In a series of articles, Shaun Gillanders, a freelance Finance Director and Interim Manager, explains the tools available to produce a plan and manage its implementation in order to ensure a business can generate value for its principals in a highly competitive environment.
The owners and principals in many Scottish law firms are already working long hours to satisfy ever more demanding clients who are expecting to pay less for the services rendered. With deregulation on the horizon, more providers of legal services may be about to step into an already crowded marketplace. How can a practice profitably compete against a major UK bank operating a 24 hour call centre? No matter how poor we think service is when delivered by call centres, they are always available and can capture clients when they are most in need of quick advice. If Scottish law firms are to compete against large, efficient, and customer service-focused businesses, they need to be very clear about what they want to achieve, and how they are going to achieve it.
So if you are worried about what the future holds for you and your business; if you can't see how life will get any easier, better or even just more profitable, now is the time to stop, make a plan and then start using that plan to support all the business decisions you have to make. This series is intended to lead you practically through the processes involved in creating and implementing a business strategy. Here we will concentrate on the different ways to measure the financial performance of the business.
Performing for value
Assuming that the goal of the business is to create value for the owners, how do you define value, so that you know when you have succeeded? With owner-managed businesses there are two parts to this value creation, the return generated from working within the business (notional salary) and the return generated as owner and investor. Value creation revolves around maximising the investor return and ensuring that it is high enough that the return in reality creates value. There are a number of different measures of investment return that we can briefly compare:
Balance sheet net asset value
Advantage: Easy to calculate; Easy to understand; Disadvantage: Values are accounting values which don't necessarily represent true value; For example fixed assets are shown at depreciated book value and not resale value or repurchase price.
Adjusted net asset value
Advantage: Strips out accounting entries to the balance sheet (like depreciation) that mask the true value; Still easy to understand. Disadvantage: Doesn't take account of quality of assets in balance sheet; Carries estimates for resale values which are subjective and open to interpretation.
Advantage: Easy to calculate; Easy to understand. Disadvantage: Profit may be positive but still not value-creating if investors/owners suffer higher costs of capital than the profits generated.
Advantage: Ensures business generates return in excess of investors' cost of capital and therefore profits exceed total cost. Disadvantage: Harder to calculate cost of capital when number of investors increases.
Discounted cash flow return on investment
Advantage: Provides a time value to cash generated by the business. Disadvantage: Difficult to calculate. Not straightforward to understand.
Of these, the theoretical best is some form of discounted cash flow measurement. This calculates the return based on cash generated by the business, but also feeds in some form of bias for cash generated quickly over cash generated slowly. This is not the easiest measure to calculate or utilise on a day-to-day basis. A more straightforward measure of value creation is the economic profit and economic return in excess of the owners' weighted average cost of capital. If a business can create a return on its capital invested in excess of the cost of its investors' funding, true value is created. If this economic profit is done year in year out, then the time value of the profit stream can be pretty much ignored.
As a quick and easy measure of a business's performance, economic profit works well. This is essentially the after-tax profit generated by the business but adjusted for accounting entries, has the notional salary of partners deducted from profit and suffers a charge against the profits representing the cost of capital for the investors/owners. The actual accounting adjustments vary from business to business but will include the adding back of the depreciation charge, the aim being to attempt to focus on the cash-generative nature of the business.
A worthwhile return?
To calculate the cost of capital, the weighted average cost of capital for owners' needs to be determined. Each owner needs to detail their investments, cash and borrowings and the rates of return earned on investments. The box provides a very simplistic example of how to calculate this. Tax has not been taken into account (to increase simplicity), but should be in reality. The growth in the value of the house is disregarded because it is assumed that any money taken out of the business could not be used to buy a bit more of the house (as opposed to paying off a bit more of the mortgage). Obviously the capital could be used to buy another house, but the calculation assumes that this is an investment and generated the investor's average investment return.
Calculating the cost of capital
A partner has a house valued at £350,000 and a mortgage on this of £200,000 with a 5.5% interest rate. The local property market is rising at an annual rate of 17.5%.
The partner also has a loan for capital injected into the business of £25,000 at 6.5%. This partner then has an investment portfolio valued at £65,000 earning a total return of 8%. The partner has capital invested in the partnership of £45,000. The cost of capital for the partner can be calculated as follows:
less Investments....£65,000.....8.0%................. £5,200
Cost of capital.................7,425/160,000 = 4.64%
Therefore the business has to pay the partner 4.64% of £45,000, £2,088, on top of any notional salary to ensure that the money invested in the partnership is better left in than removed and used to repay the partners net borrowings. To calculate economic profit £2,088 has to be deducted from the profit to reflect the cost of this capital.
Economic profit can now be calculated for the business by taking after-tax accounting profit and adjusting for depreciation, notional partner salaries, a cost for replacing assets, any research and development costs and the cost of capital based on the level of capital invested in the business. If after all these relevant adjustments there is still a positive profit then the business is creating value. In addition by expressing the cost of capital as a percentage of the total capital in the business (the 4.64% in the box) we have a hurdle rate of return against which we can benchmark any projects within it.
Whilst very important, having a financial benchmark that we can use to ensure that the business is creating value for its owners is only one small part of the strategy. Knowing what profits need to be made is the starting point but of itself is not a strategy. Someone still needs to begin devising a business strategy that can generate the return that creates value.
Unlocking the pyramid
This involves identifying where the business currently is and its problems and financial weaknesses, then identifying alternative options for the business going forward, evaluating the options to identify the most appropriate one, planning the change from where the business is to where it needs to be and finally implementing the strategy. Simple really! In the next article this part of the process will be covered in much more detail, providing useful tools to facilitate this process.
In the bottom third of the pyramid we have low margin commodities , where each sale generates a small profit. However, because the price of each product/service is low there are a large number of customers available to sell to and the business can have a high number of sales (high volume).
In the top third we have high margin commodities, where each sale has a high cost and generates a high profit margin. However, because the price of each product/service is high there are a small number of customers available in the marketplace.
The hardest place to sit in the value pyramid is in the middle where the products/services are neither high margin (requiring few sales) nor low margin (requiring efficient systems).
When building a business strategy, understanding where a business's products/services lie in the value pyramid and deciding where the business wants them to lie is a key decision driving different business models. If your business wants to focus on low margin commodity services then you need to be able to win lots of business and process it efficiently and quickly to maximise the total return across the business. If your business wants to focus on high margin services/products then you need to ensure that your clients consistently approach you because of your actual or perceived quality or expertise, and that your cost base is managed to ensure that the profit created from the number of transactions won is able to generate a value-creating return.
If the future of Scottish law firms is to be shaken up with new market entrants, partners and principals need to prepare their businesses to succeed in a different marketplace. This article has focused on how to measure value, as it is important that the owners of the business can be confident that their investment is creating wealth for them. Deciding on a required financial return does not build a business strategy. The return is in reality the product of implementing a good business strategy well. Looking forward, next month I will cover the tools available to begin building a business and ultimately your strategy for winning clients. If a business successfully implements its strategy, the reward should be a financial return that creates wealth for its owners.
Shaun Gillanders is a Scotland based freelance Finance Director. Following a successful career as an FD of one of Scotland's leading growing private law firms, he has begun advising a wider range of law firms on strategy, financial management and operational development. If you wish to discuss any issues raised by this or any of the other articles in this series then please feel free to email him at firstname.lastname@example.org
Originally published in the Journal Online