In talking with small business owners, I am surprised how many have trouble off the top of their head responding to simple questions like what are your revenues, how much is in your bank account, what is your cash flow? Research studies find over 80% of the time poor cash management or poor understanding of cash flows contributes to the failure of a small business.
Another way of describing this predominant problem is a lack of funding or working capital. It is amazing how many people just jump into business without planning and understanding their working capital needs. Even the term working capital is foreign to their vocabulary. So, if you don’t know, it is the capital in the business used for short term operations. You take what is current assets such as cash in the bank, receivables, and inventory less the current liabilities and obligations you need to pay out in the short term considered less than a year.
You need to know more than what is working capital. Somehow accounting leaves many with that deer in the headlights look. In many ways, I understand. Even though I have a master’s in accounting, it was never my favorite subject. But I also understood back then when getting my degree accounting is the language of business and a necessity for running businesses.
In teaching a Corporate Strategy course to undergraduate business school seniors, far too many of the students didn’t understand balance sheets, income statements, and cash flow statements even though they had introductory accounting courses. It’s hard to execute a strategy without understanding the underlying economics.
Now to the purpose of this article. In my 4 Stage Growth Model for small businesses, those with this lack of knowledge on the basics of accounting and financial planning are generally in the Development Stage with revenues under one million dollars. My focus here is on the second and third stages of Growth and Take-Off with revenues generally from two to ten million or more. I will also give some additional profitability concepts for the Expansion Stage.
Margins and Overhead
If you look at a basic income statement, it is made up of revenues and costs. Revenues bring cash in, and costs take money out of the business. In understanding how to run the business, you need to break out the income statement into more useful concepts like margins. Gross Margin is Net Revenue (i.e., Revenue minus adjustments like refunds and discounts) minus Cost of Goods Sold. Cost of Goods sold refers to direct costs to produce the goods, that is material and directly involved labor. For Service Companies, this would involve cost of direct services. Service Companies do not always need to calculate a margin particularly if all the salaries are fixed.
Gross Margin tells you how much you have left in revenue to run the business. Often, you will want to turn this into a % by dividing the gross margin by the net revenue. If you have a large percentage, that is a good sign you have an attractive offering.
Your operating expenses beyond Cost of Goods sold such as administrative salaries/costs, rent, utilities, and the like are referred to as overhead. The higher your gross margin and the lower your operating costs the more income you make. It is important to keep a close eye on your overhead costs that can get out of hand. In other words, the margins do not support the overhead and income/profit is underwater.
Again, most small business owners in the Growth or Take-Off stages fully understand their gross margin and overhead expenses. You should have a financial plan for the year that targets Gross Margin and Overheads. Obviously, if the Gross Margin falls below the target, you will likely need to reduce overheads. There is a tendency to say these overhead costs are in the budget and just keep spending.
Key Performance Indicators
As the name implies, these indicators are about how the business performed. Not what you did to obtain that performance. However, as the performance looks strong or improves that is a clear sign you are doing things that make a difference to the company’s profitability.
The word key highlights that these indicators are very important in achieving your business objectives. A natural key indicator for Growth and Take-Off stages is revenue growth, particularly as a percentage. Gross Margin percentage (of revenue) is another indicator of the health of the business. As the company enters the Take-Off stage, understanding how this Gross Margin percentage compares to your competition gives insight into the competitiveness of your offering.
Don’t ignore net profit which deducts depreciation of your physical assets like equipment and amortization of your intangible assets such as computer software. As you become more sophisticated, also determine your return on investment. In simple terms, it is your net profit after tax divided by the capital (debt plus equity) you have invested in the business. That is a reasonable measure of the overall performance of the business. A similar measure is return on equity that excludes longer term debt in the denominator. That gives you a sense of how much your investment in the business is making that you can compare to other options for your money like interest on savings.
It’s not all about growth and income. Ultimately, you need to understand the very fundamental flow of cash in the business that can signal issues of sustainability. A key indicator is your net cash flow defined as net cash flow = cash flow from operations + cash flow from investing + cash flow from financing.
We already discussed working capital which gets impacted by net cash flow. Many Development Stage companies have a difficult time maintaining positive working capital which puts a strain on paying wages and vendors. As you grow, this working capital indicator needs to be positive. If you have robust growth, that will necessitate cash flow from financing.
Your debt-to-equity ratio will help give you an understanding of your ability to borrow. If this percentage is high, banks will be reluctant to give you more money. You may need to bring in investors to help grow if you are already highly leveraged. Having a low debt-to-equity may give you the capacity for acquisitions to accelerate your growth.
And for many companies, days receivables are outstanding triggers action to speed up cash flow. Other accounting metrics may also be useful for understanding your business’s performance. You may want to use variations of these financial indicators that fit your business better, but this should give you some ideas if you don’t already have these KPIs.
Break Even Analysis
What we have discussed so far is basic financial accounting. Managerial accounting can give you more insight into strategies and decision-making to enhance the company’s profitability. There are many specific costing concepts in managerial accounting often applied to larger companies, but for me break-even analysis can be very helpful for a small growing company that has unit product sales.
The concept is like gross margin analysis we discussed earlier. The distinction is in the nature of the cost. Some costs are inherently fixed such as rent. They generally remain constant regardless of changes in the level of activity.
Other costs vary with the level of activity and are termed variable costs. Examples are production wages, material, shipping costs, sales commission and so forth. The difference between revenue and variable costs is termed the contribution margin. You can then determine a contribution margin per unit of volume by dividing the contribution margin by the number of units sold.
To get the breakeven point, you then divide the fixed costs by the contribution margin per unit. That tells you how many units to sell to cover fixed costs or in other words break even. As you can visualize, the fixed cost per unit goes down as the number of units sold grows.
This break-even methodology can prove a fruitful modeling analysis by changing volume, contribution margin per unit, and fixed costs. You can get a real sense of how to improve your business performance by seeing how these changes impact your profitability. Obviously, there are a lot of cost nuances such as semi-variable costs and so forth. Overall, understanding contribution margin analysis can give some real insight into the business.
Break-even analysis is one form of understanding value drivers. Unlike key performance indicators, value drivers deal specifically with operational activities that create value for the company. Sometimes, these are not controllable by you but knowing how they impact the business can improve your decision making.
In Shell’s downstream manufacturing business, we followed closely what was termed the light-heavy differential. In simplistic terms, heavy crude requires a lot of coking or cracking to break down the molecules into usable products such as gasoline. Lighter crudes can be turned into gasoline with a lot less sophisticated and less costly equipment. If the spread between light and heavy crude is large, then the “cokers and crakers” will be very profitable. That can influence heavily the decision to invest in this type manufacturing equipment. Thus, this light-heavy differential is a significant value driver for refineries.
Other value drivers you can control directly. You might find that the number of calls from your call center has a significant impact on your revenue generated. You can plot the relationship and determine the profitability impact not unlike break even analysis for such a value driver. Likewise, number of returned items or redoes could be a value driver in that the lower the activity the higher the profit. A similar concept is zero defects as a value driver. The point is these are the operational activities you spend time understanding and acting on.
Certainly, as you enter the Take-off Stage, you will want to follow indicators of how your company will be valued by potential investors or acquirors. The concept of EBITDA should become part of your vocabulary and following.
The acronym stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. Ultimately valuations come down to cash generation. EBITDA is a proxy for cash generation. There are many factors in valuing your business; in a typical industry you often hear multiples of EBITDA like five times. In high growth high opportunity industries, the multiples will be much higher and low growth stagnant industries will likely be lower.
Similarly, revenue is another barometer of value. There is no value unless the business can generate revenues. You will hear metrics like one times revenue as a measure of the company’s worth. High potential industries will have much higher multiples. In the Take-off and Expansion stage, you will want to keep up with the going value of your business.
Discounted Cash Flows
In the Expansion Stage of the growth model, you will want to become familiar with discounted cash flows as a measure of value. EBITDA and historical revenue relate to the past and are only proxies of the future. The true value of the business is what it can generate in the future. The concept of discounted cash flows is based on forecasting the future and then valuing the cash flow stream.
The forecasting you do goes out a number of years like ten and then you set a terminal or sale value at that point as the final cash input. The key concept is that cash today is worth more to me than cash in the future. Why is that so? Because I could invest cash today and get a return on that cash. You include not just the projected future cash generated but the cash outflows you must make. The major investment usually occurs in the beginning and is not discounted as it is in the present. It represents a negative cash outlay that must be overcome.
The return on the cash is the discount rate much like the ROI discussed earlier. For any year out into the future, you apply the return multiplicative to the number of years out in the future. What you find is the value out ten years is much less than the value generated a year from now. The higher the rate of return, the lower the value of future cash generated.
Using this technique, you can determine the exact rate of return on the future cash flows you projected for the business. That occurs when the rate of return causes the present and future cash flows to equal zero. Some people refer to this rate as the earning power of the business.
By the time you consider using this concept to value your business, an acquisition opportunity, or a large investment in the business, you may have determined your cost of capital. There are many definitions you get when you do an internet search. Simplistically, it is the minimum return you want from making an investment in an acquisition or big expenditure. From the capital markets standpoint, it is the weighted average return of what it costs you to borrow or have stockholders invest.
It is very useful to know your approximate cost of capital. Venture capital companies have a much higher cost of capital expectation because they are taking on more risk. It is somewhat similar for angel investors. Debt is almost always cheaper as they will have the rights to your assets in the case of default. If you can get debt, that is generally the preferred option as it lowers your cost of capital. When the risk is too high for the bank, you will have the higher cost from investors.
If you have determined a cost of capital, then that rate can be used to discount the present and future cash flows projected. There will be a discounted cash value that may be positive or negative. If the value is negative, then you reject the outlay as the projected value does not meet your cost of capital. If it is positive, then from a financial standpoint the investment is worthwhile. The resultant is called present value profit.
As you grow and have more investment alternatives, it can be useful to determine profitability index by dividing the present value profit by the initial investment. This enables you to compare the attractiveness of these various alternatives.
None of these measures are without problems and issues. Discounted cash flows would be very exact if you could in fact accurately estimate future cash flows. Thus, you may have to run various cases. ROI does not incorporate the future and so forth. Most of the financial indicators are snapshots in time.
The combination of what we have discussed is much better than flying by the seat of your pants as is often done in the development stage. The more you know and understand these concepts the much greater your chance of growing a successful business.
What you use of these financial concepts should grow as your business grows. You must understand working capital as fundamental. As business develops, get a grip on your margins and overheads. With maturity into the Growth Stage, managing the business with KPIs can be very helpful. To continue to grow, understanding your value drivers will be key. Break-even analysis can be helpful in this understanding. As you reach the Take-Off stage think more about valuing your business. At first, that will be traditional measures like EBITDA and revenue multiples. Then as you expand, discounted cash flows can provide more insight which is why large companies use this technique.