Taking the Temperature of Risk

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Just as in The Hitchhiker’s Guide to the Galaxy a single number, 42, represents the Answer to the Ultimate Questions of Life, the Universe and Everything, so I like to reduce the health of a business (in my case a professional services organisation) to a single number. Or, not so much health itself, as the fluctuating risk to health.

Answer_to_Life

I take the good things, the bad things and an ugly thing and express them numerically:

The Good

Revenue Growth is good. I calculate the growth in revenue over the last 12 months compared to the previous 12 months.

Profit Growth is good. I calculate the growth in profit over the last 12 months compared to the previous 12 months.

The Bad

Customer always owe money, but growth in debt as a proportion of revenue is bad.

Work in Progress (the value of consulting that we have not yet billed) is never zero, but growth in WIP as a proportion of revenue is bad.

The Ugly

Bad Debts are very bad.

I then give the following weight to these values before adding them together:

Revenue Growth – I multiply the absolute value of Revenue Growth by 0.4

Profit Growth – I multiply the absolute value of Profit Growth by 2.

(This expresses the view that if revenue grows by 100, profit should grow by 20, and gives equal weight to both on that assumption. The assumption that 20% of revenue is profit is something you may want to adjust.)

Debtors – I take the absolute value of debts.

Work in Progress – I multiply the absolute value of WIP by 2.

Bad Debts – I multiply the absolute value of Bad Debts by 3.

(This expresses the view that a rise in Work in Progress is twice as bad as a rise in Debt, and Bad Debts are three times as bad as Debts.)

Then I calculate, on the good side of the balance, decreasing risk:

(Revenue Growth * 0.4) + (Profit Growth * 2)

And on the bad side of the balance, increasing risk:

Debtors + (WIP *2) + (Bad Debts * 3)

I then calculate the Bad Side minus the Good Side and divide the whole by the absolute value of the last 12 months’ revenue:

(Debtors + (WIP *2) + (Bad Debts * 3) – (Revenue Growth * 0.4) + (Profit Growth * 2)) / !2 Months’ Revenue

The result is what I call the Risk Index. A rise in this number from one month to the next is bad, and a fall is good.

For example:

  • Revenue 1000
  • Debtors 150
  • WIP 100
  • Bad Debts 10
  • Revenue Growth 200
  • Profit Growth 40

This means:

  • Revenue Growth of 20%
  • Profit Growth of 20%
  • Debtors of 15% of revenue
  • WIP of 10% of revenue
  • Bad Debts of 1% of revenue

This delivers a Risk Index of 0.22.

The index does not itself, reflect growth. If everything grows in proportion from one year to the next then the index stays the same. Risks are under control.

If revenue grows by 200, but profit doesn’t grow then the index increases to 0.3.

If both revenue and profit are static then the index increases to 0.33.

If revenue grows by 200 but profit grows by 60 then the index drops to 0.18,

If revenue grows by 200 and profit by 40 but bad debts to 30 then the index increases to 0.28.

The risk index reflects my own view as to what’s good and what’s bad, and alerts me to deteriorating or improving health, and its absolute value is of no consequence. Our company is made up of a number of subsidiaries and these are managed in groups. It’s useful to be able to track the trends in each from month to month.

You will note that I don’t include cash in the equation nor liabilities to suppliers. Given the kind of company we are (software reseller, software author and provider of consulting services (this being the largest part by far)) I believe everything else follows on from these five key values. If the risk index is static I assume I don’t have to worry about cash.

Please note that this measure is relevant to a professional services organisation, and would need extension to reflect the health of any other type of organisation. You might include inventory value, etc.

And note that on this scale 42 would be a very unhealthy number indeed!

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