Owners are often so immersed in the day-to-day details of their businesses that they can’t always see financial warning signs of tough times ahead. If you can’t see the warning signs, you can’t avoid the danger.
At the Numbers Coach, we teach business owners how to spot the warning signs. We closely monitor revenues, receivables and cash flows. These three figures are closely related. Businesses often struggle because of poor cash flow, which usually indicates declining revenues and/or slow collection of business receivables.
12/12 Rate of Change
One of my favorite tools to provide an early warning sign of potential trouble is a chart called the 12/12 rate of change. During difficult economic conditions, I watch this rate of change closely. If I start to see it slip from 20 percent to 19 or 18 percent, we need to investigate why. If a business continues down that path for too long, the impact will be quite negative.
Let’s take revenues as a simple example. Each month, we calculate total revenues for the past 12 months and we compare it against the same figure for the prior year. Then, we calculate the rate of change from last year to this year. If last year’s 12-month revenue figure is $1 million and this year’s 12-month revenue figure is $1.2 million, we have a 20 percent rate of change. Perhaps you can’t change the revenue figure during tough times, because customers postpone the purchase of your product or service. In that event, it may be possible to lower your expenses and avoid losing money.
The 12/12 rate of change provides a long-term view of your business. It is very useful for spotting changes in a business trend, positive or negative, that have occurred during the past year.
12/12 Rate of Change for Fixed Overhead
To take the analysis a step further, I like to review the 12/12 rate of change for the fixed overhead of a business. It tends to be a leading indicator of future bottom-line results when combined with the 12/12 rate of change for revenues.
Fixed costs are those incurred whether you generate any revenue or not. They include rent and, for many service businesses, staff salaries and benefits.
Let’s imagine a business has a 12/12 rate of change for revenues that shows 5 percent growth. If the 12/12 rate of change for fixed overhead shows 10 percent growth, the business has a problem to address. The business is adding to its fixed overhead at a rate that exceeds top-line revenue growth. That’s a financial warning sign. Because of the long-term nature of the 12/12 rate of change, there is no need for immediate panic. However, if the situation is not remedied, it will pose a threat to the future health of the business.
To investigate further, I look at the trailing 12 months of revenues and fixed overhead expenses – not the rate of change, just gross dollar amounts. Is the revenue increasing or decreasing? We plot points on a graph to develop a clear trend line. We do the same for fixed overhead expenses. If, earlier in the year, you noticed an unhealthy rate of change trend and took corrective action, you can check your progress by reviewing the trailing 12. Using both metrics gives you a better read of the situation you face today.
What type of corrective action can you take? There are several possibilities, including increasing your sales, speeding up your collection cycle, or cutting expenses. If you are not sure which path is best for your business, contact us for a free consultation.