Analyzing Profitability in a Turnaround
In companies facing financial distress, management is often the last to recognize the cause of the underlying problems. The reason typically lies in the fact that management was not focused on the right performance measures.
The task of successfully implementing a long-term turnaround strategy can be daunting. One of the most challenging issues is determining the sources of financial difficulty. It is impossible to identify a solution for the company’s problems without pinpointing the specific causes.
A profitability analysis can be an effective tool for identifying or confirming a distressed company’s underlying problems. An ideal outcome of this type of analysis is one where the results fall under the “80:20” rule. If 20% of a distressed company’s customers, products or locations accounted for 80% of its losses then one could reasonably shed these and continue with the remainder.
The major steps involved in performing a profitability analysis are as follows:
1) Gather Financial Information
A profitability analysis starts with gathering pertinent, accurate and timely information. Sales by location, product or customer must be obtained from the company’s financial statements and supporting management information systems.
It is important to sort out all expenses to determine which correspond to a specific product, location or customer, which are allocable based on workload, usage or some other cost driver, and which expenses are accumulated centrally for the benefit of the company as a whole. By determining whether the costs are accurately accounted for, a comparison between product, customer or location may point to a specific cost that needs attention.
2) Identify Key Performance Measures
Financial and other quantitative information is used to establish key measures in the analysis. These measures may vary depending on the nature of the business and industry, and must be carefully identified to accurately reflect the drivers of profitability. For example, measures for the health care services industry may be occupancy rates, profitability by payor or customer, and profit margins. A retail company may want to analyze average weekly sales, profit margins, average order size, or high versus low volume categories. A manufacturing company may look at turnover rates, capacity utilization, or production backlogs.
3) Set Performance Benchmarks
The ultimate goal in a profitability analysis is to use comparable information to identify products, customers or locations that are underperforming, to help make decisions that will increase the overall profitability of the company.
It is important to set minimum performance criteria for each of the key profitability measures. Some factors to consider include acceptable margins necessary to fund corporate overhead, debt service, capital expenditures and shareholder returns, and minimum return on working capital invested. Even if a product or facility is profitable, it may not be contributing the desired minimum return. It may therefore be in the company’s best interest to commit its capital elsewhere.
Performance benchmarks may be established in several ways. One method is a location profitability analysis to bring to light “model locations.” This can help establish a performance threshold that should reflect a minimum standard.
Another way to make decisions based on profitability is the “break-even” method. This threshold maintains that the earnings from a facility or product be sufficient to fund the cost or working capital deployed. The facilities or products that do not meet this requirement should be discontinued. Those at the break-even point should be retained, but should be subject to further analysis.
4) Identify Poor Performers
The profitability analysis will help companies evaluate performance levels based on the minimum criteria and categorize. Segments may include:
- Good and therefore retained;
- “Watch listed” and therefore requiring further evaluation or monitoring;
- Poor and therefore candidates for closure or discontinuation.
Within each segment, the company should then rank the customers, products or locations from greatest contribution to greatest loss. This will allow management to focus on the poorest of the poor performers first.
5) Look for Trends and Unusual Items
It is important to consider location, product or customer group trends and unusual items in a profitability analysis. For example, when looking at a year’s profitability, non-recurring items should not be included. Similarly, an extraordinary expense may have been incurred at a specific facility or with a particular customer group that could skew the actual operating profits and would need to be adjusted.
6) Identify Future Strategies
Once the causes for an underperforming product, customer or location have been identified, an effective action plan can then be developed to remedy the problem.
New profit-focused strategies for marketing, cost reduction and product realignment can be implemented. Improving customer or product profitability may require a company to reassess product-pricing practices, improve customer and distribution mix, enhance sales and marketing productivity and effectiveness, and increase profit per customer. Improving facility profitability may also require the development of ongoing productivity improvement programs, new cost systems such as activity-based costing, and periodic analysis of overhead.
In most instances, the payoffs and benefits of this process, if properly executed, far exceed the costs.
This article was written by Mohsin Y. Meghji, principal at Loughlin Meghji & Company and originally ran in the April 2005 issue of CapitalEyes. | 
