business is if you get a lot of people coming in and trying it are kicking the tires. A lot of them actually buy one year subscription. It’s like getting Netflix to watch one particular show now and then I’ll drift off. What the VC was looking for with SaaS businesses is these metrics that show minimal churn, growth in existing customers, and long term commitment to subscriptions.
I looked at my Xero data and I was like I know in my head which of these customers have been around for a long time. But I haven’t really done numbers on for example my average subscription price. So what we often have is a large company come to us and say we’ve got 200 users, what can you do that for? We’ll negotiate with them and we’ll talk about what they’re going to use the system for, how many people are going to use it, how frequently and we’ll negotiate a price that we both think is reasonable. But as a result, the price for one customer with 10 users might be $12,000 per user per year, whereas for a large company it might be $300.
Understanding over time what’s our customer composition changing, how is it changing, what’s the average price we’re selling it per user. We’ve gone from 1000 users to 5000 users and our revenue has gone from X to Y, is this because we’re moving into a bigger space with more discounting for example?
But that’s the type of analysis where even now I’m not comfortable within our own business because SaaS businesses are really complicated and there’s lots of them. Even with a start up, it’s hard because you sit there and a lot of them have monthly and annual plans and a lot of them have trial periods and a lot of them, for example monthly, you can roll off whenever you like.
Being able to actually provide a convincing case as to where you’re actually winning your work, where you’re getting loyalty, and where you’re getting churn just even for a small software start up is absolutely fundamental to understand effectively the burn rate of the business. But the same thing applies to a large company.
Property is another example where you need to actually really get on top of what analysts that look at your business look at, and make sure that you know more than them at any point in time.
Numbers can get hidden amongst other numbers
Recently, one of our senior guys left after about 10 years because we’ve been really moving towards the SaaS model and what we really needed was the senior guys driving a lot of new revenues purely because we’ve got a lot of junior guys coming up that are now able to do the senior roles and they are a lot cheaper. What you end up with is the situation where the senior guys aren’t really bringing in a lot of revenue as the company grows so you have natural attrition. Otherwise, the structure becomes top heavy.
Last year, we sat down as a group and talked about this. It was all really friendly. But what we noticed was our revenues were going up but the contribution of some of the people on the team was actually going down quite significantly as the business focus changed.
You had a line that looks pretty healthy, but then what was happening was one of the guys that was really driving a lot of the growth in that line realised that he’s part of the business growing at 50% but the business as a whole might be growing at 20. So he’s asking why it wasn’t my bonus a lot higher? He turned around and put together a chart showing his contribution to the overall top line and then you look at it more closely and realise that you actually have people that aren’t contributing as much as they were.
This is the type analysis where you can look at a business and go wow our business is doing really well. What it could actually be is one business doing terribly and one doing astronomically well, and as a whole you’re doing okay.
If you don’t detect that type of thing, which good analysis brings out, what ends up happening is your really good guys realise that they’re not being appreciated properly because overall the company won’t do well after paying everyone great bonuses. If you don’t recognise where the money is coming in from, you don’t pay the better people better than the people who aren’t doing as well. You end up in a situation where you lose your best people so you get stuck with people who aren’t performing and you end up merging into the worst performing part of the company.
That’s what business is all about. It’s working out where things are working and where they’re not, and that’s what numbers do. The historical analysis which a lot of companies don’t do should really be driver based. The perfect model looks at your historical data, tells you basically how your business performed on a driver based level and enables you to forecast using your historical driver basis as a realistic basis for forecasting. Most companies just still aren’t doing that. The ones that are are performing noticeably better.
Financial modelling for service businesses
We were 100% consulting business for our first 8 or 9 years and then we flipped into software and started burning cash on software so we’re effectively, sort of robbing Peter to pay Paul. We did that for many years because we didn’t want to do VC. We had to run the business really well to not run out of cash because we started to pay bonuses, we still had to ideally return to shareholders but at the same time we wanted to cross transfer some of that profit to build the software so we wouldn’t have to answer anybody. There is a real natural hedge between two businesses in that the software drives a lot of sales of consulting now and vice versa.
With our professional services business, we got so obsessed with looking at capacity utilisation and it’s funny because the worst way you can build a model in my mind of a services business is you forecast revenue. So here’s my revenue for the next say 12 months and then you back solve basically what your staff cost would be based on a margin.
The reality with consulting businesses is it takes 3 to 6 months, if you’re doing something sophisticated. I mean law firms are even more like this but without this, it takes a 3 to 6 months to get to a point where somebody is operating at a level where we can put them in a client’s office and they can help them. You’ve got to factor in the fact that when you get somebody up to 6 months.
The whole analysis that assumes that when your revenues fall off you can just reduce your staff based cost and maintain the same margin ignores the fact that you can’t have a couple of bad months, fire 5 or 10 of your staff, and then suddenly wow you’ve got a few big projects, hire and get people going because you may not be able to service it.
The love and hate thing that I have with professional services, which to be honest is one of the reasons why I’ve gone into the SaaS space to provide a buffer to the storm of professional services is that professional services is all about is all about capacity management and training timetables versus the natural attrition of staff.
We built a model for Investec, the investment bank who’s one of our clients. We’ve got a model for them quite a few years ago that they still use which actually analyzes every single staff member salary, bonus and then looks at basically the utilisation of staff and what the different groups are bringing in revenue and does a really detailed margin analysis on each of the different divisions and they use that as a basis for all of their remuneration and all of their hiring policies financially.
We were amazed. This model is an absolute behemoth. But they wanted to do it so they could actually look at specific people’s contribution to the business profitability and that’s a big business.
I know the investment banks do that as well because they’re all fighting over the pie. Everyone’s desperate to prove that they’ve played their role in getting the record bonus for the year. They get record profits so they should get a record bonuses.
Don’t throw away understanding
The absolute key, and I think I said this on our last in our last chat, is you need to actually get your hands on some good financial models and people protect them like they’re God’s gift to the world because once you’ve got a good financial model a lot of people just sell templates and make good money out of it.
That being said, the world is changing and we have a community of users that communicate with each other.
We sell software and make money and as part of that we actually help people by giving them content to learn how to use our system. You still need to know how to build financial models in using our system. A lot of softwares are designed to take away the understanding and that’s for me a major issue.
People that actually want to know how to build financial models still need to be able to go into excel and build what’s called an integrated three-way model, a model which has an income statement, balance sheet and cash flow. You need to actually understand how that works. We’ve got some training on our website that we give away for free.
We’re sort of motivated to do that because if people get a relationship with us they’re more likely to buy our software. It’s one of the upsides of tech is that you get a hold of stuff for free that used to be really expensive. They’ll give you a free cab ride and they’re going to try and sell you pizza while you’re in the cab. You’re given something for free in exchange for someone reserving the right to try and sell something to you quietly on the side, which is what the whole social media platform is.
In our business, we give away a whole lot of really powerful training and knowledge and examples and we hope that you get impressed enough that you look at our software in the process.
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