Tate J. Kerst, VP – External Practice Development with Waddell & Reed, Inc.
Great Practice Solutions
The COVID-19 crisis has forced certain financial realities for your business -- investing in infrastructure so you can work remotely, facing potential revenue declines, and balancing practice growth with keeping your team and family safe. While uncomfortable and challenging, the current environment has made one thing clear: knowing your numbers can help eliminate the impact of emotion on your business decisions and temper and strengthen your decision-making process. This blog explores cash flow analysis and is part of a GPS Practice Insights series on financial management for advisors.
In crisis and in calm, you want to and need to make good decisions quickly for your business. Doing so relies on having data you trust at your fingertips. We’re talking well-managed financials and in-order balance sheets that let you assess the level of investment you can make and the impact of it on your earnings. We’re talking cash flow analysis.
Cash flow analysis tells you where your money is going and how much cash you have on hand. Understanding cash flow analysis can make you a shrewd business person who is able to set budgets, establish baselines, track trends and ultimately make better business decisions. While it may sound like a complex process, cash flow analysis boils down to one basic equation: Earnings - Expenses = Net Operating Profit.
Let’s break down the components.
Earnings determine income for your business. Every business has at least one endeavor that creates a stream of earnings, and stronger businesses have multiple earnings drivers broadening their sustainability. Making up your income are two types of earnings:
- Recurring earnings typically come from fee-based advisory products, trails from multiple types of products, and financial planning fees. These are the earnings that establish your baseline income.
- Nonrecurring earnings are additional earnings that you receive above and beyond recurring earnings, such as commissions on insurance and investment products and one-time financial planning fees. Your nonrecurring earnings should serve as discretionary income to drive investment in a business or bolster profitability.
Business expenses are costs incurred during the ordinary course of business. They generally are divided into direct expenses and overhead expenses.
- Direct expenses are the costs involved in driving your production, such as compensation for individuals who create revenue through their work with clients. Specifically, base salary or wage, incentive compensation or commissions, or any other type of paid bonus is a direct expense. Tracking this expense separately allows you to measure the effectiveness of employees responsible for driving revenue. Investment in this area should drive earnings and yield multiples of the expense in terms of yield for your business.
- Overhead expenses are all other expenses outside of those that drive revenue, such as rent, utilities, salaries and benefits. These expenses must always be met and can be easily controlled. Other expenses are variable, such as incentive compensation, marketing and technology. These will often fluctuate based on conditions and need. They should be budgeted but can be pushed during difficult operating environments. Budgeting for these expenses and measuring their progress can help you understand variances on a monthly basis and make decisions quickly if there is a change in the operating environment.
Long-term analysis of overhead expenses enables you to evaluate the effectiveness of new staff and monitor activities and investments that may have paid dividends, such as marketing and technology. Controlling these expenses without impacting investment in the practice is the balance you want to achieve to affect business growth and profitability. Overhead expenses should be between 35% and 40% for most advisory practices.
Gross Operating Profit
Gross profit is the income left over after covering direct expenses. Typically, an advisory practice will have a gross profit margin of 60%. That means that 40% of income is typically spent to drive production of earnings. This should remain fairly consistent except for times when a new producer is added. You should see a temporary drop when adding a new producer followed by an increase in gross profit margin three to six months later.
Net Operating Profit
Net operating profit is what is left over after expenses are subtracted from total earnings. As a business owner, this is the third area that drives income. The first two are what you pay yourself under direct income for managing the practice, seeing clients and driving revenue. The advantage of being an owner is that you get the net operating profit or get to determine how this will be spent. The disadvantage: If there is no profit or the number is negative, you make up the difference out of your reserves. A net operating profit margin below 15% may be cause for concern, between 15% and 25% would be adequate, and above 25% would be healthy and provide a capacity to grow. This number is the bottom line of cash flow analysis.
As you navigate uncertainties as a financial advisor and business owner, understanding your cash flow and being able to analyze it will enable you to make better, more informed decisions. What’s more, monitoring month-to-month, annual and longer term trends uncovers business intelligence that can inform how you manage your financial picture.
Understand your numbers
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