INDUSTRY UPGRADE, Part 1:
How to assess your needs
This is INDUSTRY UPGRADE: a blog made for manufacturers. This series equips manufacturers with helpful tools for investing in new equipment, planning smarter, and facing challenges like labor shortages and rising manufacturing costs.
In Part 1: How to Assess Your Needs, you will learn:
- How to read your financial statements
- How to use financial ratios
- How to create a robust capital expenditure plan
Keep scrolling to read Part 1, or click here to get in touch with a financial expert with manufacturing expertise.
Intro: Today’s manufacturing climate is tough. Success starts with understanding your business’ finances.
It’s both a good time and a bad time to be in the manufacturing business.
On the one hand, demand for manufactured goods has remained high since the beginning of the pandemic. The majority of manufacturers reported year-over-year growth since the beginning of COVID-19, in part due to the rise of online retail.
On the other hand, the operational side of manufacturing has become much more complicated. A volatile supply chain has led to skyrocketing material costs, while a variety of factors have led to one of the biggest labor shortages of all time.
According to a recent study by The Workforce Institute at UKG, manufacturers are having a hard time finding the skilled workers they need. And many of the workers who are coming to work are less reliable. Since the pandemic began, a majority of managers have reported that employees are calling off shifts more frequently, often with less than 24 hours of notice.
But you already know all that. You’re looking for solutions. And while there’s no silver bullet that will help you solve labor shortages and rising material costs, carefully planning your investments and developing a deeper understanding of your business’ finances can help you:
- Optimize your production efficiency
- Introduce new technologies that automate portions of your line, reducing the need for labor
- Ensure that your company remains solvent in the coming years, with steady cashflow and no unpleasant surprises
Of course, investing in new technologies is easier said than done. What may seem like a simple purchase can be a daunting task, one that requires careful planning and deep knowledge of your manufacturing business’ current and future financial position.
Assessing your current financial position is a good place to start. Whether or not you’re currently looking to invest in new equipment, developing a better understanding of your company’s finances can help you create smarter plans, make better decisions, and achieve greater efficiencies. As a business leader in a complex, capital-intensive industry, it’s always a good time to review your finances.
Let’s start by taking a look at your financial statements.
Lesson 1: How to read your financial statements
If you want to understand why your car runs the way it does, start by popping the hood and consulting the manual.
If you want to understand why your business runs the way it does, start by reading your financial statements.
These reports provide key facts about your business’ financial health—revealing how much cash flows through your business, what proportion of your assets are fixed vs. current, how much you have and how much you owe—giving you a greater understanding of your business than what you can naturally intuit.
While these reports are often used by lenders or investors to gauge the health of your business, they’re also useful for internal decision-making. Of course you know your business—it’s on your mind every day—but financial reports can help explain why you tend to run into a cash-flow problem around the third quarter of each year, and they can describe this issue with pinpoint accuracy.
And although these documents have some terms you may or may not be familiar with, they’re surprisingly easy to read.
Let’s take a look.
Most financial statements have four components: an income statement, a balance sheet, a cash flow statement, and the notes. Here’s what you should know about each one:
- The income statement shows how much revenue the company has made over a fixed period of time (often one year) as well as expenses during that period.At the top of the report, Income Statements typically show the total amount of sales made during that period. As you work your way down the statement, you can see how various operating expenses—costs for materials, equipment, payroll, taxes, etc.—are deducted from the overall revenue. When you reach the bottom of the sheet (literally the ‘bottom line’) you can see how much money your company actually earned during this period.The income statement paints in broad strokes, giving you an overview of your company’s health during a given time period.
- While the income statement is about the money you made (and the money you paid out) during a given period, the balance sheet reveals how much you have (assets) and how much you owe (liabilities) at a specific moment in time. It’s a snapshot, rather than a broad story.A balance sheet is often divided in half, with assets on the left (or top) and liabilities on the right (or bottom). One of the most valuable insights you can find on a balance sheet is what portion of your assets are current (meaning that they are expected to be converted to cash within one year, like inventory) vs. fixed (meaning that they are not expected to become cash anytime soon, like machines or land).Because manufacturers often invest in large-scale facilities and expensive equipment, a large portion of their value is usually locked in fixed assets.
- Cash flow statements show how cash moves into and out of your business over a given period of time, such as one year.While the balance sheet shows absolute dollar amounts, the cash flow statement shows how your financial situation evolves over time; it shows you the rhythm of your finances.By understanding your cash flow, you can plan for investments and determine when you will have the cash needed to make your purchase and cover other expenses—or whether you will have to consult a lender or investor for more capital.Of all the documents described in this section, you’ll want to study your cash flow statement the closest when considering a purchase. Even the most successful businesses have been nearly broken by cash flow issues. When Nike was still a fledgling shoe company, Phil Knight came close to shutting it down; not because his product wasn’t selling—it was—but because his business was growing so rapidly that he struggled to find the cash to finance his investments.
- Although it may not sound like the most compelling section, the notes sometimes contain the most valuable information of your entire financial statement, including disclosures that explain to investors the context behind some of the data in the rest of the financial statement. While the balance sheet, income statement and cash flow statement show you what is happening within your business, the notes sometimes tell you why.
Lesson 2: How to use financial ratios
Now that you’ve familiarized yourself with the information found within your financial statement, let’s take a look at how you can take that data and transform it into useful insights.
Ratios are tools that allow us to see patterns and relationships within your business. They can also be used to compare your finances to those of other businesses within your industry.
A ratio is simply a comparison between two things. For example: 1.) your total revenue compared to 2.) the average value of your fixed assets (your equipment, plant, etc.). By comparing these two numbers, which can be found on your financial statements, we can calculate a value known as the Fixed Asset Turnover Ratio (or the FAT Ratio). This value indicates how much your business is generating in revenue for every dollar invested in your fixed assets. By calculating your FAT value, you can begin to determine how efficient your operations are, which can ultimately help you determine whether you should upgrade your equipment.
If we write this ratio as a formula, it looks like this:
Fixed Asset Turnover (FAT) Ratio = Total Revenue / Net Value of Fixed Assets
Let’s say that over the last year your business earned $1.5 million in total revenue and the net value of your fixed assets was $500,000. That gives you a Fixed Asset Ratio of 3:1, which can be expressed as a ratio, a numerical value, or a percentage.
Alone, the FAT ratio doesn’t tell you much. It’s when you compare it to the industry benchmark—the median FAT value of your peers—that you can see whether your ratio is high or low.
Which is better: high or low? That depends. If you have a high value, it could be because you have high capital productivity, or it could be because you have old, depreciated assets that break down frequently. A low value could be explained by lower capital productivity or simply because you’ve recently purchased new machines, which may provide you with higher revenues in the near future.
Keep in mind: the ratio doesn’t tell you the whole story. It’s not simply ‘good’ or ‘bad.’ It’s just one clue that, when investigated carefully, may lead you closer to the truth.
As for industry benchmarks, these vary from year to year depending on major events and market trends. When making a comparison, it’s important to use the benchmark of your specific sub-industry, since each industry has its own constantly shifting standards. Please contact us to learn more about your industry benchmark; we can also help you explore what your FAT Ratio is telling you about your business.
Note: While we only covered the FAT Ratio here—a very useful ratio when considering investments in new equipment—there are countless ratios out there. Some of the broad categories include:
- Efficiency ratios, which give insights into your cash flow and operations
- Liquidity ratios, which measure how easily you can cover your debts by converting assets to cash
- Profitability ratios, which help you evaluate your financial viability
- Leverage ratios, which reveal the extent to which your business relies on long-term debt
All of these ratios can be useful when making business decisions. The important thing is to remember that they are insights and clues—nothing more, nothing less. The full story is often more complicated than the numbers reveal.
Lesson 3: How to create a robust capital expenditure plan
Now that we’ve covered how to gather valuable data by reading financial statements—and how to turn that data into insights or clues—let’s wrap up by taking a look at some of the general factors you should consider when planning your capital investment.
A capital expenditure plan is a detailed strategy and timeline used to plan investments in equipment and other capital. However, since these investments affect (and are affected by) your business’ finances, we recommend taking a broad approach:
- Start the process by outlining your long-term business goals, then create a strategy that details short-term and longer-term objectives.
- During this stage, you should perform a full audit of your existing equipment, detailing each component’s condition, its downtime vs. uptime, its performance compared to other equipment on the market, etc. This can be time-consuming, but it’s time well spent. The data you gather here can help you identify pain points and reveal whether you actually need new equipment, when you will need it, and how much disruption a replacement will cause within your operations. Perform these audits regularly to keep your data up-to-date.
- As part of your long-term strategy, develop a capital expenditure plan. This will include proposals for investments in new equipment, the expected end-of-life for each machine, and the planned downtime of existing equipment during installation.Essentially, you’re outlining when you expect each component to stop working and what machines you would like to replace them with, as well as the process of replacement. Be sure to account for the fact that it may take six to twelve months for manufacturers to create certain components (or longer, given the state of the supply chain).
- When selecting a new machine and considering when it will replace a current machine, run a cost-benefit analysis for each possible situation. Sometimes, it’s more profitable to keep a machine running, even if it’s slightly outdated; other times, the need for repairs and the risk of downtime just aren’t worth it. When creating your analysis, consider how each machine will affect other components of your operation, the costs and time associated with redesigning your floorplan, and the required staff training. (We’ll go into greater depth on cost-benefit analysis in Part 2.)
- In general, we suggest that manufacturers invest in equipment that is digitally integrated. Devices that collect data give you valuable information to use when planning.
Keep learning. Keep upgrading.
In Part 1 of INDUSTRY UPGRADE, we covered how, as a manufacturer, you can assess your needs, better-understand your finances and begin planning new investments. In Part 2 and Part 3, we’ll take a deeper dive into performing a cost-benefit analysis and explain how to finance new investments.
We hope these tools will help you continue to make smart business decisions and overcome challenges like rising material costs and labor shortages. If you have any questions, reach out to the Dugan & Lopatka team today.
Financial guidance, made for manufacturers.
At Dugan & Lopatka, our team of financial experts has served manufacturers in the Chicagoland area for more than four decades. We provide a comprehensive range of financial guidance and accounting services to help you overcome emerging challenges, maximize your profitability, plan successful investments, and strategize for the future. Contact our team to learn more.