Measuring and Managing Customer Profitability

The only value a company will ever create for its shareholders and owners is the value that comes from its customers – current ones and new ones acquired in the future. To remain competitive, companies must determine how to keep customers longer, grow them into bigger customers, make them more profitable, serve them more efficiently, and target acquiring more profitable customers.

But there is a problem with pursing these ideals. Customers increasingly view suppliers’ products and standard service lines as commodities. This means that suppliers must shift their actions toward differentiating their services, offers, discounts, and deals to different types of existing customers to retain and grow them. Further, they should concentrate their marketing and sales efforts on acquiring new customers who have traits comparable to those of their relatively more profitable customers.

Some customers purchase a mix of mainly high-margin products. However, after adding the non-product related costs to serve for those customers apart from the products and service lines they purchase, these customers may be unprofitable to a company. This is because they demanded extra services that caused greater expenses than low demanding customers. How does one properly measure customer and supplier profitability? How does one deselect or “fire” a customer?

As companies shift from a product-centric focus to a customer-centric focus, a myth that almost all current customers are profitable needs to be replaced with the truth. As just noted, some high-demanding customers may indeed be unprofitable! Unfortunately, many companies’ managerial accounting systems aren’t able to report customer profitability information to support analysis for how to rationalize which types of customers to retain, grow, or win back and which types of new customers to acquire.

With this shift in attention from products to customers, managers are increasingly seeking granular nonproduct-associated costs to serve customer-related information as well as information about intangibles, such as customer loyalty and social media messaging about their company and its competitors. Today in many companies there’s a wide gap between the CFO’s function and the marketing and sales function. That gap needs to be closed!

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Interpretation of Financial Statements

When reviewing the financial statements of a business, what interpretation can be extracted from these statements? This article covers several types of financial statement analysis, mostly related to the ratio comparison of different line items in the statements. By comparing these results, and especially over multiple reporting periods, you can arrive at a reasonable estimation of the financial results and condition of a business.

There are two key techniques for analyzing financial statements. The first is the use of horizontal and vertical analysis. Horizontal analysis is the comparison of financial information over a series of reporting periods, while vertical analysis is the proportional analysis of a financial statement, where each line item on a statement is listed as a percentage of another item. Typically, this means that every line item on an income statement is stated as a percentage of gross sales, while every line item on a balance sheet is stated as a percentage of total assets. Thus, horizontal analysis is the review of the results of multiple time periods, while vertical analysis is the review of the proportion of accounts to each other within a single period. Later sections describe horizontal and vertical analysis more fully.

Another heavily-used technique is ratio analysis. Ratios are used to calculate the relative size of one number in relation to another. After you calculate a ratio, you can then compare it to the same ratio calculated for a prior period, or that is based on an industry average, to see if the target company is performing in accordance with expectations. In a typical financial statement analysis, most ratios will be within expectations, leaving a small number of outlier ratios that require additional detailed analysis.

There are several general categories of ratios, each designed to examine a different aspect of a company’s performance. These categories are:

Liquidity ratios. This is the most fundamentally important set of ratios, because they measure the ability of a company to remain in business. Samples of ratios in this category are:

  • Cash coverage ratio. Shows the amount of cash available to pay interest.
  • Current ratio. Measures the amount of liquidity available to pay for current liabilities.
  • Quick ratio. The same as the current ratio, but does not include inventory.
  • Liquidity index. Measures the amount of time required to convert assets into cash.

Activity ratios. These ratios are a strong indicator of the quality of management, since they reveal how well management is utilizing company resources. Samples of ratios in this category are:

  • Accounts payable turnover ratio. Measures the speed with which a company pays its suppliers.
  • Accounts receivable turnover ratio. Measures a company’s ability to collect accounts receivable.
  • Inventory turnover ratio. Measures the amount of inventory needed to support a given level of sales.
  • Fixed asset turnover ratio. Measures a company’s ability to generate sales from a certain base of fixed assets.
  • Sales to working capital ratio. Shows the amount of working capital required to support a given amount of sales.

Leverage ratios. These ratios reveal the extent to which a company is relying upon debt to fund its operations, and its ability to pay back the debt. Samples of ratios in the category are:

  • Debt to equity ratio. Shows the extent to which management is willing to fund operations with debt, rather than equity.
  •  Fixed charge coverage. Shows the ability of a company to pay for its fixed costs.

Profitability ratios. These ratios measure how well a company performs in generating a profit. Samples of ratios in this category are:

  •  Breakeven point. Reveals the sales level at which a company breaks even.
  •  Gross profit ratio. Shows revenues minus the cost of goods sold, as a proportion of sales.
  •  Net profit ratio. Calculates the amount of profit after taxes and all expenses have been deducted from net sales.
  •  Return on net assets. Shows company profits as a percentage of fixed assets and working capital.

This article is an excerpt from Steven Bragg’s new guidebook Financial Analysis: A Business Decision Guide.

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Stepping Up to the ‘Big Picture’: From Controller to CFO

Good leaders are usually made, not born. Sure, there’s the bred-in-the-bone verve, the judgment that’s often instilled at an early age, the outgoing and fearless personality.

But according to a recent survey of finance professionals, a leader’s most highly-regarded traits are carefully cultivated. He or she is a visionary. Principled. Caring. Motivated. Credible and inspiring.

For many professionals, the ultimate expression of leadership is the office of the chief financial officer, and they plan for that role in their future. What’s the biggest difference? (Other than the paycheck, of course.) Well, whereas the CFO is responsible for the “big picture” and is outward-focused, the Controller is more inward and historically focused, says Russ Palmer, longtime CEO and dean of Wharton School of Business.

The CFO is a strategic business partner who helps raise capital and manages the care and feeding of internal and external stakeholders. A great CFO also has what Palmer calls the “Likeability Factor.”

The two jobs have a lot of overlap, of course. Both incorporate the same general fields of study: managerial and financial accounting, federal, state and local taxes, regulatory compliance.

But also expected from the CFO are deep analytical skills, a dynamic presence and optimistic spirit. So how do you learn to be a motivator? To develop open and effective lines of communication both inside and outside the company? To know instinctively what your company needs?

According to CPE Link instructor, Miles Hutchinson, CPA, the CFO’s role in modern business management is moving away from simply providing information to management and towards acting as a key consultant and decision maker in an organization.

Are you ready to take on this role?

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