By: Frank A. Stasiowski, FAIA
Financial Areas to Look at, Metrics to Track and Processes to Improve
A recent PSMJ A/E Financial Performance Survey indicates that clients take about 71 days to pay the typical A&E firm—that’s well over two months! This cash-flow benchmark reached its most recent low in 1989 at 64 days, and has been rising ever since. A/E firms are essentially lending funds to their clients at zero interest rate, but at the same time paying either investors or lenders to finance their working capital. Most firms focus lots of attention on trying to improve their cash collection performance.
But before a client will pay an invoice, they must first receive it. During the course of each month the firm pays salaries to its staff, rent, insurance, taxes, etc. These costs are recovered ultimately when the client pays the invoice. The firm must finance these working capital investments, called work in process, which occur even before the invoice is sent to the client. The magnitude of these costs depends the firm's billing process. It is important to both benchmark your performance and implement steps that reduce the firm's investment in work in process.
Use “Average Billing Days” as the Benchmark
The most common benchmark used to measure how well firms manage their work in process is called “Average Billing Days.” This benchmark uses the same measurement technique as collection period for accounts receivable. By definition, Average Billing Days is equal to the average of the work in process account divided by the average daily gross revenue for the respective period. For example, in our survey we ask firms to total the work in process account values for the entire year and divide by 12. We compute the average daily gross revenue for the year by dividing the total revenue by 365 days.
The latest survey results indicate that the Average Billing Days is 25 days. Therefore the typical firm is financing an additional month of working capital in work in process.
Does Firm Size Make a Difference?
Cash flow is more critical to smaller firms since they are less able to borrow large amounts of working capital funds. Therefore, we expect more focus on shortening the billing process and reducing the firms average billing days. Unfortunately, the PSMJ Financial Performance Survey does not support this assumption. The Survey indicates that:
- The minimum average billing days (25th percentile) appears to rise as firm size increases. Firms in the 21-50 range report the lowest minimum values and larger firms report higher values.
- The maximum average billing days (75th percentile) does not indicate much difference as the size of the firm changes. With the exception of one group (351- 500), there are firms in each size category reporting average billing days near 40 days—well over a month.
- Very small firms (1-20 people) report the highest average billing days of over 40 days.
Benchmarking and Trending your Results
A wide variation exists with respect to how well design firms manage their internal billing process. Even within the same peer group of firms, results can range from 6 to 40 days. The reason? Different managers assign varying levels of priority to their billing process. If you do not currently measure this important financial benchmark, here are a few simple steps to get you started.
Using last year’s financial reports, calculate the Average Billing Days for your firm. If you have the monthly financial reports, use the method we suggest in our survey to calculate the average work in process value. If you do not have the individual monthly reports, use your balance sheet account value at the end of last year. Benchmark where you stand against our overall survey results and against your peer group of firm size.
Calculate the average billing days at the end of each month and trend the results. You can perform the monthly calculation by using the average work in process account value at the end of each month, and divide this by the month's average daily gross revenue (e.g. monthly gross revenue/calendar days).
Another method is to use data from the last 12 month period and perform the calculation similar to our survey instructions. Focus on making improvements to shorten your billing process. Issue bills more than once a month, simplify your bills, create unit prices for routine activities, and don't hold bills to resolve minor issues.
There are firms in your peer groups that achieve Average Billing Days in the single digits, and there is no reason why you cannot also achieve these results.
Profit and Cash Flow Performance
To remain financially sound, your firm must stay running on all cylinders—especially with respect to profitability and cash flow. Firms that generate high profits end up insolvent if they cannot collect their cash fast enough. On the other hand, no matter how fast your clients pay your bills, if your prices and costs result in negative profits, you’re heading for bankruptcy.
Return on assets combines both profit and cash flow performance into a single benchmark. This ratio reflects the profits generated by the firm’s assets—both working capital and fixed assets. In the design profession, working capital assets are primarily the total of accounts receivable and work-in process and total more than 75 percent of the firm’s assets.
Return on Working Capital Assets
Return on working capital assets (ROWC) is defined as Net Profit (after incentive/bonus) divided by accounts receivable plus work-in-process. ROWC can be computed by multiplying the following two factors:
- Net Profit Margin, defined as Net Profits (after incentive bonus) divided by Net Revenues.
- Working Capital Turns, defined as Net Revenue divided by the total of Accounts Receivable plus Work-in-Process.
Separating the formula into these two factors emphasizes that ROWC measures both critical aspects of financial performance—profitability and cash flow.
Design Industry Benchmarks for ROWC
We added ROWC as a benchmark to the PSMJ A/E Financial Performance Survey, in order to indicate its ability to focus on both aspects of financial performance. The survey results show the median ROWC achieved by the overall survey group is 9.44 percent. However, the survey shows variation within each benchmarking peer group.
Architectural firms report the highest ROWC at 15 percent; achieved by earning a high net profit margin but lower working capital returns. Engineering (subconsulting) and architectural/interiors report the lowest values for ROWC, nearly 5 percent, primarily due to lower profit margins.
Internal Benchmarking Using ROWC
PSMJ recommends that you use this technique to compare internal organizational unit performance against each other. It should be possible to compare different offices, business units, practice areas, are more using this technique. If you focus your attention on this important benchmark, you will send a clear signal to your leadership team that both profitability and cash flow are equally important. For example, if you’re negotiating with a client for lower profit margins, you should be getting better cash flow parameters in return.
Extend ROWC to Individual Projects
Finally, you can use this technique to evaluate the combination of profits and cash flow performance at the individual project level.
The material contained in this blog was authored by PSJM Resources and originally published as a whitepaper “Better AE Business Management”, sponsored by Axium.com, which is now part of Deltek.com.
To learn more about this topic – check out the following webinar and case studies:
Webinar: “5 Steps to Improving Cash Flow” with Herb Cannon, President of AEC Management Solutions <Watch Now>
- Why collections is a process - not an event
- Techniques for invoicing quickly and accurately
- Terms and conditions to include in your proposals and contracts
- Strategies for developing high-level relationships with your clients that increase your chances of quick payment
- How to follow-up with your clients to ensure prompt payment
Read how two AE firms dramatically streamlined their billing processes with an A&E specific accounting and project management solution:
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