We talk with a lot of small to medium-sized business owners who plan for profitability, yet end the year with cash flows coming up short and balance sheets in the red. Here is our process for creating the awareness and discipline to ensure profitability.
Running a business is hard work. For a small to medium-sized business, that work is even harder due to the fact that as an owner or CEO, you have a lot of extra work to do. We work with a lot of companies who have great products and great people, but they can’t seem to push through the barriers to profit, preferably with a correlating positive cash flow.
Profit is not the purpose of a Business, it’s a Requirement
We should start with the fact that in business, profit is a requirement. The purpose of business is to create value, but unless you make a profit, you’re not a successful business. To take this one step further, it’s not just making a profit, but making one on schedule. If you have investors, and you’re planning on making a profit, then you have an obligation to generate it.
At a higher level, profitability is the key performance indicator showing that your company creates value your customers are willing to pay for.
Simply put, Profit = Validation.
1. Validation that your product or service is something customers want.
2. Validation you’ve correctly identified and found those customers.
3. Validation you make the product or perform the service in a way that creates enough money for your business to continue operations, invest in your future, and provide a return to your investors, even if you are the sole owner.
Ensuring Profitability is a Discipline
With variables such as change of pace, new opportunities, and unforeseen circumstances, maintaining a competitive profit margin is no doubt difficult. When you consider a profit percentage of 5% to 10% is respectable in many industries, we’re talking about preserving $100,000 in a $1M company, or on the low side $150,000 in a $3M company. That’s a relatively small amount of cash when you consider the many unforeseen circumstances that can arise. The cash from your profit margin can decrease quickly due to a poor hiring decision, increasing inventory requirements, or bad debt. It takes hawkish discipline and constant attention to ensure that profit is preserved.
Profitability is a Strategy
Most businesses don’t have the luxury of not making a profit each year. Chances are that if you are in that unprofitable group, saying you are stressed is an understatement. You may also be using a policy like factoring invoices, which in most cases, by their structure prevents you from ever achieving profitability. If you’ve planned to lose money in a certain year beyond your startup, then the discipline and care to do so wisely also applies to you - we’re not big fans of that strategy unless you are well established and really know your market.
The point is that somewhere in your organization there are inefficiencies or a process is broken. These are likely decisions you are or are not making that create a passive system that creates short term cash flow, but hurts long term profitability. Our goal is first to help you identify exactly what those things are and secondly help execute those critical projects to get your business back on track.
We implement a process to ensure profitability in the companies we work with. The purpose is to either keep it, or increase awareness about the barrier to profit and fix them.
A Simple Business Process to Ensure Profitability
We’ll be adding blog articles on strategy, budgeting, forecasting, sales and the other functional areas which are critical to success, but if you’re expecting a profitable year, here’s what we do.
At the end of each month, transfer whatever percentage you’re planning for into a savings account based on the Accounts Receivable collected. For example, if you received $100,000 in a given month and you’re planning a 10% profit, then $10,000 should be transferred to a special savings account. Don’t forget the fact that an average of 24% of that profit will be due in federal income tax.
If for some reason the monthly allotment is not deposited, it requires a written explanation from every member of your team responsible for the management of your strategy and operations. It’s a team problem, and whether you all do it together or as individuals, it enforces the discipline and ownership of success. The key question to answer is “What went wrong?” in a given month.
If you draw funds from the savings account, you must develop a plan to get that money back in the account as soon as possible, also in writing.
That account is protected; if you want to draw from those funds, the whole team has to agree in writing. It might make good sense in some cases to save interest, invest in R&D, or make a capital purchase. The key issue here is that you intentionally use the funds for a declared, well thought out purpose.
That fund becomes your cash reserve, which is critical in allowing you to sleep at night as an owner or CEO. It’s amazing to see how things change in a business that operates with a safety net in their cash reserve.
Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) doesn’t really count. Cash is king. Long-term profitability can still suffer when smaller companies talk big about EBITDA profitability to cover the fact that interest payments or depreciation is glaringly high. It’s not a valuable indicator until you want to sell. Net Profit matters most.
The Act of Writing is Important
One of the aspects of company culture we work hard to instill in company leaders and employees is ownership of both success and failure. Recording your successes and failures helps the team own the process. In turn, this helps drive a stronger, more honest culture by forcing employees to analyze and process past plans.
- Here is a simple starter checklist to use in analyzing common profit problems.
- Did sales meet projections?
- Did customers pay on time?
- Is your overhead too high, what is the industry standard?
- What unexpected events occurred?
- What costs were over budget?
- What specific actions will you take right now to remedy the above?
This Process is Critical
As a leader in your company, profit is your responsibility. This process forces you to think through the most important aspect to your future survival in business. It trains your thinking which will stay with you through your business career. Even if you’re the sole employee, write a letter to yourself explaining what you did or didn’t do so moving forward you can change it for the better.
Perhaps most importantly, this process creates a cash reserve which many smaller businesses lack. Even if you like living on the edge as an entrepreneur, your creativity and sales ability will be enhanced by a good night’s sleep knowing that you’ll always make payroll.