Let’s face it. While there certainly has been an increase over the years in the number of architects, engineers, and other design professionals who have had formal business education, the solid majority of firm owners today still do not have any. And even though some owners do have a business degree or MBA, not even all of them understand a few of the most critical financial concepts that they should know in order to run their firms effectively.
Let’s take a look at two of these financial concepts that every firm owner SHOULD know and understand:
- Return on equity. It has been interesting to me over the years to hear discussions of owners talking about the low profitability of our industry, coming to the conclusion that their money would be better invested elsewhere. To start with, profitability is only one aspect of “return.” More important is return on equity. If I told you I sold a house and made only $10,000 on it, you may not be very impressed. But if I told you I borrowed 100 percent of the money and sold a house that I made $10,000 on five days a week, you might feel differently. The same idea applies to our business.
Return on equity is defined as our pre-tax, pre-bonus profit divided by our “book value” or “net worth.” Net worth is assets minus liabilities (what we own vs. what we owe). According to Zweig Group’s 2017 Financial Performance Survey, the median return on equity for all firms was 63.9 percent. Lower quartile firms made (only) 23.4 percent, and upper quartile firms 102.6 percent! And this is after paying out salaries and benefits and other good things to the owners.
What other investment does so well? Not many I can think of! Compare this to real estate appreciation. The AEC firm looks pretty darned good! This is important for people to understand. I think if they DID understand it, they’d be a lot more willing to invest in their firms versus stripping out all the profits every year as many small companies tend to do. They do so on the advice of their accountants to avoid paying taxes and in the process ensure their companies can’t grow and maximize their real returns to owners.
- Average collection period. We were at a client’s office a few months ago when one of the principals questioned why having a 100-plus day average collection period was a bad thing. He said the clients would eventually pay and they have been able to stay in business in spite of it, so “what’s the big deal?” The big deal – and it is big – is when the receivables get that old, the risk of ever collecting them increases dramatically. Not to mention another super critical idea – that being the amount of capital that is needed in the firm to cover that ridiculously slow collection of money owed them.
If they were doing $20 million a year in net service revenue, they would need to have 100/365 worth of their annual operating expenses in cash and credit just to pay their bills. Assuming a 10 percent profit, that would be $4,931,507 in cash and credit needed to cover their expenses for 100 days. That’s insane! It also drives down your return on equity because equity has to be higher to finance the businesses of your clients who don’t pay their bills. For every day they can reduce that average collection period, our example firm could extract more than $49K from their firm – or pay off more than $49K of their debt. That’s significant!!
Understanding these two financial concepts could potentially change everything that an AEC firm does. The entire strategy of investment versus harvest, ownership transition, and even what types of clients and work a firm undertakes, may need to change.
Mark Zweig is Zweig Group’s chairman and founder. Contact him at email@example.com.