As a small business owner or professional running your own practice, you didn't sign up to be an accountant did you? That's why you hired one - to do your books for you while you got on with providing solutions for your customers, either a great product or a great service. However, you can't run away from the numbers.
You want to make a profit right? So, you want to make a profit but you'll leave the numbers to your accountant? How does that work? How does that work if you only see your accountant once or twice a year? How does that work if they are not the type of accountant to give you proactive management information? Are you even making a profit?
Here are 10 financial facts that you should know about your business.
Number 1 is your Break-even Point.
Your break-even point is the amount of sales at which your business breaks even, covering all expenses, whether fixed or variable. Fixed expenses are those that don't change with the volume of your purchases, sales, or activity. For example, rent is a fixed cost.
Variable expenses are those that vary in some sort of formula with the level of your activity. For example if you run a transport company, the cost of fuel is variable with the number of miles you drive.
How do you calculate your break-even point?
First, calculate your total fixed expenses in a year - let's say it's $100,000.
Then, calculate the percentage of sales that is your margin after variable expenses. Let's say for every dollar of your sales, it costs you 80 cents in the cost of goods or service, so your margin after variable expenses is 20% of sales.
Divide your fixed costs ($100,000) by the margin (20%). This means your break-even point is $500,000 in sales per annum.
That is, you need to sell $500,000 worth a year before you start to make a net profit. Any sales below that and you are making a loss. This is the most important financial fact about your business, and helps with sales targets and pricing.
Number 2 is your Cost of Goods Sold.
Cost of goods sold are all the direct costs that it takes to produce a sale. Each business will have a different combination of costs that make up their cost of goods sold. Here are some examples:-
- A legal firm's cost of goods sold include lawyer's salaries;
- A retailer's cost of goods include the cost of buying the stock, and freight to get it to the shop;
- A manufacturing company will include raw materials, freight, a portion of machinery costs, and possibly salaries.
Why do you need to know your cost of goods sold? Because your sales less your cost of goods sold gives you your gross profit, that is, the profit you make on your products or services that contributes to paying for your overheads like rents and administration of your business. The higher your gross profit, the higher your net profit (and by the way, the lower your break-even point). This gives you the information to make pricing decisions, as well as compare the cost of suppliers and the effect of volume discounts and help you in negotiations.
Number 3 is your Gross Profit percentage.
There is a relationship between your cost of goods sold (above) and your gross profit. Gross profit is the difference between the value of the sales and the Cost of Goods Sold (COGS).
A lot of businesses make a mistake with this financial fact. Most businesses mix up Markup and Gross Profit. They say that their gross profit is 25% when they really mean markup. They compare this 25% with others in the industry and find that it's the same or even better so they feel satisfied. However they may be comparing their markup with others' gross profit. For example:
Gross Profit Percentage = Gross Profit divided by Sales x 100% (be careful…it is on Sales)
Markup is what you add to your Cost of Goods Sold to work out your sale price (look carefully, on COGS not Sales)
Here’s where the misunderstanding can cause you problems:-
If you want Gross Profit (on Sales) of 20%...you must markup your cost by 25%
If you want Gross Profit (on Sales) of 25%...you must markup up your cost by 33.33%
If you want Gross Profit (on Sales) of 35%...you must mark up your cost by 53.8%
Number 4 is how much net profit is your business really making.
Net profit is made up of many things and is not measured just by the cash you have left in the bank at the end of the year. What happens if you have $100,000 cash in the bank at the end of the year? Have you made $100,000 net profit? Not if you owe your suppliers $110,000 at the end of the year - in fact you've then made a $10,000 loss despite hat you have in the bank.
Ask your accountant to show you what expenses come off your sales to make your net profit. This information will help you to decide on what to improve.
Every type of business, and indeed, every business is different. A net profit of 25% on sales might sound wonderful but what if everyone else in your industry is making 30%?
Number 5 is understanding which product or service makes you the most profit.
This is where the 80/20 Rule applies. In any and every business, only about 20% of the things you do make you about 80% of the profit!
Hard to believe but it is true!
You need to analyse and understand all the parts of your business and see what the gross profit for each part is. With this information, you can prove for yourself which 20% of the business is really profitable and make decisions like discontinuing certain lines, creating loss leaders, reallocating marketing and other resources.
Number 6 is your cash flow.
Okay, you've found out your break-even point and sold above that level. You understand your COGS and your gross and net profits and it's looking good. But you're struggling to pay your workers and suppliers.
What's wrong with this picture? You've sold it and you've billed it - but you haven't collected it!
You already know (or should!) when you have to pay your expenses - some are payable as and when they are expended (say salaries), some may have credit terms like 30 days from delivery. What you also need to understand is the pattern of these payments - are summer months when you buy more and so will need the most cash flow outwards? How much do you have to pay out every week on rents, salaries and the like?
You also need to know when your customers pay you. You give them payment terms, do they stick to it? What happens if they don't? Do you chase them? Again, you need to understand the pattern of receipts of cash - and match them to your pattern of outwards cash.
Number 7 is the type and level of your expenses.
You added them up when you calculated your break-even point, and when you looked at gross profit. But have you looked to see if you can reduce them?
Do you need to spend on all the types of expenses? For example, do you need to pay a freight company to deliver your goods when the supplier is a short drive away for yourself to pick up?
Can you reduce the level of expenses? Can you change to a cheaper supplier or reduce the number of times you buy something? Remember if you save a penny in lots of different things, it adds up to lots of pennies!
Number 8 is how you compare?
Compare to what? Compare to everyone else in your industry for a start. There are benchmarks for every industry - yes, these are averages, and the quality of the benchmark does depend on how many businesses contributed to it, but it gives you a picture of how you are comparing to something, not just on your own.
Knowing this can give you important insights on financial matters such as, for example, how much rent you pay compared to others. This can lead to non-financial insights like perhaps others operate out of cheaper areas, and why would that be? Perhaps those suburbs have more customers for that product.
Number 9 is whether you might be better investing in something other than your business.
Being in business is stressful. Apart from comparing what your Return on Investment is with a "safe" investment like a bank deposit, you need to understand what premium you might want for all that stress and risk. Take the example where your net profit might be $100,000 per annum, after investing $1,000,000 in the business. Your return on investment is 10% per annum. If the bank returns 3% per annum, you might feel pretty good. Until you ask whether all the stress and risk is worth a premium of 7% - worse, what if you found out that others are getting 20% per annum from their businesses in the same industry?
So now you have the question. Tat is if I sell up and then invest in something else, would I get better or the same return for a lot less risk and stress, and would I be happy with that better or same return in that environment?
Finally number 10 is how financially resilient is my business?
What if the economy took a downturn? What if the economy stayed down for a number of years?
Firstly, what is your level of debt, in comparison to your assets and your income? When the economy is booming and your business and house are worth a total of $5 million, a debt of $1 million is reasonable, especially when you consider your business is making a net profit of $500,000 per annum.
But what if there was a downturn and the value of your business and house dropped to $3 million? Now you owe 1/3 of your assets. And in a downturn your profit is likely to also drop to let's say $250,000 per annum. Now you have annual profits to cover 1/4 of the debt instead of the original 1/2 cover. Scary.
What happens if the downturn lasts 3 years? Or 5 years? Or more?
Secondly, what is your ability to shed expenses if there is a downturn? Can you quickly reduce staffing numbers without excessive cost (say in having to pay redundancies and unpaid holiday pay all in one go)? Can you scale down your production capacity?
These are the financial facts you really need to know about your business. It's important that you know them and you keep updated about them.
If you want us to help you understand yours, get in touch with us and ask us to look through your accounting and business information.
If your accountant is unable to help you pull this information together, click on the Contact Us tab on our website at www.otsmanagement.com.au and get in touch with us to organise an obligation free first meeting.
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