“An ounce of prevention is worth a pound of cure” applies to personal health as well as to the health of a business. Just as a doctor takes your vitals to assess your overall state of health and to recommend corrective changes in diet and levels of physical activity, an owner should assess the overall financial health of their business regularly.
While there are numerous metrics available, I’d like to focus on two interrelated financial measurements that are vital to the long-term success and survival of a business.
Cash is the lifeblood of any business. An owner who does not have a firm grasp of their cash flows is akin to someone taking a long journey in a car that does not have a working fuel gauge. A recent bank survey noted that 70 percent of businesses that failed were profitable when they closed their doors. Guessing about cash flow is both dangerous and unnecessary.
Cash forecasts, in the form of simple spreadsheets or more sophisticated (but easy to implement) cloud-based tools, can help provide early warnings that corrective action is required. A robust cash forecast, combined with a monthly review of the business’ statement of cash flow, helps an owner keep their finger on the pulse on the business, and provides advance warning signs of troubles ahead.
An owner can incorporate the following best practices into their operations to improve the cash flow of their business:
- Invoice a customer as soon as the product is sold, or the service is delivered. Waiting until month-end or adhering to some other artificial schedule extends the cash flow cycle, which is detrimental to the business. If invoicing all sales daily is not practical, establish a dollar threshold (as low as possible) and invoice the same day all sales that exceed that amount.
- Require deposits and progress invoices for products and services that are large sales and/or have a long delivery cycle. Smaller dollars and more frequent invoices make it easier for customers to pay. Larger dollar invoices typically require a more rigorous approval process and slow down the customer’s payment process.
- Confirm that a customer has received their invoice and, for large dollar invoices, call the customer as the payment date approaches. This can be a “happy” call to check up on their satisfaction with the product or service and serve to remind the customer that payment is due soon.
Not all revenue is good revenue. This can be a difficult concept to digest. After all, sales revenue is the start of the cash flow cycle. What owner does not want more sales?
Good revenues are sales that produce enough gross profit (i.e., net sales less cost of goods sold) to cover the operating costs of the business and provide a sufficient net income to compensate the business owner for the risks they take. If a company’s gross profit margin is 25 percent of sales and the operating costs are 15 percent of sales, there is ample profit falling to the bottom line. But if that company’s operating costs were 23 percent, they are in a precarious situation with little margin for error. There is net profit, but it is so small that the owner is constantly in a state of stress worrying about unforeseen expenses, making necessary investments in the business, funding payroll, and cash flow.
There may be valid and strategic reasons for an owner to accept minimally profitable revenue or sales that produce an overall net loss. However, it is imperative that owners be fully aware and cognizant of those decisions, and that they identify expected outcomes within an established timeframe. Deciding upfront what actions will be taken if and when the expected outcomes are not realized helps avoid the inevitable doubt that arises when unprofitable revenue needs to be cut.
Owners should perform a regular review of the gross margins and trends of their business and know and communicate to managers the targeted and breakeven gross margins. Gross margins can be analyzed by:
- Product or service
- Customer or customer segment
- Period such as day of the week, the month of the year or by season, among others
There are numerous levers to pull to improve gross margin including pricing strategies, reducing the cost of goods sold, focusing on more profitable customers and customer segments, and eliminating unprofitable products, services, and customers. There is also ample opportunity to reduce operating costs which will make the existing gross margin more acceptable. A board of advisors, with diverse areas of expertise, can greatly extend the knowledge and provide a wider perspective to an owner around what works and what does not.
Owners that track and monitor cash flow and gross margin on a regular and frequent basis are better equipped and prepared to take the required and necessary actions to maintain and improve the overall financial health of their business.