The appeal of being in business is clear even to small children. Create a desirable thing or perform a service well, and then sell it to people for more money than it cost you. It’s the kind of logic that has spawned a thousand lemonade stands or impromptu roadside muffin stalls. The main thing that drives each of these ambitious enterprises is the thought of the weight of all those gold coins in your pocket at the end of the day.
Although the process of running an online business is considerably more complicated than that of a one-man high school lawn-mowing business, the basic appeal remains. Have an idea, sell the idea, perform the idea, profit.
But, having spent months and months perfecting the first three parts of that equation, many business owners become too heavily invested in the last part: the profit. The daily cause and effect of a business might be rewarding to watch if it’s ticking along nicely, but focusing too closely on the microeconomics of incoming dollars can be a dangerous way to gauge a business’s financial health.
It may seem like an unnecessary difficulty to see over the towering peaks of an impressive bank balance, but there’s a lot more to gauging a business’s success than the profit and loss.
Beyond the profit and loss
The profit and loss statement is a document that shows how the business has performed over a period of time. It shows the money coming in and the money spent over a particular period. This might sound like the most logical way to measure a business’s liquidity, and it is. But the fact that any P&L focuses on a particular span of time opens up the temptation to only look at how well things went yesterday, or last week, as opposed to over the whole life of the business.
“Most CEOs will jump out of bed every morning and have a look at their profit and loss,” says Nathan Keating, general manager of Pearl Finance. “If they’ve sold lots, and they’ve made some profit, they pat themselves on the back and say ‘well done’. But 60% of businesses that we see would be making a profit and still never have cash.”
This is because a healthy profit doesn’t necessarily equate to a healthy business. If last week was particularly fruitful, the profit and loss statement for that period will look like an A+ on paper, but it’s not the whole story, and certainly not the most useful indicator of the overall business’s financial situation.
At the end of the day, a business’s cash flow is the most reliable indicator of its financial wellbeing. After all costs and profits, over the entire history of the business, have been taken into account, the money that the business can actually, legitimately account for speaks the loudest of its success. What’s confusing about this is the figure that greets you as you log into internet banking each day does not necessarily represent the business’s cash.
“What small businesses tend to do, and their biggest mistake, is they concentrate on the daily bank balance,” says Gregory Will, principle and owner of Armstrong Dawson. “Even though that, as a broad indicator, is not a bad barometer for how the business is going, it only gives you a snapshot of that point in time as to what’s happening within the business.”
The bank balance may look impressive, but it doesn’t show pending expenses. It doesn’t always delineate the startup costs of the business, and it doesn’t acknowledge the mountain of invoices that might be sitting in the ‘to pay’ inbox. This may sound like an absurdly simple mistake to make, but it’s common enough among small businesses to warrant a warning.
For more on how to use profit and loss statements read Understanding Profit and Loss Statements.
In contrast to a profit and loss statement, the balance sheet of a business is meant to give an accurate impression of a business’s liquidity: how healthy the business is financially after all has been taken into account.
“The balance sheet is keeping score of how much wealth you have in your business,” says Pearl Finance’s Keating. “The profit and loss report that your accountant would produce shows how much money you’ve made for the year; your balance sheet shows how much money you’ve made for the duration of the business.”
He continues to note that, although a balance sheet is a better indicator of where a business is at, it, like the profit and loss, can be deceptive.
“Your balance sheet is an opinion. The only thing that’s actually a fact in your business is cash, which is a line in your balance sheet,” says Keating. “There’s two types of cash. There’s positive cash – cash in the bank – and then there’s debt, which is negative cash, if you like. That’s why banks are obsessed with cash, because it’s the only true thing in your business that they can look at and know and touch and feel and say ‘right, that’s real’.”
He suggests that there are six distinct factors that act to drive cash flow in any given business: pricing, sales volume, operating expenses, inventory, accounts receivable (debtors) and creditors.
“I think it’s important that everybody understands what a 1% movement in each one of those drivers will do for cash,” he says. “Then you set a goal of how much cash you want the business to make, and a combination of the drivers well then help you achieve that. Once you understand what 1% is, you can do a lot.”
Although a balance sheet is designed to be an accurate gauge of the business’s wellbeing, Keating explains that its ability to ‘take’ cash from the business makes it an unreliable benchmark.
“Where that cash goes is into things like debtors, and inventory,” he explains. “If you collect too much inventory or let your debtors go out, that’s cash that could’ve been in your pocket, but is sitting in somebody else’s pocket. And businesses don’t always take into account the movements in the balance sheet.
“Ultimately, if you’re making more cash than you’re making profit, then you’ve done a good job for the year,” continues Keating. “You can make more cash than profit. If it’s the other way around, then your balance sheet is stealing cash from you.”
A much healthier approach is to take a step further than the face of the balance sheet, and to keep close tabs on the things it’s meant to detail.
“Depending on the style of business, what a business owner has to look at is what accountants call the balance sheet items,” says Armstrong Dawson’s Will. “Those typically are cash at bank; they’re debtors balanced, which is the receivables – the money that’s owing to them or coming into the business; and the creditors, or the payables, the moneys that they need to pay to suppliers and invoices.”
Taking each of these things into account will help you to gain a more accurate impression of the true, current financial value of the business, referred to as ‘return on capital employed’.
“Return on capital employed is the amount of money that you’ve made with the all the funds that are available to you in your business,” says Pearl Finance’s Keating. “It’s taking your balance sheet and all the assets that are in there, and it’s saying how much profit you have made from those assets.”
One of the most commonly overlooked factors that bear on the vitality of a business is the nature and volume of its inventory, particularly for businesses that keep stock. It’s easy for owners to view inventory as things on shelves, rather than a vast collection of assets that may depreciating or weighing the business’s financials down.
“What that inventory represents is not only stock that they can sell, but it’s money that’s tied up in the business,” says Armstrong Dawson’s Will. “What we’re finding is that, particularly with retail businesses, or businesses that do have stock where sales might be a little bit sluggish, you tend to find that there’s been this build up of stock there that is slow moving, and that’s what’s really draining cash out of the business.”
This problem can be averted by constant close monitoring of the stock’s movement and changing value. If inventory is starting to weigh on the business’s financial health, it’s important to settle on a quick way to keep the stock moving through the business rather than stagnating on the showroom floor.
“Cash flow is king to a small business,” continues Will. “Even if you have to cut your margin a little bit and discount, it’s a lot better to have cash in your pocket than to have stock sitting there on the showroom floor. You have to manage that carefully – you obviously don’t want to give the stock away – but if it’s going to take you three or four months to sell that stock, you’d rather take a little bit of a haircut in price, and sell it within the next week, than hold onto it for the next two or three months.”
Managing debtors and creditors
A creditor is anyone that the business owes money to. Typically, creditors supply things that the business requires to keep running – computers, stationery, electricity, or stock. It’s this type of expense that CEOs, keen to track the rise and rise of their balance sheet and profit and loss statements, sometimes overlook.
It’s essential to have a rigorous system in place for monitoring what the business owes. More importantly, it’s a good idea to be communicative with your suppliers, particularly when it comes to payment terms. The longer you can take to pay your creditors, the more cash you have to use in the business in the meantime.
“With accounts payable, or creditors, you want to maximise those payment terms,” says Will. “I’m not suggesting paying late, but working with your creditors to negotiate 30 or 60 day terms. Use the maximum amount of terms that you can get, and pay right on that last day. Creditors won’t pat you on the back or say ‘thank you’ for paying early, because they expect their invoices to be paid. Pay them within terms, make sure you squeeze every last minute out of those creditors, so you can get the maximum cash flow benefits.”
While this type of discussion might seem like a huge challenge, the truth is that most creditors will be more than open to it, provided you already meet your current terms reliably.
“When you’re a creditor, you don’t mind giving extended terms, as long as you know those terms are going to be honoured,” says Will. “If they have a good quality client that they can see has had a consistent payment record of paying on time, then there’s no harm in asking for better terms. As long as you can stick to those terms, most creditors would be happy to have that discussion.”
If extended terms aren’t an option, then it’s still worthwhile trying to work with creditors to maximise the amount of money in your business by negotiating discounts.
Conversely, keeping close tabs on debtors is essential for keeping your business finances buoyant. If the figures on your profit and loss statement and balance sheet look as though they’re suffering, slow-paying debtors could be one of the reasons.
“A good practice with debtors is to make sure that you’re on top of your customers early,” says Will. “If they are late, or if they are coming close to terms where they haven’t paid, make sure you get on the phone early. If you can identify an issue, you can deal with it. But once they are late or they’re delinquent, and they haven’t paid, or they’re not performing well themselves, you’re almost too far behind the eight ball before you can get that money in.”
It helps to be very clear about payment terms. Outline how long debtors have to pay on all invoices, and offer incentives for early payment, if possible.
Once you factor in debtors, creditors and inventory, past and present, into the profit and loss, you’ll have a much more reliable impression of how your business’s financials are tracking. From there, the trick to keeping a finger on the pulse is to be assiduous in how you gauge financial performance.
“It’s one of those things that, once you get it into your mindset, and once you’ve got it set up, it’s quite easy to look at it weekly,” says Will. “But it comes back to that discipline and focus. If you don’t have that discipline, it can get out of hand very, very quickly. It’s just like weeding the garden. If you do a little bit here and there, they’ll always be at bay, but if you don’t do it for a couple of months, you’ve got a major job at the end to get all those weeds out.”
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