I. Audits: Beginning with B for Business to W for the Website
Introduction - The Audit Hierarchy
A natural audit hierarchy is (1) Your Business - how do you define it, (2) Strategy - where you are going, (3) Marketing - what your customers want - with 3.1 Advertising and 3.1.1 Website reviews as subsets, (4) Operations - how to provide what they want, and (5) the Financial Auditing for quarterly and annual reports. We change that order, as follows below.
Some prefer a rifle approach, focusing on a few key questions. Others prefer a shotgun, with a long list of them. To accomodate different styles, both approaches are offered. The former is taken with the basic business audit and the strategy audit. The latter is taken with the marketing audit. The website audit takes a middle-of-the-road (best of both worlds) approach.
1. The Website Audit
You only have one chance to make a first impression. For many of your customers, that first impression is your website. Therefore we suggest you begin by taking a hard look at it, within the context of your business, your strategy and your marketing, as introduced below. Further information is given on the Aladin subpages.
2. A Basic Business Audit
1) What business are you really in? How do you define it in terms of solutions?
Shoes, bicycles, cars and airplanes are all solving transportation problems, getting from A to B, as different as those industries are from one another. An aspect common to most solutions, including those provided by the transportation industries, is the role premium branding can play - Bally & Gucci, Bianchi & Coinago, Ferrari & Lamborghini, Lear & Concorde.
2) What do you need to do to grow your business significantly in the next six months, year, three years?
3) What frustrates you the most about your business?
3.1 - What strategies have you tried that did NOT work? Why not?
4) What thrills you the most about your business?
4.1 - What strategies have you tried that did work? Why?
5) What is your number one priority to accomplish in the next two to six months? Why?
3. The Blue Star Strategy Audit
Strategic clarity is a must. The three questions that IBM uses to determine it are a good follow-on to the basic questions above. IBM's triad is:1
1) What's the pain point for the customer?
2) Who are we going to come up against in the marketplace?
3) How can we deliver more value to our customers than our competitors?
A more detailed approach is given on the subpage The Blue Star Strategy Audit.
4. The Q3 Marketing Audit
The subpage The Q3 Marketing Audit gives a check-list as a basis for devising your own questions.
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Bridges is not usually directly involved in operations or financial audits, although both are critical for due diligence. Therefore we limit ourselves to the brief comments below about them.
5. Operations Audit
Operations audits are usually about improving production (the factory), but can also apply to the provision of services. Quality is the key criterion, and should be understood in terms of the total customer experience. A major task involving a close "A to Z" review of operations is to go through the procedure to receive ISO certification. An example is ISO 9001 for quality.
At " IX. 36 Tools/Techniques" three of them are relevant to the auditing of operations:
- 9) HOQ (1972) (House of Quality), Dr. Yoji Akao, a tool from his QFD (Quality Function Deployment), 1966; and the associated HOQ tutorial, Dr. A. J. Lowe (2000)
- 12) Six Sigma (1981,´86) (quality management process reflecting 3.4 defects per million, an integral part of TQM - total quality management) Bill Smith (Motorola)
- 16) TOC (1984) (Theory of Constraints) Eliyahu Goldratt
These are discussed further at "Tools/Techniques" and its subpages.
6. Financial Auditing
1) Forensic Accountants - the Sherlock Holmes of the profession!
Is forensic accounting only for litigation support? Alan Zysman, a forensic accountant in Canada, has written a good answer to this and other FAQs. More than one highly touted acquisition that quickly "crashed and burned" would not have been made if the financial due diligence had been done by the "real detectives" of the profession.
Most accounting firms focus on internal auditing (interne Revision) and that for quarterly and annual reports (Abschlußprüfung). Relatively few offer, let alone specialize in, forensic accounting (forensische/gerichtliche Rechnungslegung). A prominent U.S. firm in the field is Kessler International, with overseas offices in London, Hong Kong and Beijing. A German firm that apparently does some work in this field is Ebner, Stolz, Mörning & Bachem, with branches in 14 German cities, including Munich. Its well done website is in English and German.
2) Ratio Analysis
The financial literature is replete with ratios. The typical variance for a ratio differs widely by industry, and also by culture. "Normal" debt/equity ratios for the same industry in Japan, Germany and the U.S. may be quite different. One also needs to understand a) the impact on a ratio of the time value of money and b) its sensitivity to data input error. Therefore ratios are best used by someone who understands them in the context of that particular industry in that country. Futhermore, like all accounting data, they are subject to manipulation. Just one example is making a quick midstream shift from LIFO to FIFO ("last in first out" versus "first in first out") in recording your inventory, with a resultant impact on the stated cash flow.
Ratios may be grouped into four categories: (1) Capital Structure (2) Liquidity (3) Turnover and (4) Profitablity. Examples of some of the more commonly used ones follow.
2.1 - Capital Structure
a) Long-term debt to equity: Long-term debt / Shareholders' equity
The difficulties with this ratio are three. The first is the allocation of convertible securities, a combination of debt and equity. The second is the treatment of deferred taxes. The third is the differance between using the book values on the financial statements, or adjusting them to market values.
b) Total debt to equity: Total debt / Shareholders' equity
One has added current liablities to the numerator. The same three difficulties as above apply.
c) Operating income coverage: Operating income / Annual interest payments
This ratio indicates the margin of safety a corporation has to meet its payments for long term debt.
2.2 - Liquidity The term refers to a company's ablity to generate cash for its immediate needs: "Cash flow is king." Commonly used liquidity measures are:
a) Current ratio: Current assets / Current liabilities
The numerator is the sum of cash, accounts receivable (adjusted for the probablity of actual collection), inventories (adjusted for "dead" inventory), pre-paid expenses and those marketable securities classified as current assets. The denominator is the sum of the short-term payments that need to be made.
b) Quick ratio: Quick assets / Current liabilities
The numerator of the current ratio is adjusted by subtracting inventory and pre-paid expenses, as these are not convertible to cash. Both the current and quick ratios are "photographs," i.e. static. A "movie" of one's cash flow tells a more useful story. Cash flow spread sheets give this information in detail. However here too there is a ratio, as follows:
c) Cash flow ratio: Quick assets / Average weekly (or daily) operating expenditures
An expenditure is an expense which has to be paid! The calculation tells you how many weeks (days) the company can continue to operate using its liquid assets to meet obligations, without increased debt or equity funding. The burn rate of capital is a key concern of newly funded start-ups.
2.3 - Turnover These ratios indicate how well a company uses its assets to generate sales or profits by showing how fast products move through the company.
a) Inventory turnover: Sales / Average inventory
The ratio shows how many times the average level of inventory was replaced in the course of the year. For perishable foods in supermarkets, the ratio is high. For items such as expensive collectibles (classic cars, old paintings, rare books) it can be so low that one is tempted to measure it per decade instead of per year.
b) Accounts receivable turnover: Sales / Average accounts receiveable
Note that accounts receiveable should be adjusted for bad (uncollectable) accounts. A decline in this ratio is an early-warning signal of impending liquidity problems.
c) Assets turnover: Sales / Total assets
High operating profits are usually associated with a low asset turnover, and vice versa. Two extremes are supermarkets and selling high end antiques. Supermarkets make a very low profit per item, with tremendous sales volume. The antique dealer may take years to sell an item, but then at a multiple of its purchase price for a very high operating profit. The best of both worlds is represented by the successful information product (e.g. an E-book) sold on-line. One has a very high turnover at a very high operating profit.
2.4 - Profitability
a) Return on assets: EBIT / Total assets
The numerator, EBIT, refers to Earnings Before Interest and Taxes. It is the sum of net income plus interest expense plus taxes. Net assets are the assets less depreciation and less a bad debt allowance. The ratio is an indication of how efficiently a company is using its assets.
b) Return on shareholders' equity: Net income minus preferred dividends / Common stock equity
This ratio is an indication of how efficiently a company is using the assets financed by common stock.
c) Operating Profits: Net sales / Total sales
Net sales are total sales less the cost of goods sold less selling and administrative expenses. Operating profits are the funds available to pay the interest on debt, pay dividends, make capital investments, and set aside as reserves (contingency funds).
d) Earnings per share: Net income / Number of shares
The numerator refers to the net income available to the holders of common stock. The denominator refers to the number of shares outstanding of this common stock. The number shows how much income is available to each shareholder for dividends. This ratio is a common "over-emphasis" error in stock market investment analysis. The ratio depends on how much stock the company has issued. That arbitrary decision is completely different from one company to the next.
e) Price/earnings ratio: Market price per share income / Earnings per share This ratio is one of the most widely used in stock market analysis. There is a good introductory article "P/E Ratio" at Wikipedia.
f) The Z-score: sums a weighted average of four ratios It indicates the liklihood a company will go bankrupt within two years. The calculation was developed in 1968 by Edward Altman, a professor of finance at New York University. (Its Stern School of Business is one of the top ten MBA programs.) For scores at the extremes of its range for "at risk" and "safe" the ratio is remarkably accurate. The Z-score and its calculation are discussed as the last of the tools under the acronym ZEBRA at the subpage "IX. 36 Tools/Techniques" of Services.
Other ratios are legion. Many of them are to be used with caution, such as the often disparaged "book value per share" and the rather dubious, albeit popular, "cap rates" for real estate.
1 The source for the IBM triad about strategic clarity is the twenty page “Emerging Business Opportunities at IBM (A)” by David A. Garvin and Lynne C. Levesque, a Harvard Business School case. It has two supplements, which they also wrote, a (B) of two pages, and a (C) about a specific EBO (Emerging Business Opportunity), Pervasive Computing, of six pages. (A), (B) and (C) were published March 2004 and revised Feb. 2005.
The series can be purchased for a modest fee of about $15 for all three as pdf downloads (cf. the preceding link). A brief two-page summary of key points from the case is presented at "A. Blue Star Start-up Strategy for Intrapreneurship" at VI. Start-up Strategy.
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