Using Key Metrics and a Z Score to Determine the Financial Health of a Professional Services Firm

True or false: The primary indicator of a professional service enterprise’s financial success is its profit and loss statement. This is a trick question; the answer is actually true and false. That’s because the two main objectives in running a successful business are profitability and generating adequate operating cash.

An unprofitable entity can have positive cash flow (in the short-term) by:

  • Collecting accounts receivable faster than accounts payable are paid
  • Recognizing significant depreciation expense (a non-cash item) or
  • Receiving prepaid deposits for long-term projects and using the cash to meet current expenses

A profitable entity can run out of cash if:

  • Accounts receivable collections are longer than its accounts payable cycle
  • It made unwarranted investments in equipment or
  • It is making payments on excessive debt

A look at the following five balance sheet ratios provides further insight into possible clues about a company’s health:

  • Equity/Liabilities – whether the business has an appropriate amount of debt, or excessive debt
  • Net Working Capital/Assets – whether the firm has sufficient cash
  • Retained Earnings/Assets – whether there are sufficient cumulative profits
  • EBIT/Assets – whether there are adequate profits
  • Sales/Assets – whether there are adequate sales

What is a Z Score?

An entity’s Z score is derived by calculating the five ratios listed above and comparing them to an industry standard. A popular set of standards to compare your results is available from the Risk Management Association (RMA), which offers ratios by Standard Industry Code (SIC). The RMA’s benchmarks are a favorite of bankers in assessing credit risk. So ask your banker or another advisor if they can access your ratios for a comparison.

The Z score looks at the proximity of these ratios to the SIC mean. The closer the entity is to the industry mean, the better the Z score. So the balance sheet ratios and sufficiency of cash flows are important to an owner and to a lender.

Other Key Metrics

However, this is only one step in sound business planning and operations management. Do not pat yourself on the back if your scores indicate modest to robust financial health. There’s more work to do in order to ensure that these ratios improve or stay strong.

There are other key metrics not found on the profit and loss statement that can be used to manage and monitor your professional service business. They include:

  • Realization Rate (Average billing rate/hour earned). This is determined by dividing the total dollar amount of fees by total hours.
  • Utilization (Average # billable hours /employee). This can be figured by dividing the total number of billed hours by the number of employees.
  • Productivity: You can ascertain this by multiplying realization by utilization.

While these three metrics are key, because the basic revenue-generating formula for a professional service business is hours multiplied by the hourly rate, there may be other metrics specific to your organization that can be measured and improved.

Also, don’t overlook the impact of annual budgeting. The budgeting exercise is not simply taking last year’s numbers and increasing them by the Consumer Price Index (although for certain fixed expenses that is appropriate). Companies should take a focused, line-by-line look at the numbers. Use a reasonable budget to motivate improvement in the ratios and metrics discussed above to target greater success.

Timothy C. Hilbert can be reached at thilbert@kmco.com or 215.441.4600.

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