In “When Is Revenue Real?” we examined the belief that more revenue means more market share and more success, and we found that trying, like Wal-Mart, to compete on prices to get market share will drag down your profits. Now let’s imagine your business has gone the other direction and increased prices.

If your nominal revenues increased 10%, but you had raised prices 10%, you would have zero net Real Revenue Growth. You didn’t sell any more than last year; you just charged more for what you sold. Let’s say your revenue growth increased 10%, but at the same time you raised prices 15% across the board. Your real revenues declined 5%! Your nominal revenues increased, but you actually did less business.

Remember nominal revenue growth is simply measured by the change in revenue growth from one year to the next, positive or negative, as a percentage over the prior year. Measuring revenues this way does not account for any change in pricing or improvement in managing the cost of goods sold (or direct costs with a service business).

As demonstrated above, The Business Ferret subtracts price adjusted revenue growth from nominal revenue growth to determine Real Revenue Growth. Price adjusted revenue growth can be determined easily by dividing gross revenues by the cost of goods sold, producing the gross profit mark-up index. The change in the mark-up index represents the actual price increase or decrease overall within your firm.

It’s best to either redeploy your cash in your business or take it out of the business to invest elsewhere, even if your business has to borrow cash with interest expense. Using Return on Assets (ROA), one of The Business Ferret’s 12 key financial metrics, we can easily see why it’s best to invest.

Imagine your firm holds $500,000 of total assets, including $100,000 in cash. Given current low interest rates, let’s assume your cash is earning 2% ROA (after tax), or $2,000 annually. Your business should earn a higher return on total assets than it earns on cash balances, so let’s assume your business is earning 12% ROA (after tax) on total assets including cash, or $60,000 annually.

It’s not hard to see that if you redeployed your cash in your business, then your firm’s annual ROA on that $100,000 would increase from 2% to 12%, increasing earnings from $2,000 to $12,000.

But what if there’s no redeployment opportunity in your business? This is the point at which most business owners stop analyzing and sit on the cash, but we’ll use ROA to look further.

If you take that $100,000 cash out of your business and instead use a line of credit for intermittent cash needs, your ROA will increase. Still assuming your business has an ROA of 12%, or $60,000 return on $500,000 of total assets, removing the cash would increase your ROA to 14.5% ($60,000 minus $2,000 of interest income divided by $400,000 total assets).

The cash is dragging down your ROA by 17%; without it, your return would be 21% higher!

Are you complaining, “But now I have to pay interest”? Even if you borrow the entire $100,000 for a whole year at 7% interest, your after-tax cost would be $5,000. Subtracting $2,000 of foregone interest income and $5,000 of after-tax interest expense from your $60,000 ROA, your company earns $53,000 in after-tax income. Dividing by $400,000 in total assets, you produce a 13.25% ROA, still up from 12%.

By taking that $100,000 cash out of your business, you are free to put it in a higher-ROA investment. The main issue, though, is that you reduce the risk of your overall asset holdings by diversifying your investments. Even if you put your cash in the same bank at 2% ROA, by taking it out of your riskier business asset, you will have reduced your overall risk.

Still want to hold onto that cash?

When most firms hire a CPA they are look primarily for one who comes with good recommendations. An excellent CPA doesn’t have to know how your industry works in order to prepare your financial statements or taxes. How about your bookkeeper, how do you find that person? Probably the same issues that apply to the CPA apply to the bookkeeper.

If you look for an inventory specialist don’t you want the best whether they know your business or not? Inventory is – basically – inventory. Yes, wine inventory is different from eggs and eggs are different from specialty composite materials but at the end of the day it is all inventories. The age of inventory and the accounting for inventory can be different but it does not change the fact that it shows up as inventory dollars on the balance sheet!

What about the investment banker? Do you want to work with someone who is considered an expert in the field of selling companies doing the greatest volume or would you want a small boutique that only sells your type of firm? One of the greatest investment bankers, Bruce Wasserstein, opined that industry experts can be limiting because, “tactical and strategic considerations know no industry boundary.”

Finance was at the center stage of the 2009 mega-recession yet firms still don’t apply strategic finances to their business. They all seem to know that cash is “king” but that has really always been true. Business owners seldom hear from their specialist consultants how important cash flow is to the firm.

When did the last industry expert talk to you about how important return on assets (ROA) is to the owner and firm? How many of your experts talked to you about cash conversion cycle (CCC) or net trade cycle? How about your cost of capital (COC) and why ROA has to exceed the COC in order to increase your equity value?

I could go on, but the answer is most often that no one has said anything about finance to you, let alone held you accountable for accomplishing strategic financial objectives. Strategic finance knows no boundary within industry firms or between industries. Business is business and finance is finance no matter what you sell.

Let’s work out this situation in several scenarios.  First, we need to make a few assumptions. The company increased revenues a positive 5%, so if revenues were at $100 they went to $105. The cost of good (COGs) sold is assumed to be 50% of the revenue, producing a gross profit of 50% to revenue. Revenues at $100 with COGs at $50 produces a $50 gross profit (GP). Finally, the price reduction of 15% is accomplished through a reduction in the gross profit, or selling more products at lower mark-ups on COGs.

Revenues at $100 with $50 GP was the pre-existing situation. Now revenues increase to $105. Prices reduced 15% means that the GP margin percentage goes from 50% to 35% across the board. Instead of making $50 GP on revenues of $100, the firm makes $36.75 (105 x 35%) on $105 of revenues. The price reduction was 15% but the gross profit dollars dropped (-26.50%).

What would happen if the company did nothing? If a 15% price reduction increased revenues +5%, then doing nothing potentially drops revenues in the opposite direction, or a  (-5%) decline. So instead of revenues of $100, the revenues would go to $95.00. The gross profit margin of 50% would remain the same but 50% of $95 revenues would result in GP dollars of $47.50, or a change of( -5%) in GP dollars instead of a (-26.50%) decline in the actual change that occurred to increased revenues at 5%.

What would sales have to go to at an unchanged 50% GP margin to produce a (-26.5%) decline in GP dollars to $36.75?  If we divide the $36.75 by 50%, GP margin produces revenues of $73.50, or a revenue decline of (-26.50%).

Conclusion: the best policy for the company would have been no change.

Download the National Revenue Matrix

The Internal Revenue Service has kept data on around 5.5 million plus active corporations (C and S corporations) that file with the IRS each year. These businesses are filing both cash basis and accrual basis but over 80% (weighted by revenues) file accrual basis. These 5.5 million plus companies have over 95% of the assets and produce over 95% of the revenues each year. These are the businesses in aggregate you want to compare with each year and are the ones detailed in the chart.

Why is it important to know where you stand in relation to other businesses? First, the revenue size of your business will factor significantly into your business value. The smaller the firm the larger the risk to operate it and hence the valuation is discounted significantly more. Second, your sources are more constrained the smaller your firm’s size by revenue. Third, the positioning will help you understand your competitive landscape in a general sense. Fourth, an overall perspective is good to have when making business decisions so as not to act out of visions of grandeur.

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Annual aggregate revenue growth over the 12 year period is 5.75% annually. Around 28% of the total aggregate revenues are privately produced and the rest is produced by publicly traded companies. The average overall annual gross profit is around 45%. In 2001 and 2002 both incremental annual revenues and gross profit collapsed followed by a strong multi-year upsurge. The same incremental revenue and gross profit declines began again in 2005 .

Aggregate operating expenses as a percent of revenues approached almost 40% in 2002 and declined year by year to under 33% by 2007. Net operating income as a percentage of revenues dropped to a low of 7% – rebounding over the next several years to over 13% to revenues.
Cash flow before financing peaked out in 2005 at 12.89% to revenues and the dollar amount also peaked that year. From here it began a decline that bottomed out in 2009′s Great Recession. This occurred even though the EBITDA dollar amount kept increasing each year during the same period. EBITDA means earnings before interest expense, taxes, depreciation, and amortization but it should mean “every bad idea that draws attention.” Using EBITDA is not a good idea! EBITDA is a highly misleading placeholder for a company’s cash flow.

The aggregate companies are aggressive negative net trade cycle operators – good during expansion but for many of them quite dangerous during business downturns or recessions. The aggregate businesses also hold too way too much cash on average and invest too much in other assets that are not always necessary to the operation of the businesses.

Further the average return on assets for all the businesses is a miserable 3.5% annually throughout the whole time period. These businesses could not even hurdle their low aggregate average weighted cost of capital of 8.4% annually which meant that they generally were wealth destroyer in aggregate and over most of the time. Yes, the leveraged return on equity was around 48% but one needs to keep in mind that the aggregate is also substantially over-borrowed from a conservative banking point of reference.

The incremental annual revenue change to the incremental gross profit change to the incremental net operating income (NOI) change shows the different periods of struggle to maintain margins for the aggregate companies. #6 and #7 show the trauma of 9/11 and the recession in 2001 and 2002. While the gross profit did not incrementally keep up with the incremental change in revenues after this period – the NOI did go up dramatically due to the leaning of operating expenses.

Cash flow before financing (after tax) begins to deteriorate in 2007 before the Great Recession of 2008 – 2009. This is the best indication of cash flow to a company and might have been the indicator that, even though companies were making more net income, they were not converting as much into cash flow as in the prior years.

The aggregate balance sheet of the companies shows a great deal of investment into other assets. Under detailed analysis one might find that much of these other assets is not necessary to the operation of the business. In many cases one would have to ask why this money – used to purchase the assets – was not just distributed to shareholders. Ah yes, a lot of it is intangible goodwill but when you look at the overall aggregate investment performance of these companies one would have to assume that the goodwill purchased along with other intangibles did not warrant the investments.

Using stringent banking requirements that many smaller private companies must meet, the aggregate borrowing (including current liabilities) shows an over-borrowed position relative to total assets. This situation proves to be a complete disaster entering into the Great Recession of 2008 and 2009.

This chart shows how over the last several decades the aggregate U.S. companies have moved from a net positive trade cycle (more accounts receivable and inventory to accounts payable) to a net negative cycle with a vengeance. Negative net trade cycles work great when the revenues are growing but when they contract the negative trade cycle has results like a category 5 hurricane – catastrophic! The recession of 2008 – 2009 brought many companies to their knees and this type of financing, along with being over-borrowed, was one of the primary reasons for the extraordinary amount of failures.