Understand Profit and Cash Flow
So you want to know how your profit and cash flow is looking? Do you ever look at a set of financial statements produced by your accounting software and get overwhelmed? Maybe you don’t even print them because you are not sure which numbers to look at and you don’t have time anyway. You wouldn’t stand alone if you had answered yes to either question.
A typical set of financial reports, made up of the Profit & Loss and the Balance Sheet. They contain quite a few numbers and it can be a daunting task to make sense of these numbers, and know which of these numbers is important. Really all of them are important, but seven of these in a typical set of accounts are critical.
7 Key Profit and Cash Flow drivers
The seven key numbers or profit and cash flow drivers are:
- Revenue Growth as a %
- Price Change %
- Cost of Goods Sold % (COGS)
- Operating Expenses
- Days Payable
- Days Inventory & Work in Progress (WIP)
Below is a brief explanation that outlines why these numbers are so critical.
Revenue Growth as a %
Typically Business owners will focus a lot of attention on revenue and making sales and this obviously is critical. What is even more critical is what those sales cost you to make or procure, and to fund. As soon as you sell something, and very often beforehand there have been some typical cost incurred that will involve some labour, freight and overhead. It is important to know these costs. If they should exceed your revenue you are making a loss and heading for some cash flow problems.
Revenue growth % is important because growth can be the killer of small businesses! How is this so you might ask? Because so many numbers are important besides profitability, and if these other numbers aren’t being managed correctly, revenue growth will just exacerbate cash flow issues. This is not a good situation and it won’t get any better, but it will get very serious. Revenue Growth is a cause for celebration but it is also cause for attention to other ‘Key Drivers’.
Price Change %
Means the percentage increase or decrease at which you sell your products or services.
How tempting is it to sell for the cheapest price possible? Don’t cover the costs with the price you are charging and you will not make a profit. Don’t make a profit and you are draining your cash.
One trap that a lot of businesses will fall into is not increasing prices regularly by small amounts – say by CPI. Failing to do this will cause what is referred to as margin squeeze. This means that your Gross Margin will suffer, due to reduced revenue, when compared to the cost of delivering the goods or services.
Get the desired result!
Customers can get a shock when you don’t increase your prices suddenly by a large amount. Regular small increases will be easily achieved the desired result! Have you ever noticed how McDonalds, will increase the amount of a meal by between 15 and 40 cents. This price increase is barely noticed by a customer. Usually it won’t be enough to take the customers’ business elsewhere for the sake of a few extra cents. These types of increases are probably quite justified. Increases in the cost of petrol and delivery of products. Love them or hate them this is part of the success of company’s such as McDonalds.
Many business owners have a fear of losing customers by putting up prices? In reality you may not loose as many as you think. If you do loose a small number of extremely cost conscious customers, it may not be such a bad thing. Modelling usually shows that increased price and reduced overall revenue could actually have a positive impact on your bottom line. One approach could be to increase prices selectively to less valuable and new customers, and offer existing prices to your better customers.
‘Cost of Goods Sold’ (COGS) are the costs incurred to get the product or service to the customer, before overheads. This is a really important number as it has a huge impact on your Gross Profit. Some people will refer to the COGS as ‘Direct Costs’ or ‘Variable Costs’.
Many business owners focus a lot of attention on revenue and this is important! A small reduction in COGS% can have as much impact on gross profit as a large increase in revenue.
A little attention to what makes up COGS, and some negotiation or investigation with suppliers for better prices, can pay huge dividends on your gross profit.
A service based business, should pay attention to its work practices and job management. They can have the same effect on your gross profit, e.g. knowing how many labour hours you are selling compared to those you are paying for. This provides opportunity to investigate differences and tighten up your processes.
A lot of business owners will focus attention on the overheads in the Profit and Loss Statement. They don’t compare them relatively, (by percentage) to the revenue whereas comparing them by percentage is important. This has an impact on the profit, and this will be made clearer as a percentage.
By just looking at the overheads dollar figure you could be making more revenue without increasing your net profit. You will find it much easier to focus on one number being the overheads % rather than getting too bogged down in all of the numbers listed.
If you don’t have a budget it can be very difficult to know if overheads are reasonable anyway! Increasingly we find that very few smaller businesses have a budget. This makes it difficult to know how they are going during the year. If you are trying to reach a goal in business then you need a budget. If you don’t have a budget in business it is like trying to find a new destination without a road map.
It has been said before that by “failing to plan you’re planning to fail”.
This is the number of days, on average your customers take to pay your invoices. You need to manage this number, as it can have a huge impact on your businesses cash-flow. By way of example, if your accounts receivable days is currently seventy and you can get it down to say fifty, you could be putting tens of thousands of dollars back into your bank account.
You could improve this number if you focus attention on your accounts receivable and debt collection procedures. It’s fine to look at the report out of your accounting system which lists all the customers and how much they owe you. However, when your business is growing rapidly you need to know how much, accounts receivable days are changing compared to revenue growth. If it’s not comparable you could experience a cash-flow squeeze and you could run out of working capital.
This is the number of days, on average; you’re taking to pay your suppliers. It’s equally as important as accounts receivable days, and can have a significant impact on your working capital situation. Have seen instances where a business will oil the squeaky wheel and pay suppliers who hassle them for money (sometimes before it’s due). I have also seen businesses ignore potentially better terms, offered by suppliers because they get so focused on revenue.
Some small changes to procedures relating to accounts payables can pay big dividends in your bank account. If your business is growing managing your accounts payable well could be critical cash for funding growth. I’m not suggesting stringing out suppliers beyond the agreed terms, but negotiating better ‘agreed’ terms for your business.
This the number of days, on average, that goods for sale are sitting in your warehouse or shop, from when they are delivered by suppliers, to when they are shipped out to customers. Often these goods have to be paid for before they have been sold, which means you have had to spend valuable working capital to have the stock sitting there waiting to be sold. By managing this situation better, and reducing the number of Inventory Days, you can have a big impact on your bank account and working capital situation.
It’s very tempting when a salesperson calls and offers you a discount to buy more stock, however it’s useful to consider the amount of working capital that this will be tied up in that stock, compared to the discount being offered. If you are borrowing funds it’s important to consider the amount of interest payable on those funds tied up in slow moving stock.
If you are in a service based business Work in Progress (WIP) Days is very similar to Inventory Days, in that your ‘stock in trade’, is the labour and materials you have to sell. Slow WIP days can be just as dangerous to cash-flow and working capital as Inventory Days. Anything that you can do to tighten up processes and speed up the time work is ready to be invoiced, will pay dividends in your bank account and reduce your interest expense.
Just a thought about the Seven Key Drivers…..of the seven numbers:
- Four are calculated from the Profit and Loss Statement, and
- Three from the Balance Sheet.
How many business owners look very closely at the Balance Sheet?