Category “Finances”

Financial Intelligence – It’s Not Just for the CFO

October 21, 2015 by Josh

Here at Setpoint, we often tout our open-book-finance style of management. To us, open-book-finance means that key financial data is shared with each employee on a weekly basis. Sharing this information with employees isn’t a revolutionary idea per se but training employees to understand the information is. In order for Setpoint employees to maximize our contribution to the company, it is important that we understand how our jobs impact income, cash flow, expenses, losses, etc. So how do Setpoint employees learn to be financially intelligent?

Our CFO, Joe Knight, owns a separate business called the Business Literacy Institute. He travels the globe training Fortune 500 companies and their employees on the art of finance and accounting. Recently he took time to provide training to all project and department managers at Setpoint. The training consisted of 4 sessions. The first 3 sessions were dedicated to the 3 financial statements – the income statement, statement of cash flows and the balance sheet. The final session focused on principles of time value of money and return on investment. While finance is an important (and riveting) subject in its own right, what did the training do to make Setpoint better?

First, it helped everyone understand that their decisions affect our bottom line. But it went deeper than that. It helped everyone understand that their decisions and contributions affect cash flow, receivables, payables, inventory, COGS, expenses, etc. For example if the sales department doesn’t require sufficient down payments on new projects, we choke our cash flow and we may have to finance the project until we finish the job. If our procurement group doesn’t stage their orders correctly, our payables may outrun our receivables. If a project manager doesn’t manage his project efficiently we may make less per hour than we bid. Any of these examples can (and sometimes do) happen at Setpoint and they hinder our ability to run efficiently. The key for our employees is to understand that they are equipped with the knowledge that their actions impact the company.

The important take-away from this blog post is not the idea that you should only hire accountants or finance majors to work for your company. The important take-away is that every employee needs to understand how their job directly impacts the financial statements.

So what if your CFO doesn’t have a side business training Fortune 500 companies in matters of finance and accounting? That’s OK. Have someone in your organization, who understands your financials, train your people. Get your employees to understand your numbers and you will have a more financially intelligent company.

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How to Gain Approval from Senior Management

July 3, 2014 by Clark

You have identified several issues within your operations.  You feel that if fixed, your company will benefit greatly by eliminating these issues; how do you now go about soliciting senior management for funding approval to pay for the solution that you feel will solve the issues you have identified?

All senior management will bias their decision to fund a project based on a financial analysis of the opportunity.  In other words, “is there a ROI or Return on the Investment?” Understanding how to present a financial analysis to senior management therefore is very important.  You might be thinking “I don’t have the proper training in financial analysis to present a solid case for funding my project.”  This is where Setpoint can help; we have developed an online ROI calculator (Return On Investment) to assist you in putting together a high level financial summary that will ultimately be required by your Sr. Management, to fund your potential project.

You may not be a financial wizard; but, everything you do can be quantified in monetary terms.  Here is a road map that you can follow in your quest to gather this information.  It all begins with your company’s pain or in the discovery of “what do you have to much of or not enough of?“  For instance, you have too much scrap, too much labor, not enough equipment utilization, not enough throughput, or you can ask yourself what are the current issues facing your business, whether it is management dictated or issues that you have identified yourself.  Start by listing all of the issues you have identified, then prioritize each of them by importance to solve, and assign each one a monetary value.  You could say your scrap rate is 5% and that equates to 25,000 parts per month.  If each part scrapped costs $.50, you just valued the scrap being produced at $12,500/month.  Do this same analysis with each of your issues.

Once you have established what all of the issues are, you can then make a correlation between what your current business situation looks like now, and then you need to decide what you want it to be once all the issues are solved.  You may not be able to solve all of the issues you identified right away but start with those issues that pose the largest potential gain for your company if solved.    For example, if you currently have 10 operators and you believe you can get it down to 6, or if your throughput is 60 ppm and you believe you can get it up to 90 ppm, there will be a benefit to your company that can be calculated if you can indeed achieve this level of improvement or change.  After making it through your list of pains and you have quantified what it is now and what you would like it to be, that the differences will now need to be converted into a monetary value to get your annual benefit.  If the improvements are related to a project with a specific time frame, you can multiply the annual benefits x the number of years the benefits should be realized. Below is an example project to give you an idea of how to complete this analysis.

Annual Benefit Calculations

 

Now that you have your annual benefit calculated, you will need to know your estimated cost of your project, the number of years your new equipment will be used and your annual minimum interest rate or what interest rate you need in order to make the investment, sometimes this is referred to as the hurdle rate.  For our example we will assume the cost of the solutions or the new equipment is $4.5 million.  We have determined that will use this new equipment for 5 years and the minimum interest rate is 7%.  With your annual benefit calculated, an estimate of the cost, years in production and interest rate, it’s time to go to our ROI calculator and plug in the numbers to find out if your project is worth pursuing.  Below is a screenshot of our ROI calculator for the above example project.

Return On Investment Calculator

 

From our inputs we are given three important numbers that will sell your CFO on your project; the Net Present Value (NPV), Payback – in years, and Internal Rate of Return (IRR).  We will briefly explain each number and why it is important.  Because a dollar earned in the future won’t be worth as much as one earned today, the NPV method provides a value for your project in today’s dollars minus the initial cost of the project.  When interpreting the NPV, if the number is greater than zero, it should be accepted.  For our example project, our NPV came back at $17,349,952.14; compared to the investment of $4.5 million this project should be an easy sell.

The payback method is the simplest way to evaluate the return of a project; basically, it tells you how many years it will take to get the return on your money or investment. For this method, the payback period must be shorter than the life of the project.  In our example, we are estimating an equipment life of five years and our payback period is under one year (0.84 years), you should definitely feel confident in presenting this project to senior management.  We find that most companies require an ROI period to be less than or equal to 2 years.  Some very aggressive companies actually won’t invest in capital equipment unless the ROI is one year or less.

The final metric shown in the ROI calculator is IRR, which calculates the actual return provided by the projected cash flows.  The IRR can then be compared with the company’s hurdle rate.  When considering the IRR of your project you want it to be greater than your company’s hurdle rate, otherwise the project doesn’t make sense financially.  In our example, the IRR was calculated at 115.84%, which is greater than the 7% hurdle rate, making this project a good one to pursue.

Next time you have identified some issues in your operations and need funds for a project to correct these issues, remember to calculate the ROI to see if pursuing the project makes sense before spending a bunch of time and effort on something that will not ultimately get funded for lack of an acceptable ROI.  As long as your return is positive you will have the financial evidence and confidence to present your project to senior management and sell them on your project.

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The Setpoint ROI Tool

February 28, 2013 by Joe Knight

At Setpoint Systems we sell automation equipment for manufacturing. It turns out that our products are capital equipment to our customers. Capital equipment represents large investments for most businesses that need to be depreciated over time. Capital sits on a company balance sheet as a long-term investment. Getting capital equipment approved as an investment is usually pretty tough. The finance people really don’t like see hard earned cash being spent on capital that is based on some manufacturing engineer’s idea to improve a process on the production floor.

Lately the importance of cash is greater than ever. With the financial crisis of 2009 and the seemingly constant cases of financial fraud, investors and business owners don’t like to see cash coming out of their businesses. This trend on Wall Street and in the executive suite has made it harder than ever to pry out the cash required to make those capital investments. Consequently, it’s been a tough few years for business that make and sell capital equipment like Setpoint.

So one way we have battled the trend away from capital investment on new manufacturing equipment is to provide a Return on Investment (ROI) tool on our web site. Now that new idea from the manufacturing engineer can make sense financially. This tool allows one to take an investment in capital and apply financial analysis to the numbers to see if they make sense financially.

The ROI tool provides net present value (NPV) and internal rate of return (IRR) on that automation project. To use the tool one needs to know how much an investment in equipment will be including all the costs to ship install and start-up that new automation equipment. Then you must estimate the annual savings in the machine will provide the business. These savings can include increased production, less labor requirements in the process, or less scrap. Once the savings are estimated and the initial costs are identified the last step is to provide a minimum initial rate of return on projects in your business (usually the finance group can help you with this). Armed with this information you are ready to plug the numbers into the ROI model.

The results will tell you thumbs up or down on that new capital project. Armed with a positive ROI result, now that new project is not just a cool idea but also helps the company make profit and more positive cash flow. Try the model out and then when you find yourself a winner. Contact us at Setpoint Systems. We love to help our partners and customers make more money.

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Financial Management is the Same Big or Small

August 5, 2010 by Joe Knight

Setpoint Systems is a small automation manufacturing company with revenues raging from 5 million to 25 million annually. Setpoint has always been able to grow to the projects it has. We have learned to flex with the opportunity. In the new work world much of what companies’ do is through outsourcing. Setpoint had always been able to find a way to do that. The other challenge for a small manufacturing business like Setpoint is to keep the cash flowing. In today’s world it is nearly impossible to get financing if you are a small business.

I am the CFO of Setpoint and when I am not at Setpoint I am on the road training people on how to read finance. I have a book published called Financial Intelligence that outlines how to read financial statements and is representative of my training approach. I have done or am currently training companies like General Dynamics, General Motors, Metlife, Visa, Electronic Arts (EA), NBC, and Boeing.

In my experience with these large Fortune 500 companies, I have realized that the issues that these large companies deal with are very similar to the problems we face at Setpoint. One of my clients is that small company called General Electric (GE). As I was struggling at Setpoint to stay cash positive and not exceed our limited credit line on a major project, I was training at GE (I do the finance segment of their MDC, Management Development Course, at their Crotonville training campus.) As I was presenting information on the cash flow statement this last year, an attendee from GE capital talked about how she recently was unable to get funding for a $50 million credit line requested by a borrower. When she called the GE treasury department for the funds they said we are out of funds. With the commercial paper market collapsing, we do not have the liquidity to provide the funds for the credit line. As I heard this I remember thinking this sounds like the problems I am having at Setpoint trying to make payroll. Of course, we always do find a way to make payroll and GE found a way to work around the collapsing commercial paper market as successful companies do. But what was interesting to me was that our problems with cash were similar. GE has over $150 billion in revenue and Setpoint has around $10 million.

Later in that same session, another attendee said that his business was a project based business. He said that during this last year GE management required that all projects must remain cash positive. This means that customers must provide funding up front for GE projects during this same cash crunch period. As I heard this student talk about this issue, I remembered a week earlier telling my team at Setpoint that given the lack of credit out there from now on all contracts had to be completely funded by the customer. I smiled as I thought about how similar my problems were to GE. Now as GE is losing revenue, they are learning more and more how to access the contractor approach for growth just like Setpoint is.

What I have learned by working at Setpoint and watching the struggles of large Fortune 500 companies is that business is the same no matter the size. It doesn’t matter if you are the biggest company in the world or a small sole proprietor. You need to figure out how the make a profit and generate cash if you are to stay in business. GE has been doing that for nearly 100 years. At Setpoint we are approaching nearly 20 years with a lot of good years to come.

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Revenue Recognition in Managing Projects

June 22, 2010 by Joe Knight

One of the issues that the founders of Setpoint, Joe Cornwell and Joe VanDenBerghe realized early on was that they did not like the way the accountants did project based accounting. At the crux of the problem was the cost versus budget approach to revenue recognition. Under GAAP (Generally Accepted Accounting Principles) the rule for project revenue recognition was percent of cost complete. For example, if one spent $1,000,000 on a project and the total project cost budget/estimate to complete was $5,000,000 then the project would be considered 20% complete for revenue recognition purposes. So to complete this example if the project revenue was $7,000,000 then 20% of revenue would be $1,400,000. So the period profit and loss statement for that project would look as follows:

Revenue    $1,400,000
Expenses   $1,000,000
Profit         $  400,000

The Joes questioned the validity of that profit. They debated with their accountant. They struggled with the concept. Their issue was with the way their automation equipment business operated. A large machine can take 6-9 months to complete. A lot of the work is at the end of the project when the machine is starting up and being debugged. The problem with the GAAP accounting method is that the profit is recognized before the real tough work is completed. As an example say Setpoint builds a $3,000,000 machine that will take about 9 months to complete. In the first 3 months the machine’s materials are received and design is complete. Let’s say that material costs on the machine are $1,500,000 and the design cost another $100,000 in labor. So by the GAAP accounting method the machine is $1,600,000/$3,000,000 or 53% complete. Therefore, 53% of the projected profit can be recognized in the first 3 months. One the other hand, a small fraction of the total labor to complete the job has been incurred at that point.

Let’s assume that Setpoint estimates that the total labor costs will be $1,000,000. So by labor measures Setpoint has spent 10% of its labor budget or $100,000/$1,000,000. Yet the accountant will say that the machine is 53% complete. This discrepancy can create a false sense of safety early on in a project when little work is done. Furthermore, if there was large labor overruns later in the project during the startup/debug process those past profits could be overstated.

Because of this issue Setpoint decided to measure revenue in a different way. At Setpoint, we measure percent complete by labor only. We evaluate how much labor was spent on a project every week and then we estimate labor required to complete the work and use labor only to recognize percent complete for revenue recognition.

Setpoint uses two methods for estimating labor. First, for smaller projects we look at labor by discipline and estimate how much will be needed to complete the project relative to what has been spent. For our larger projects we look at these numbers based on schedule based earned value tools. We update these projects on a weekly basis so our project engineers can stay close to the performance of our projects and to make it possible to communicate our profitability to the entire company on a weekly basis. We will talk more on project tracking and earned value in a later blog.

We also have a white paper that talks more about our project management techniques, feel free to download it.

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Anticipating Cash Flow on a Large Contract

June 17, 2010 by Machel

Does your company play offense or defense, when managing cash?  Cash flow management is always best when played offensively, rather than defensively.  If there is a project on the horizon that is larger than normal and will stretch a credit line, calling vendors ahead of time to request credit limit increases or terms extensions is vital.

Over the last eighteen years, Setpoint has developed a great working relationship with their vendors.  This has paid off more than once.  Because we pay our bills consistently on time and/or take discounts, we have been told by most of our vendors that we are one of their preferred customers. If you have not been paying your bills on time, or you consistently drag them out – quit reading right now, you won’t have a chance. Occasionally when we have needed a little flexibility in our payment terms they take our calls and work hard to get us the help we need.  When we go to the vendors with a request, without a doubt every one of them have said “Yes”.  Sometimes vendors can’t provide the terms we requested, but they come back with something that we both can work with to help us during our crunch time. This can only be done if you are playing offense and know well in advance that you need the help. Calling when you are already 60 days overdue on your bills will not get you very far in negotiations.

These calls can be a difficult thing to make.  Here is where the old adage applies, “if you don’t ask, you don’t get”.  There are a few questions that need to be asked before calling on the aid of the vendors.  For instance:

  • Do we pay our bills on-time?
  • Do we award PO’s to the lowest bid?  Or do we use a variety of matrices for awarding PO’s?
  • Do we have someone who can communicate well with our vendor’s credit department?
  • Can we articulate the reasons for the extension?
  • Are we willing to pay a finance charge to vendors, if needed?
  • Do we ask the same thing from all vendors?

If you can answer positively to these bullets, you are prepared to go to the next step.  Some other questions you should consider are:

  • Is it a temporary or permanent change?
  • How often do we ask them for changes in terms?
  • Can we afford to order from vendors who can’t or won’t extend terms?

Who do you call?  No, not Ghostbusters.  Who makes the calls?  It is good to have both the purchasing and the finance department make the calls.  Purchasing can start the dialogue with the sales department, while the finance department can contact the vendor credit department.  Generally, the credit department will request information from their sales force to check on the customer’s stability and contract viability.

Any coach will tell you that their offensive team is the most important part of the team.  In business this means that understanding your cash flow needs well in advance – will keep you out of trouble. Ask yourself this, are you ready to play offense?

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Why does the huddle work at Setpoint Systems?

January 14, 2010 by Joe Knight

Setpoint Systems is an open book company. This means that our books are open to our employees. Even though we are a privately held company we choose to share our financial information.

When the company started in 1992, the engineer founders Joe Cornwell and Joe VanDenBerghe (aka the Joe’s) decided they wanted to share financials with their employees. As a project based company they found that the way their part-time CPA did the books with them did not give them a good measure of how the projects were performing financially on a week-to-week basis.

So the two Joes with the help of others developed a way of tracking their projects on a weekly basis that included hour tracking by labor section, material costs tracking, and earned value project management concepts. This allowed a fairly accurate measure of the financial performance for projects on a weekly basis. This type of the project financial analysis did not comply with GAAP (The Generally Accepted Accounting Principles). Their CPA did not like it but it made sense to them and their employees.

The weekly tracking process happens on a big white board where projects are measured for material costs and percentage progress every week. The key project number, that every employee follows, is GP or gross profit by project (at Setpoint GP is simply earned revenue by percent complete less actual material costs). After the gross profit by project is measured then we compare that to our week OE or operating expenses. You take GP – OE to measure our profit for the week.

We track closely three measures on our huddle board. First, is GP/OE. For us, 1.2 is good and anything less is not good enough to sustain the business. Second, we track what percentage of our labor is direct to our automation projects. Third, is GP per direct hour charged to projects. Everyone knows that if our GP per hour is over a key threshold and our percent direct is over a key threshold Setpoint will make a nice profit and GP/OE will be well over 1.2.

It’s actually a really simple system. We have a monthly and annual bonus that pays out based on beating minimum GP-OE targets for the month and year. We also train all of our employees on how the huddle board works and what the key metrics mean.

So why does our huddle work? Well I think that there are few things that have made this simple 15-minute weekly meeting work for Setpoint. First, it’s a simple way to track projects and everyone understands it. Second, we tie objective financial rewards to how the board looks. Third, we involve every employee in the process. In the weekly huddle every employee has a seat at the table.

The power of Setpoint’s weekly huddle is evident in the survival and success of this business. When a project is bad on the board, the assembly people blame the design and engineering people, the design and engineering people say the project was under funded when it was sold and blame sales. We are all together in the meeting and it needs to be worked out between these groups or we do not have a business. The huddle creates at Setpoint what I like to call ‘psychic ownership’. Ever though all the employs do not own stock in Setpoint they act like owners because they see the performance on a weekly basis and want the company to perform well.

We have seen this ‘psychic ownership’ express itself in many ways over the years. Recently, when a project was nearing completion some shop people approached our CEO and challenged the percent complete shown on a specific project. They were in final assembly and thought the machine was well beyond 90% complete but our project engineer had the number much lower on the huddle board thus lowering our GP-OE and bonus for the month. In short, our assembly people accused the project engineer of sandbagging on the project. After a brief review an adjustment was made. We’ve also had situations where percent complete has been challenged as being farther along than we really are.

With everyone involved the huddle really keeps us safe and accurate on our business. We believe the huddle process and the systems behind it is the single greatest asset that Setpoint Systems has.

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Project Cash Flow Forecasting

December 16, 2009 by Machel

Bidding on large projects is bittersweet.  If you have an opportunity to bid on a project that could be either a blessing or a burden, it is important to manage the cash flow.  Because cash is King, it has the ability to put you in a castle or a shack.  What kind of living quarters you live in can be decided by cash flow.  A significant number of companies go out of business because of lack of cash, not a lack of great ideas.

When bidding on large projects there are a few questions that need to be addressed.  First, when are the costs of the project due?  Second, when will the majority of the labor be needed?  Third, what size of a down payment do I need?  When do I need progress payments?  Most companies think the down payment question should be answered first, but that is not always the case.  It is necessary to know when your costs are going out so you know what size your down payment needs to be and when your progress payments need to come in.

Let’s assume some facts for our example:

  1. Revenue on the project is $3,000,000
  2. Cost of Goods Sold (COGS) are $1,500,000
  3. Operating Expenses are $10,000 for the first 4 months, then gradually less as the project closes

 

Cash Flow Forecast Tables

 

Following the tables listed above, if you change the down payment from a 30% down payment to a 50% down payment, you go from needing $480,000 to not needing any additional cash at all during the entire project.  This is assuming a progress payment is scheduled four months into the project.

A spreadsheet like this does not take very much time to set up.  By putting in that extra time your company can go from living high on the hog to searching the couch cushions for change.

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Return on Investment (ROI) Calculator

December 3, 2009 by Joe Knight

The ROI (Return on Investment) calculator is a new tool added to Setpoint System’s web site.  This tool allows you to measure the viability of a potential automation project that Setpoint Systems could provide.  The tool requires the following information. 

First, you need to provide and estimate of the total cost of the automation project.  This cost is more than just the cost of the equipment.  It should include items like installation and support. 

Second, the ROI tool requires your best estimate of the annual savings the automation will provide.  These savings could include added profit from increased volumes, labor cost savings, lower scrap rates, floor space savings, and higher consistency in the output. 

Third, you will provide the number of years the annual savings will be realized. 

Fourth, you will provide the minimum annual interest rate return required for the automation equipment.  This rate is often provided by your finance organization.  It is a measure of the return that the money invested in your business should get.  Some call this the hurdle rate or the cost of invested capital in your business if you want to use finance jargon.

Once you have entered these inputs into the ROI Tool, you will get an output report.  This report will provide three ROI metrics that your finance guru will love.  They are NPV (Net Present Value), Payback, and IRR (Internal Rate of Return). 

NPV measures the amount of money the project returns in today’s dollars when compared to the initial investment.  A NPV below 0 means you are better off rejecting the investment because the benefits of the automation in today’s dollars do not cover the initial costs.  On the other hand, a positive NPV tells you that this investment beats your initial required rate of return in using current dollars. 

Payback simply tells you how long it will take to get your initial investment back – clearly the shorter the payback the better.  Payback is a simple tool that is used for a reality check.  Since it does not consider the investment to the return in current dollars, it is considered inferior to NPV and IRR. 

IRR measures the rate of return that the project pays out based on the initial investment and the return information.  If the IRR is higher than the minimum annual interest rate, then you are getting a better return than the minimum.  IRR method is a terrific way to present a project to management.  If your IRR is 25% on a project and your minimum required rate is 12%, you can say that this investment beats your required rate by 13%.  You would be crazy not to proceed with this project.

So have fun with this exciting tool.  I know a lot of you working on automation are technical.  I hope that you realize that this tool can be as exciting as running calculations on your old HP 11C calculator.  It can also help your company make more money.

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Why cash and profit are different

September 24, 2009 by Joe Knight

As managers and business leaders we tend to focus our efforts on the income statement.  After all isn’t business all about being profitable?  The income statement measures profit so that should be our focus as we look at the success of our business.  If the bottom line of the income statement is positive then life is good.  If it is negative, then it’s time to find some outside investors.

Well what many managers and owners don’t understand is that the real key to being successful in business is having cash flow.  Cash is king.  A business fails when the cash runs out not when the company had losses on the income statement.  Cash flow is becoming a key measure on Wall Street right now.  Why?  Because investors and analysts know that in a liquidity crunch if a company can generate its own cash it will survive.  A second reason is that cash flow is not subject to as many estimates and assumptions as profit from the income statement.

So now the question how can cash and profit be that much different?  There are really three reasons why cash flow and profit do not match up well.

First, we book or record sales not when we collect on them but when the product or service is delivered.  This can lead to sales on the income statement that will not be collected for a great deal of time.  In most cases it can take 30-90 days to collect on those sales recorded this month on the income statement.  In the case of long-term contracts the recognition of the sale and the collection of the cash can be more than a year a part.

Second, we record expenses on the income statement when those expenses are incurred not paid in cash.  This is part of the accrual process.  The income statement is about matching expenses with sales.  So if I make payroll on September 1st, I do not charge that expense to September.  Rather, I charge it to August since the September 1st payroll is to cover work that was performed in August.  So we show an expense in August even though the cash did not go out until September.

Third, when I spend my cash to buy capital equipment for a business, things like computers, building, and vehicles, I depreciate them on the income statement as expenses over several years.  When I spend my cash on capital it’s gone.  On the other hand, the expense associated with this capital takes years to impact the income statement.

When one takes these three issues into account, it’s easy to see why cash and profit are two different things.  The message here for the financially intelligent business manger is to watch both cash and profit because understanding them is critical.  Why do most businesses fail?  Because they run out of cash.

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