High-level industry analysis can bring a significant amount of insight into driving business value. However, drilling down to the nuts and bolts of financial management analysis also offers significant insight and provides balance. Here are six simple financial KPIs to look at every month to increase the value of your business in the automotive aftermarket industry.
Many of these financial KPIs are similar to metrics that the largest consolidators in the industry use to evaluate individual locations across their networks. While there are many more complex metrics that are important to evaluate regularly, this is a list of what I consider to be simple financial KPIs that a business owner ought to be looking at on a monthly basis, if not more frequently.
The first place I look when evaluating a business, even before looking at sales, is gross profit. Gross profit is one of the most important financial metrics of a business. Small changes in gross profit can have significant impacts on the overall value of your company.
A common mistake I often see is a business managing to sales rather than gross profit. The premise is that an increase in sales will take care of everything else. Often I see compensation plans that reward sales with little to no emphasis driving profitable sales. This can be counter-productive as it may provide perverse incentives and does not always align employees with ownership's best interests.
Gross margin varies by sub industry, but even seemingly small differences in margin can lead to substantial differences in EBITDA and net margins. While it is great to maximize gross margin, there is a trade-off. When the gross margin is too high relative to peers, I become concerned about the long-term ability of the business to sustain those margins and retain their customers. When margins are significantly lower than industry average, I become concerned about the long-term profitability of the company. In both cases I want to know what drives the margins: i.e. is it a pricing issue, a discounting issues, a cost of goods sold issue, or a combination of all of the above.
After I look at the gross profit of a business the next number I look at is EBITDA, which is one of the most important drivers of business value. The value of a business is determined by its projected free cash flow. EBITDA is a quick approximation of cash flow that you can calculate every month.
A great way to incentivize managers and employees to think like owners is to create a compensation plan based on EBITDA. Because EBITDA is based off of earnings, not sales or gross profit. The benefit is that managers and employees will be focused on the “bottom line” in a similar way an owner is. But if you do decide to go down that route, it is important to ensure that your EBITDA is clean. Often, businesses have many owner discretionary expenses lumped into general administrative expenses. It may be wise to create an incentive program around a clean adjusted EBITDA number your staff can control rather than a murky EBITDA number.
EBITDA varies substantially by sub industry as well. Privately held automotive service-based companies, i.e. collision and mechanical services, see EBITDA margins generally between 12% and 20%. Publicly traded service firms, i.e. Monroe Muffler, Boyd Group Income Fund, Pep Boys, etc., see slightly lower EBITDA margins , generally a result of higher corporate overhead expenses relative to privately held peers. Automotive retail, i.e. auto dealerships, see substantially lower EBITDA margins between 3% and 5%, but with substantially higher sales figures. Parts, paint and tire distribution companies generally see EBITDA margins greater than those in auto retail but less than auto service.
Determining a privately held industry standard EBITDA can be challenging. When I am evaluating a privately held business, I spend a significant amount of time recasting the EBITDA number to come up with a standardized number. The way expenses are classified varies substantially from company to company, as does the amounts and types of personal expenses that often are run through a business. As a result, when comparing EBITDA across companies, it is very important to ensure that EBITDA is truly comparable. Additionally, while multiples of EBITDA can be valuable as a benchmark to approximate business value, due to the lack of insight into the drivers of EBITDA company to company, I am hesitant to rely exclusively on multiples of EBITDA in a business transaction.
Only after I have looked at gross profit and EBITDA will I then turn and consider sales. Sales and, more specifically, sales growth, is important. But more important than sales growth is profitable sales growth. If a company is growing sales 25% annually, but unable to generate positive cash flow from those sales, the company is in a worse position than had sales been flat but gross profit increased by 25%.
But I do not want to be cavalier. Sales growth is essential to any business. It ought to be managed as closely as gross profit and EBITDA. Management teams and sales staff both ought to have sales quotas. But they ought to have gross profit and EBITDA expectations as well.
The silent killer of a business is poorly managed accounts receivable, also referred to simply as A/R. Accounts receivable is a balance sheet item and will not show up on any P&L/income statement. But receivables have a significant impact on the overall health and cash position of the business.
Accounts receivable are simply sales yet to be collected and are a natural part of the cash conversion cycle. The structure and norms of the industry often dictate the length of the collection cycle. High performing teams actively work to manage A/R.
When I analyze a company, I look at A/R both as a percent of sales as well as the amount of days outstanding. Again, A/R days vary substantially according to industry dynamics, customer power, and sales channels. Companies selling into a retail environment generally have less A/R as a percentage of sales and fewer days outstanding compared to distributors and wholesalers who often provide credit terms to customers. I also keep an eye on receivables written off as uncollectable as this often signifies a poor sales and collection management. Generally, for well managed businesses throughout the automotive industry, uncollectable receivables tend to be a small percentage of total A/R.
Active management of A/R ensures a company quickly receives cash from sales and minimizes working capital. The less working capital required by a company, the more valuable a business. But, as with everything, it can be taken to an extreme. Over-aggressive A/R collection policies can actually hinder sales and lead to customer alienation if your terms are too far outside industry averages.
Accounts payable, or A/P is also a balance sheet item. Whereas A/R is an asset, A/P is a liability. Accounts payable represent bills due that the company has not yet issued payment. A/P does not show up on the P&L.
But just as A/R has significant implications for the cash position of the business, so too does A/P. Leading companies actively manage A/P so as to maximize the time available to issue payment to vendors. When I analyze a company, I am more interested in the days outstanding than I am the percentage of A/P to COGS. But again, A/P will vary depending on industry dynamics and the relative size of the buyer to supplier.
But just as A/R collection policies can be overdone, so too can A/P payment policies. While large companies can leverage their significant purchasing power to negotiate favorable contracts, smaller companies need to be cautious how they approach vendor negotiations. Stretching out payment cycles can have an adverse impact on pricing and discount, and in the worst case scenario, can cause a vendor to “fire” their customer or suspend credit purchases and demand immediate cash payment.
Inventory & Work in Process (WIP)
Inventory and work in process is a commonly overlooked item in many businesses, but more so in service businesses that have less experience with inventory management. Both are a huge drain on cash when left unattended. The challenge of poor inventory and WIP management is that these items do not show up as a line item on a P&L. Instead both WIP and inventory are listed as assets on the balance sheet. Making matters worse, inventory accounting gets complex and tedious very quickly.
Whether your company focuses more on WIP management or inventory management depends on your sub-industry. Service and project-based companies (i.e. collision and mechanical) focus on WIP as there is very little inventory outside of WIP. Distributors and retailers (i.e. dealerships, paint distribution and parts distribution) tend to focus on inventory as these companies resale finished goods with little to no WIP. Manufacturers focus on both. Regardless, both excess inventory and excess WIP when left unchecked are a huge silent drain on cash.
In short, inventory and WIP are a significant part of the entire automotive aftermarket, whether you are focused on optimizing WIP as a collision or mechanical service business or maximizing inventory turns as an auto retail dealership or parts distributor. Companies are well served to actively manage inventory levels. Too little inventory or WIP creates inefficiencies while too much inventory or WIP becomes a drag on cash.
Reporting the Results
There you have it – six simple financial KPIs to look at every month to increase the value of your business in the automotive aftermarket. Instead of simply using Excel spreadsheets with dizzying rows of numbers to report these results, I suggest creating a dashboard which utilizes charts and graphs to show the change in these metrics over time. You will find this reporting tool to be much more dynamic and effective at telling the story about the financial management situation.