Clear examples of weighted-average analysis When we start discussing our heavy usage of weighted averages with customers, we sometimes get a questioning look, until we make the analysis more concrete for them. People are very familiar with using averages; equity analysts regularly look at numbers such as Days of Sales Outstanding that are composite numbers for an entire company. Very often, only when segment data are provided do analysts break such numbers into more discrete groupings.

In other fields, however, the use of weighted averages is more common and the benefits obvious. In this GAO report on military truck accidents, the GAO made this plain and compelling argument:

GAO's analysis of January 1987 through June 1998 accident data showed that, while M939s made up an average of about 9 percent of the Army motor vehicle fleet during that time, about 34 percent of the fleet's accidents resulting in fatalities of vehicle occupants involved these trucks;

The reader understands that while there may be good reasons for there to be more accidents in M939 5-ton trucks, that's the place to start the investigation.

Similar analysis has been done over time comparing death rates in Detroit with Baghdad, with the use of per-capita data being the critical component; per-capita is a weighted average concept.

Dr. Peter Pronovost, who has been quite popular recently [Ed.: link added], made big news with his infection-reducing checklist for use in hospitals. In a recent interview, he described a system he helped build for hospitals in Michigan. In describing the ability to check infection rates across ICUs across hospitals across health care systems across the state, Dr. Pronovost shows that he understands how to use weighted averages to identify hot spots for potential trouble areas.

With a deep understanding of finance, free cash flow, and valuation equivalents, these principles
can be applied in concert with proprietary algorithms to manage a business's generation of free cash flow.

Labels: case studies, DDA, weighted-average

Tuesday, December 09, 2008 :: posted by Rick Colosimo @ 11:16 AM

Short Form Due Diligence Request List We are often approached by small businesses that are seeking capital in connection with strategic and operational advice. For anyone corresponding with us, or frankly for anyone starting to get a handle on an existing business, here’s a short due diligence request list. This list would also serve a new director well to become acquainted with the business and its strengths and weaknesses. (We have steadily maintained that even small private businesses would benefit from outside advice, even if you don’t cede actual control to a board of directors.)

The key insight here is that the due diligence process is not the completion of the checklist. We have seen too many people gather information and fail to review it, or having reviewed it, fail to incorporate it into a transaction (investment or acquisition) plan. The due diligence process starts with a list of documents, that upon review, may trigger additional questions or information requests. One simple goal is to use the diligence process to consider the financial model underlying a proposed business transaction and illuminate the assumptions, stated and unstated, upon which the model rests.

In our framework, we look at due diligence as part of the Informed Decision-Making stage (IDM); even though the analysis of due diligence materials is part of the Data-Driven Analysis stage, the use of that analysis and its impact on the terms, structure, and price of a transaction are squarely within the IDM stage.

Here’s the list. Every transactional lawyer and banker has a vastly more detailed list, as do we. But the purpose of this list is to introduce the process to owners/founders/CEOs/directors of smaller businesses who don’t have ready access to experienced practitioners.

1. Copies of all historical financials for existing operations: Income Statement, Balance Sheet, and Cashflow statements.
   

• The easiest course of action is usually to provide a "backup copy" of a QuickBooks, or other accounting program, file (with the password!). [NB: We will soon replace this requirement with a basic UFS, or unified financial statement, after we write more on that topic.]

2. A list of property, personal or business, that might serve as security for debt financing

• Even if the owner’s desire, as one might expect, is not to encumber personal assets, many lenders are more comfortable knowing that a principal in fact has assets at risk, even if those are not security.

3. A current list of customers (should be in QuickBooks) and any LOI's/contracts with price and volume commitments (for existing as well as future business).

4. Management reports for sales rep performance and quotas for future work

5. Sales pipeline, backlog, or similar analysis, in the format used by management
   

6. A capitalization table, showing fully diluted capitalization

7. Copies of current articles/certificate of incorporation & bylaws

8. A current list of suppliers (should be in QuickBooks) and any LOI's/contracts with price and volume commitments (for existing as well as future business)

9. Other material agreements

10. Description of any pending litigation, whether company is plaintiff or defendant

11. Any audit letters from auditors if financials have been audited in last 3 years

12. Employment terms with employees regarding bonuses, commissions, stock options, profit-sharing, or anything material other than salary reflected in QuickBooks

13. Copies of all reports provided for board in the last 18 months or similar periodic management reports for the last 12 months

14. A description of any off-balance sheet obligations or other liabilities

15. A summary of any related-party transactions, individually or in the aggregate greater than $25,000

Labels: DDA, deals, due diligence, IDM

Monday, November 24, 2008 :: posted by Rick Colosimo @ 4:09 PM

Why raw data alone is insufficient for making decisions The WSj recently published an article regarding the prospects of asking/demanding that political candidates or prospective CEOs release DNA sequence information.

For us, even though data-driven analysis is the first phase in our business leadership process (Data-Driven Analytics (DDA), Informed Decision-Making (IDM), and Intentions-Based Guidance (IBG)), it is important to understand that data alone is meaningless. While the connections between sales data and pricing strategies or marketing campaigns is at least intuitively in the ballpark for most managers, the connections between DNA sequences, genetic predispositions, health risks, and actual health problems are far more attenuated. Geneticists and doctors (since the intersection is the important issue) know that only certain DNA sequences lead to definite health problems, and that only some health problems are tied primarily to purely genetic factors. For example, Huntington's Chorea, a genetic disorder, is caused precisely by a specific gene and regularly occurs when the mutation is present. Alternatively, even if I don't have a genetic predisposition to lung cancer, if I smoke a pack a day, I'm very likely to end up in trouble.

From a business perspective, it is clear to all (well, most, since we've found some of the exceptions) that if your sales price doesn't cover your costs, you're either in for a serious economic catastrophe or an antitrust investigation. But that single accounting snapshot is not a good description of how business happens. Businesses are continually making sale after sale, at varying prices, to different customers of different products and services. Tracking the change, rate of change, and source of change across those variables can point you in the right direction. Financial snapshots are like DNA; it's possible for them to point to problems all by themselves, but most of the time, you have to analyze the system dynamically because it's a dynamic system. In science, it's called experimentation; in medicine, it's called treatment; in business, it's called management.

Labels: DDA, execution, leadership

Saturday, November 01, 2008 :: posted by Rick Colosimo @ 1:32 PM