Financial Diagnostics Focusing on the Right Performance Measures in a Turnaround

In the majority of companies facing financial distress, management is frequently the last to recognize
the cause of the company's underlying problems. Why? The answer often lies in the fact that
management was not focused on the right performance measures. Specific examples of this are plentiful
and cover various industries:

</p><ul>

<li>The retailer that did not understand that a significant number of its store locations were unprofitable.
Management was too busy increasing the number of locations rather than focusing on monitoring the
right performance measures and taking decisive action to deal with under-performing stores.

</li><li>The wholesale distributor that was too focused on increasing its sales to its largest few customers.
These customers continually asked for and received pricing and payment concessions until they became
the least profitable customers of the company.

</li><li>The manufacturer that did not realize that half of its product lines were marginal or negative
contributors and did not have a disciplined approach to monitoring which products its sales force
should be focused on selling.
</li></ul>

<p>The task of successfully implementing a long-term turnaround strategy is difficult. One of the most
challenging issues involved is determining the exact causes of financial difficulty in an individual case.
Without being able to pinpoint the specific causes, it is impossible to identify a solution for the
company's problems.

</p><p>This article reviews a useful financial diagnostic tool that may be used to target the specific causes
of a company's problems.

</p><h3>Profitability Analysis</h3>

<p>One of the most effective tools for identifying (or confirming) a distressed company's underlying
problems is a profitability analysis. Depending on the industry, a profitability analysis could be
performed by customer, product and/or location. An ideal outcome of these types of analysis is one
where the results fall under the "80:20" rule. If 20 percent of a distressed company's customers, products
or locations accounted for 80 percent of its losses, then one could reasonably shed these and continue
with the remainder, presumably on a profitable basis after additional operational improvements.

</p><p>The major steps involved in performing a profitability analysis are as follows:

</p><ol>
<li><i>Gather Financial Information.</i> A profitability analysis starts with gathering pertinent, accurate and
timely information. Sales by location, product or customer must be obtained from the company's financial
statements and supporting management information systems. It is important to sort out all expenses to
determine which are direct expenses particular to the product, location or customer allocated based on work
load, usage or some other logical basis, or accumulated centrally for the benefit of the total company and
then allocated based on certain criteria. By determining whether the costs are accurately accounted for, a
comparison between product, customer or facility costs may point to a specific cost that requires attention.

</li><li><i>Identify Key Performance Measures.</i> The financial and other quantitative information gathered will
be used to establish key measures used in the analysis. These measures will vary depending on the nature
of the business and industry. Key measures for the health care services industry, for instance, may be
occupancy rates, profitability by payor or customer and profit margins. A retail company may want to
analyze comparable store sales, profit margins and inventory turns, or occupancy and distribution cost
structures. A manufacturing company may look at turnover rates, capacity, utilization or production
backlogs. These key measures must be carefully identified to accurately reflect the drivers of the product,
customer or branch profitability.

</li><li><i>Set Performance Benchmarks.</i> The ultimate goal in a profitability analysis is to use comparable
information to identify products, customers or locations that are under-performing and then make
sensible decisions that will increase the overall profitability of the company. Accordingly, it is important
to set minimum criteria for each of the key performance measures identified for the products, customers
or locations. These thresholds should consider factors such as the minimum tolerable contribution margin
necessary to fund corporate overhead, debt service, capital expenditures and shareholder returns. A
minimum return on working capital invested should also be considered. Even if a product or facility is
profitable, it may not be contributing the required minimum return. It may therefore be in the company's
best interest to commit that capital elsewhere.

<p>Performance benchmarks may be set up in several ways. One method is to create a "model store" or
"model customer base" to establish a minimum standard of performance. This model is especially
effective with a branch or location profitability analysis. Locations meeting or exceeding this
performance level should generate earnings and cash flow that, together with all other stores, would
achieve management's long-term performance objectives.

</p><p>Another method of making decisions based on profitability is the "break-even" method. This
threshold maintains that "the store's earnings, at a minimum, are sufficient to fund the cost of working
capital deployed." The stores or products that are just hitting the break-even point may continue
operating, as they are not negatively contributing to the company; however, they should be subject to
further analysis as operational improvements may be possible. The company should consider
discontinuing those that are not meeting working capital requirements or will shortly fail to do so.

</p></li><li><i>Identify Problem Customers, Products and Locations.</i> The profitability analysis will evaluate
performance levels based on the minimum criteria and then categorize the segments as (i) good and
therefore retained; (ii) "watch listed" and therefore requiring further evaluation or monitoring; or (iii) poor
and therefore candidates for closure or divestiture.

<p>The company must rank the product lines, customers or branches from greatest loss to greatest
contribution. This will allow management to focus on poor performers and make decisions accordingly.

</p></li><li><i>Look for Trends and Unusual Items.</i> One consideration when making decisions is to look for trends
within a particular store, product or customer group. Trends will indicate whether the product, customer
or branch is consistently failing to make positive contributions and whether the trend is improving or
deteriorating. It is important when looking at a year's profitability to isolate the effect of any non-recurring
items. An unusual or extraordinary expense may have been incurred at a specific branch or with a particular
customer group that could skew the actual operating profits for a given period. On the other hand, a
company that has non-recurring items on a recurring basis may be signaling problems that are fundamental
to the company's results. Trends in a detailed profitability analysis will highlight where the real problem
lies, whether it be relatively high labor expenses in a particular facility because of unnecessary overtime
charges, or diminishing order size for a particular customer type.

<blockquote><blockquote>
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<big><center>
...the payoffs and benefits of developing and using financial diagnostics should focus management on the right performance measures and contribute to increased profitability.
</center></big>
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</blockquote></blockquote>

</li><li><i>Identifying Future Strategy.</i> Once the underlying causes for an under-performing product, customer
or branch have been identified, an effective improvement strategy can be developed. Marketing
strategies, cost-reduction strategies and product realignment, to name a few, must be profit-focused. The
company should rid itself of any product line, customer group or location that is not a minimum-level
positive contributor to the company's overall financial goals.

<p>Solutions to an unprofitable customer or product may focus on improved marketing management.
The company could re-assess product pricing practices and sales-force incentives to improve the
customer and distribution mix, and improve sales and marketing productivity and effectiveness, with the
resulting objective of improving profit per customer or product.

</p><p>Improving profitability of a facility or product may also require a focus on manufacturing and operations
management. Ongoing productivity improvement programs need to be developed, cost systems that follow
cost drivers may be used (such as activity-based costing), overhead value analysis should be periodically
performed and ongoing profit improvement programs must be put in place.

</p></li><li><i>Other Considerations.</i> Several other issues must be considered when deciding the appropriate strategy
to increase profitability. The expected return on additional investment should be considered. For example,
capital expenditures to remodel a location must be evaluated in conjunction with the projected sales and
margin growth. Investing in remodeling a facility may not be an option, though, depending on the critical
cash position of the company. In the retail industry, for instance, facilities many times hold significant
amounts of inventory. The cost of holding these inventories should be taken into account during the review
process. Other areas to investigate when deciding to continue or discontinue a branch are closing costs, the
effect on pricing due to volume reduction with vendors, lease contracts and competition.</li></ol>

<h3>Challenges in This Process</h3>

<p>Persistence is a required trait for turnaround consultants and crisis managers, and it is very helpful
in this process. Many distressed companies initially resist this process as it goes entirely "against the
grain" of what they believe they should be doing. Accordingly, it can be a slow and difficult process
initially.

</p><p>The availability of reliable adequate information is generally a challenge through this process. Reliable
industry benchmarking data may also not be readily available or may not be directly comparable. Many
companies in the same industry can have entirely different views of what constitutes "fixed" overhead
versus variable costs. Cost allocation methodologies may vary significantly from one company to another,
which adds another level of complication to the process. While data necessary for effective profitability
analysis drills down a number of levels below the information provided in the financial statements, publicly
available financial data should be carefully evaluated in the benchmarking process. Doing so should at least
provide initial insight into where the company stands in relation to its competitors.

</p><p>In the end, the payoffs and benefits of developing and using financial diagnostics should focus
management on the right performance measures and contribute to increased profitability.

</p><hr>
<h3>Footnotes</h3>

<p><small>^{<a name="1">1</a>}</small> The author gratefully acknowledges the assistance of Andrea Will, an associate at Arthur Andersen LLP, in the preparation of this article. <a href="#1a">Return to article</a>