Wednesday, June 20, 2012
I heard an interesting story from a Chief Executive Boards International member who is in the process of downsizing his company to profitability. He and his partner had been in growth mode, finding and booking more new business and hiring more people. They looked up one day to realize they weren't making money any more.
What happened? No financial model. No blueprint for how the business performs at the gross margin line, and no idea how much overhead the business can afford at any given level of business volume. They over-hired, took some lower margin business, and found themselves working twice as hard for no money.
This is another story that underscores the importance of business owners digging into their financials up to both elbows. Many don't and they ignore their financials at their own peril.
So, what are you watching for? Most importantly, ratios. Specifically, ratios of just about everything on the income statement to the top (total revenue) line. Gross margin, for example is revenue minus all variable costs. What are variable costs? The costs that move along with sales revenue, such as labor and material. If you do twice as much of the same kind of work, it's likely that your variable costs will be exactly twice as much -- the ratio will remain constant. Those variable costs are sometimes called Cost of Goods Sold (COGS).
Of course, not all the business you do is the same. On some lines of business you have better gross margins than others. Do you know which is which? If so, you can model your future income statement, based on its variations from the past. More of the higher gross margin business, and the GM % to Sales (revenue) will improve. The reverse is true, also.
Then you have costs of sales (CoS) or selling costs -- the money that goes into generating new sales. Advertising, marketing, travel and entertainment, commissions and so forth. For what you're doing right now, what is your CoS as a percentage of revenue? One could assume if you plan to grow revenue you'll have to front that with stepped-up CoS. Of course, you can model that in advance, and expect that new business to lag by several months.
And, finally, there's Overhead, sometimes called General and Administrative (G&A) Expense. That's the basic cost of keeping the doors open. Rent, Utilities, Office Salaries, etc. A lot of G&A is fixed in the short term. For a given size building, rent, utilities and maintenance will stay about the same. If you can push 25% more revenue and 25% more gross margin through the same facility, you'll get to keep most of it -- G&A may move, but probably not much. So G&A as a % of revenue is likely to drop, thereby raising Net Profit as a % of revenue. You can model those assumptions and predict your future income statement.
Hint -- If you're a QuickBooks user, there's a checkbox that adds ratios of most sections of the income statement, relative to total revenue.
This future income statement model becomes your operating benchmark, sometimes called the budget. As the year unfolds, you'll see where you were right in your assumptions and where you were wrong.
You can also model your Balance Sheet, the most important part of which is forecasting your working capital as your sales grow. How much more Inventory and Accounts Receivable will you need to support 25% more sales? That depends on ratios like Inventory Turns and Days Sales Outstanding (how many days of sales, on average, are tied up in AR?). Again, ratios you need to be watching month-to-month.
Your financials are your instrumentation -- if you know airspeed, altitude and compass heading, you can predict where your airplane will be in a couple of hours and that you won't hit the ground before then. You'd want to know you have enough fuel, as well.
If you don't completely understand your company's financials or you haven't used them to forecast your next couple of years of profitability, hire some help. Find a CFO for hire -- someone who will help you a day or two a week to turn your financials into instrumentation you can use.
If you've had a similar experience, or you've decided to find a part-time CFO, click "Comments" below and let others know.
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