Sales, profit and cash are the key issues to focus on in business financial management. If you can get these three working right, you’re well on your way to building a sustainable business with capacity to grow.
Most people focus on sales to begin. I’d like to start with profit! The reason to start with profit is, if you’re making sales without profit you will go out of business.
Break-Even First. The best place to start making enough profit is to avoid losses. Understanding break-even sales is a great starting point.
Break-even sales, is the amount of sales you need to make to avoid a loss i.e. to achieve a $0 profit or loss result.
This is impacted by fixed and variable costs. Fixed costs are those that you incur all the time, e.g. rent, admin wages, telephone etc. Variable costs are those incurred in making a sale, e.g. a product and associated costs like freight inwards, packaging etc. If you’re selling a service it’s labour and materials on the job.
When you’ve calculated variable costs per product or job you then calculate gross margin. For example if a product costs $40 (including all costs associated with getting the product ready for sale) and you’re selling it for $100, gross margin is 60%.
Now you need to know fixed costs. Let’s say they are $30,000 per month. To work out break-even sales – take fixed costs of $30,000 divided by gross margin of 60%, which gives a figure of $50,000. This is your monthly break-even total sales. If your average product sale is $100, divide the total sales break-even figure of $50,000 by your average sale of $100 to come up with a figure of 500 units to breakeven. In simple language this means you have to sell 500 units per month at $100 to break-even.
Now you know your break-even, use this as a basis for setting targets to achieve your desired profit. For example: with every additional unit you sell above the break even volume of 500 units, you will make $60 profit, which is the gross margin per unit of sale. Therefore if you target to make $6000 profit you will need to sell an additional 100 units.
Gross margin is one of the most impactful results in business. If you can’t make a decent gross margin, it’s going to be very difficult to make a net profit. One of the biggest issues we find in financial management is the lack of understanding of a product or service ‘true cost’. It’s often thought of as just the raw cost of the product or service. Items such as freight inwards, currency exchange, packaging etc. are wrongly omitted when calculating cost. This is dangerous, because it means when pricing a product and calculating a margin, the true cost isn’t being accounted for. In this case the gross margin suffers and this reduces what’s available to cover fixed costs. The result is losses and constant need to focus on more volume of sales to meet cash flow needs.
This leads us nicely onto cash flow. So far we’ve considered profit… and ‘good cash flow’ comes from ‘good profit’. Surprisingly though bad cash flow can also come from good profit. This arises due to the impact of factors other than those profit related i.e. sales less fixed and variable costs. You can be making money in the ‘Profit and Loss Statement’ and losing your battle in terms of your ability to pay your expenses when they fall due (Cash Flow Issue), and much of the key drivers for your cash flow are in the ‘Balance Sheet’.
What’s in the Balance Sheet probably has more impact on cash flow than anything else. I’m mainly referring to Accounts Receivable, Accounts Payable, Inventory and Work in Progress. When you make a sale it’s a long way for those funds to get into your bank account if they are invoiced to customers who may take 120 days to pay (if ever!)
Funds are paid to suppliers, who may or may not offer good terms. They sit on your stock room floor in the form of products waiting to be sold. They sit in Work in Progress in the form of labour and materials paid for before the job gets finished and invoiced to customers.
And that’s on top of paying your regular fixed costs. Your challenge to keep cash flow healthy is to:
- Minimise the number of days customers take to pay
- Maximise the number of days taken to pay suppliers
- Minimise the number of days goods sit in stock waiting to be sold
- Minimise the number of days jobs are in progress before being invoiced
- Sell the right products/services at the right price.
- Understand your true cost to get the price right and achieve a desired gross margin.
- Know your ‘break-even’ sales as a basis to calculating a target for desired profit.
- Constantly monitor variable costs to maintain your desired margin
- Constantly manage fixed costs to avoid wastage
- Constantly manage Accounts Receivables, Accounts Payables, Inventory and Work in Progress levels.
Tools you can use to help:
- Inventory management system
- Job management system
- Accounts Receivable management system
- Accounts Payable management system
- Cash Flow Forecast
- Accounts/bookkeeping system
All these systems need to be properly set up by someone who understands the overall picture i.e. you need to understand what you want to get out of them, so they are set up with that aim in mind. Otherwise you just end up with a load of useless data and more costs.