Leading indicators and key statistics
Know when, how to use them
Jim Lindell, CPA, CGMA, CSP | December 2019/January 2020 Footnote
Editor's note: Updated November 30, 2019
There’s usually a reason behind a moment of caution. Consider these warning signs we encounter:
- “Your blood pressure is too high!”
- “22 miles to empty!”
- “Blizzard conditions are expected.”
The purpose of these warnings is to raise awareness and force a change in action, if warranted.
Our businesses are no different. There are plenty of macro warning signs in the economy, government statistics, technology innovations, etc. There are, too, multitudes of warning signs in our daily business with operational indicators, financial indicators, customer and supplier interactions, etc.
It is the responsibility of the CEO and/or CFO, with support from the management team, to establish the direction and overall vision of the organization, monitor its progress against the vision, and make the necessary course corrections to ensure achievement of the vision. To this end, it is incumbent of the management team to be proponents and users of leading indicators, scorecards, dashboards, trends and ratios to ensure success.
We are trying to establish the roadmap for measuring, monitoring, evaluating and changing business actions when we create leading indicators. Our leading indicators should influence goals, establish milestones, provide warning signs of changing business environments and identify consumer preferences.
The indicators make a “proverbial crystal ball” to know what’s going to happen and how to act accordingly. The desire to know the future is not the end-all game, but it is simply to understand how the playing field may change and how an organization can adapt to be successful.
What leading indicators should we use?
The federal government provides thousands of data series for comparisons and trend analyses. Consider two significant databases provided by the government that apply to many of our businesses: G-17 industrial production statistics and monthly retail sales statistics (MRTSSALES).
The G-17 statistics highlight the overall industrial production for the country, with its production often shared on the major news networks. As an example of the language used, here’s an excerpt from the Sept. 20, 2019, report released on Oct. 17:
“Industrial production fell back 0.4 percent in September after advancing 0.8 percent in August. For the third quarter, industrial production rose at an annual rate of 1.2 percent following declines of about 2 percent in both the first and the second quarters.”
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This series is a key data trend that is correlated with significant changes in the economy to determine if the country is in a recession or if the overall business cycles have changed. The government tracks the data and provides it for the public at no cost. The information can be obtained from text files that the Federal Reserve provides monthly; or it can be accessed through an Excel add-in that is supplied by the Federal Reserve specifically for downloading financial, economic and other key data series. A forward-thinking CFO should be investigating this resource.
As with the G-17 industrial production information that can be accessed from the Federal Reserve, it is possible to access monthly retail information for various North American Industry Classification System (NAICS) codes. The information is provided monthly, typically for a couple of decades. So, whether we’re using industrial production or retail information, data series are readily available and can be compared to the sales level of your organization. This information becomes invaluable as we determine what steps are next, as well as where the organization is in its business cycles.
Using the data
Use these data series to create trend analyses, three- and 12-month trailing charts and comparisons to your organization’s sales trends. This will help in identifying:
- The business cycle for your industry.
- When the business cycle changes.
- How your sales lead, lag or match industry cycles. (By the way, if you are lagging your industry, it also implies the need to change your organizational approach to sales.)
Your internal scorecards or dashboards do not need to be complex. But, they should monitor the most key factors, which include:
- Liquidity. Tracking of:
- Altman Z-score. Use this to determine the overall health and the direction of the organization.
- This is one of my favorite tools. Dr. Altman created the Z-score originally to identify companies that were at risk of going bankrupt. A company that has an ever-decreasing Altman Z-score is going to run into trouble at some point. The Z-score also helps evaluate acquisitions. I encourage people in the accounting industry to never accept a position with any organization without identifying the Z-score.
- Current ratio. Review the current ratio on your financial statements as the first step. Why? Companies fail from incompetent management. Incompetent management allows profits to turn to losses. Extended losses result in working capital erosion. Working capital erosion leads to cash shortages and eventually failed businesses. Therefore, review your current ratio (compared to your industry). If it is OK, then go back and begin the review of the income statement.
- Quality of working capital. This is a byproduct of the current ratio. Review the trend of A/R or inventory (each as divided by net working capital) and evaluate the slopes. Increasing slopes indicate potential problems in the components of working capital.
- Volume. Tracking of:
- Revenue, including dollars, volume (units sold, produced, hours, etc.) and gross profit.
- Profitability
Each of these metrics should be tracked over a 10-year period. For example, one quick look at the comparison of Sears revenue and Amazon revenue should be all you need to understand how consumer purchasing behavior has changed significantly. Sears’ current bankruptcy in 2018 and re-emergence in 2019 should not have surprised anyone.
Keep in mind: Your financial statements should be a confirmation of what you knew during the operating month. Trends, dashboards, etc., should be in place to determine if the organization is performing at the right level to achieve its long-term goals.
Financial statement presentation considerations
Finally, to better understand trends and indicators, consider changing the format of your financial statement presentation. There’s a good chance your current statements are inadequate because:
- They are not easily understood by individuals outside of our industry.
- They typically only reflect a couple of years of activity, which is inadequate.
- They do not access the intuitive power of users of financial statements.
Visuals quickly identify how well each of the metrics is performing. I’ve asked individuals in my seminars for their preference: seeing several years of income statements or a 10-year history of sales information on a chart. In nearly all cases, every individual said they preferred the charts. Switching to a different approach creates more meaning for individuals.
For your use, I recommend beginning with four or fewer graphs that depict 10-year trends for revenue and gross profit, current ratio, Altman Z-score and operational metrics (volume, etc.). The second part of the financial package is a minimum of three-year financial statements; the third part includes 10 years of financial statements (key information).
Putting into practice
Develop built-in warning signs for your company so that you can predict where your company stands in the industry. Tailored leading indicators and key statistics will prepare your company for the future, raise awareness and allow for better course correction if needed.
When delivering financial statement information, introduce select and effective graphs into your presentations to add more meaning and impact. Good luck leading into the future!
Jim Lindell, CPA, CSP, CGMA is president of Thorsten Consulting Group, Inc. Jim is a CEO coach, former CFO, a regular speaker for MNCPA events and author of “Controller as Business Manager.” You may reach him at jim@thorstenconsulting.com or 262-392-3166.
