FINANCIAL-STATEMENT ANALYSIS
by John Jaques
This article provides an overview for evaluating the financial strengths and weaknesses of an independent insurance agency. The material provides the necessary tool to gauge the financial position of your agency and create action plans for profit improvement.
Today’s independent agency environment is defined by flat Commercial Lines premium rates, high personnel costs, lack of capacity in Personal Lines Auto markets, high investment costs in automation, increased operating expenses, reduced commission rates, and a high level of competition. Also consider the transition from the “Mom and Pop” agency of yesteryear (with its Main Street location and two employees) to the professional business entity of today. No wonder agency managers are becoming more proficient at using financial information and analysis to plan operations.
Funding for upgraded automation, new producers, acquisitions, office facilities, starting a target market, and perpetuating buy-outs must be provided by agency profits. The intent of this article is to provide an overview for evaluating the financial strengths and weaknesses of an independent insurance agency. The material provides the necessary tool to gauge the financial position of your agency and create action plans for profit improvement.
'THERE ARE NO FINANCIAL PROBLEMS. THERE ARE ONLY OPERATING PROBLEMS.'
When any agency is in a weak financial position, its problems are not financially based. The problem is simply manifested in the financial statements. In basic terms, an agency’s financial statements reflect and measure the agency’s operating strengths and weaknesses.
If an agency is operating at a monthly cash-flow deficit (or loss, meaning that expenses are exceeding revenues), the problem is not financial. The cash-flow shortfall is only a symptom of an operating problem or a combination of operating problems. Thus, a cash loan to the agency will not make the firm “financially healthy” until the operating problem is identified and corrected.
All too often, an agency with low liquidity, high overdue accounts receivables, unmanageable debt service, and a shortfall of cash-flow profits is considered “financially problematic.” The key to effective agency-financial analysis is to use financial information to identify operating problems, design a game plan to correct these problems, and then use the financial statements to monitor the progress of the action plan.
TOP 10 QUICK FINANCIAL REVIEW COMPONENTS
When developing a financial analysis of an independent agency, these 10 items provide a checklist of the key elements that provide a true picture of potential operating problems and financial strength:
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Trust ratio (the sum of cash plus accounts receivable, divided by premiums payable) of 1.1x or greater.
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Percentage growth in base renewable commissions during the last two years should exceed 6% per year.
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Total percent of accounts receivable outstanding more than 60 days- should not exceed 15%.
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Actual total return to the owners not less than 75% of targeted return.
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Ability to cover debt-service commitments.
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Average commission split paid to producer’s gross commission handled.
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Employee productivity should exceed $65,000 revenue per employee.
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Comparison of number of new accounts written versus number of new accounts lost in each line of business or business segment.
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Level of contingent (profit sharing/bonus) commissions and interest income.
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Significant changes or variances in key expense categories during a three-to five-year period using variance-analysis technique.
Each of these 10 elements analysis is discussed in depth in the following paragraphs.
I. TRUST RATIO
This ratio measures the agency’s ability to pay premium due to its carriers. If the ratio is less than 1.0, the agency owes more to its carriers than it has available in cash and accounts receivable. The agency has spent a portion of the fiduciary funds collected from insureds and owed to carriers on its own expenses. If volume drops or the local economy slumps, the agency will end up defaulting on its premium payments owed to one or more carriers. The ratio should exceed 1.1 at a minimum, meaning cash plus accounts receivable exceed premiums payable by at least 10%.
Cash Plus Accounts Receivable divided by premiums payable = trust ratio.
2. COMMISSION GROWTH
Virtually every year, salary expense will rise 4% to 6%; rent will jump 3% to 5%; and supplies, printing, and other office expenses will rise 3% to 5% through inflation alone-without any increase in customer count. To maintain profits, an agency must average a minimum 6% growth just to stay ahead of inflation and salary increases. If an agency’s commission volume has grown less than 6% in each of the past two years, this could be an indication of operating problems that impact the long-term viability of the business.
3. ACCOUNT RECEIVABLE MORE THAN 60 DAYS OVERDUE
In reviewing an agency’s A/R, divide the amount of receivables outstanding more than 60 days by total accounts receivables more than 60 days late. (The agency’s summary page of aged accounts receivable will be needed for this calculation). An average agency will have approximately 15% of its receivables more than 60 days overdue, while a well-run agency will have around 5%.
Agencies with poor collection procedures will have more than 20% of receivables overdue (remember, premiums due carriers must usually be paid 45 to 60 days after expiration date, thus receivables more than 60 days late force the agency to forward its own working capital funds to the company). Agencies with more than 20% of receivables overdue consistently put their companies in danger of being paid late or even of being defaulted.
4. TOTAL RETURN TO THE OWNERS
The quickest and easy means of determining whether an agency is profitable is to compare the actual total return to the owners versus the targeted return to the owners. The idea is to determine the total level of compensation and profit the owners should be generating from the agency, and compare it to the actual total return. If the actual return is 75% or less of the targeted return, the agency might have significant operating problems that need attention. If not corrected, the firm might not be around long.
Figure 1 provides a formula to determine how your agency is faring, regarding its targeted return.
| FIGURE 1 | |
| A.Targeted Return: | |
| 1.Calculate total gross commissions on accounts directly handled by agency owners as producers. = | $ |
| 2.Multiply 25% times the gross commissions identified in #1. This equals the fair compensation the owners are due as producers for handling their book of business. 25% x gross owners' commission = | $ |
| 3.Multiply 5% times gross agency total revenues. This will approximate the management compensation pool the owners should reasonably be paid for their management efforts. 5% x total revenue = | $ |
| 4.Multiply 17.5% times total revenue. This equals the profit level at which the agency should be able to operate. 17.5% x total revenue = | $ |
| 5.Total Targeted Return | |
| Add: Owners' producer compensation (#2) | $ |
| Add: Owners' management compensation (#3) | $ |
| Add: Target profit level (#4) | $ |
| Total Targeted Return = | $ |
| B.Total Actual Return: | |
| 1.Total compensation paid to owners = | $ |
| 2.Add: Reported pre-tax profit = | $ |
| Total Actual Return = | $ |
| C. Shortfall Or Excess Return | |
| 1.Total targeted return = | $ |
| 2.Less: Actual return = | $ |
| 3.Shortfall or Excess Return = | $ |
5. ABILITY TO COVER DEBT SERVICE
If an agency is not developing sufficient cash flow to cover debt-service payments on outstanding liabilities and notes, it won’t be around long. In too many instances, agency owners assume debt in buying out a partner or another agency without realizing the full impact debt service will have on cash flow. You can use Figure 2 to estimate an agency’s ability to cover its debt service.
If item 5 is greater than item 4, a cash-flow deficit will exist. To be conservative and allow for taxes, item 6 should exceed item 5 by 30% or more.
| FIGURE 2 | |
| 1. Reported pre-tax latest year = | $ |
| 2. Add: Depreciation and amortization expense = | $ |
| 3. Add: Interest expense = | $ |
| 4. Total cash flow available for debt service payments = | $ |
| 5. Less: Total debt service payments to be paid in next 12 months (include both interest and principal payments) = | $ |
| 6. Total cash flow excess or shortage = | $ |
6. COMMISSION SPLIT PAID TO PRODUCERS
Few agencies, if any, can be profitable for long, paying producers a commission split in excess of 30%. The reasoning is clear: A commission dollar can be split in only a limited number of ways. Based on the agency seeking just 10% profit on commission and interest income, a dollar of commission income in an average agency breaks down as shown in Figure 3. Agencies that pay commissions in excess of 30% and cover auto and client-entertainment expenses are essentially eliminating their profits.
| FIGURE 3 | |
| 1. Gross commission = | 100% |
| 2. Target profit on Commission = | 10% |
| 3. Balance of commission dollars available to cover expense = | 90% |
| 4. Less: Business development expenses = | -9.50% |
| 5. Less: Administrative expenses = | -16.50% |
| 6. Less: Staff salaries = | -22.50% |
| 7. Less : Management override = | -5.00% |
| 8. Less employee benefits = | -9.00% |
| 9. Balance available to pay producer = | 27.50% |
7. REVENUE PER EMPLOYEE
This measure of employee productivity is one of the most basic in evaluating financial and operation strength. If an agency has low productivity, it has too many employees. Because personnel is the highest cost in any agency, excess staff leads to high expense and low profit. The productivity ratio is defined as total agency revenues divided by the number of employees (the employee count will include all staff, producers, and owners).
8. NEW ACCOUNTS WRITTEN VERSUS ACCOUNTS LOST
Many agencies with operating problems that lead to financial weakness suffer from a high turnover of accounts and often produce only as many new accounts as they lose. A quick measure of new business versus lost business activity can give you an indication of the agency’s direction. To get a full picture, do this measurement by book of business segment, as illustrated in Figure 4.
| FIGURE 4 | Number of Accounts Lost Latest Year | Number of New Accounts Written Last Year | Total Number Accounts |
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