Evaluating your Financials
Last month, we discussed accelerating the closing of your previous-year financials and taxes. One advantage we cited was the idea of readily knowing where you stand with your business and now being able to make plans for the upcoming year: revenue goals, expense reductions, margin targets, etc. The topic we want to highlight, however, is how to ensure that all the tactical actions you decide to take are, in fact, going to yield the net profit impact you expect by year-end.
If it were possible, you would want every dollar of additional revenue to go straight to the bottom-line. In reality, those dollars are picked off by variable expenses as they move down the P&L statement. And often, we don’t even know the impact of this decision-making until the end of the year. What is a good metric to use to track this? And how do I test it month over month to know if I am on pace?
Introducing…Flow-Through Analysis, simplified. The flow-through analysis measures the difference between profitability and revenue. While commonly used in the hospitality industry, it is a useful performance management tool for just about any owner, manager or investor. The flow-through analysis is expressed as a ratio of gross operating profit to revenue that exceeds the budget. For example, if a business earns $10,000 revenue over and above budget, and the gross operating profit is $7,000 over budget, then the flow-through rate is 70% (7,000 / 10,000). In this example, 30% of revenue over budget was picked off by variable costs, let’s say for labor or raw materials.
How could I use it?
- Start by setting budgets for the key P&L categories. Remember, we said to get this done early.
- Set a target for flow-through, perhaps 50%. In other words, I want at least half of every dollar of revenue above my budget to flow-through to the bottom line.
- Review the budget vs. actuals and the flow-through ratio each month or quarter. Ratios that fall below target indicate you are not capturing the profit you want.
- Determine the factors that are most impacting your ratio. Start with key variable expenses.
- Make course-corrections and monitor for the following period.
This regular practice gives you feedback on your operational decisions, which can be very empowering and rewarding as a business owner. While growth is good, you want to test for the right kind of growth. Additionally, a strong flow-through ratio on consolidated financial statements is attractive in the business sales process. Consider how this month’s topic might be helpful to you and your team.