Understanding Your Costs and the Financial Health of your Small Business
If you’re in business, an Investor or you just like to read the business press or news, you’ll often hear words or phrases like, “This Company makes Money,” “Gross Profit,” “Margins,” “Earnings,” or maybe “Working Capital.” The terminology and the slang can be confusing or downright boring, if this is not your cup of tea.
In some cases, the terms are grossly misused in the context of what is being described or the references are simply, incorrect.
One of my favorites-My Company Makes Money! To me, this conjures up an image of someone in their basement with a printing press, like an old Dickens novel. Making a profit is different than generating cash. Personally, as a small business owner, I’m not really enamored with paper profits as much as I am with generating a consistent, sustainable cash flow.
What does it really mean? What is important, and why should you even care?
Well, if you’re an Entrepreneur, Business Owner, or thinking about starting your own business, the language, meaning and grasp of these and other financial concepts is essential (and I would say, critical) to 1. the understanding of how your LLC, Partnership, S-Corp. (etc.) generates income and cash; 2. driving decisions that you will ultimately make as your enterprise evolves and; 3. the impact on your credibility to speak confidently and competently to Investors and Creditors that you may seek for capital infusions as your business grows.
If you’re a manufacturer or a service provider can you speak confidently about your Operating Margins or Gross Profit, if asked? Even more fundamental to this, how do you know if your company makes enough Gross Profit to cover your Fixed (or Recurring Monthly) Expenses? If you’re looking at a revolving line of credit to cover your Working Capital requirements, do you understand those covenants that Creditors will often place as a condition for this type of loan?
Since Gross Profit is the residual amount after deducting your direct expenses (those that vary with sales activity), how do you know if you’re pricing your product or service at a level that allows you enough to earn a profit (Net Income)? How much pricing “power” do you have-how much can you raise prices before you see an appreciable fall-off in sales volume, and how much fall-off is acceptable?
If you’re a manufacturer, and you make and sell a product that doesn’t cover your variable expenses, that’s as bad as it gets. But how would you go about determining if your direct expenses/unit are greater than your selling price/unit? Have you looked at your entire process to understand how much it costs to complete (1) unit through your operation…what about those costs that you may not think to include in your calculation?
If you decide to automate some aspects of your operation, your Operating Margins will improve, but how long of a horizon would you intend to spread your debt into the future, given that long term debt is more expensive to service?
A lot of questions, yes. But who can you trust to help you sort through this?
TMA, Accounting Services & More-The Mobile Accountant is a full-service Firm that assists businesses not only with Accounting, Bookkeeping, Tax Preparation and Planning, but with the ability to provide insight into your operation, and to provide you an understanding of the relative financial health of your business. I say relative, because the financial health of any business has meaning only when compared to its’ competitors and the sector of the economy in which it competes.
Companies amass an awful lot of financial and accounting data with little or no regard on how best to use it to help them plan, looking forward. Source accounting data and transactions provide a wealth of information to help businesses plan, if you know what to look for and how to “cut” it.
Yes, you can use historical data as a way to plan for the future. The ability of any Company to predict their capital needs depends on the quality of the data used and consideration of those external (Macro) factors that are completely outside the control of any Firm-the health of the economy, unforeseen positive and negative events, politics and policy changes, and too many others to list, here.
As an example: If your business is highly seasonal, your Working Capital needs will increase during the peak time of your “season.” Failure to take this into consideration could mean depleted Inventories, an inability to fulfill orders, lost sales and getting hammered on social media.
The idea here is to plan with what you have and what you know and to take into consideration those events that could impact or influence your business, whether they be external economic factors or legal issues.
Planning involves estimates and your best reasoned judgement at a particular point in time, and plans should roll “forward” as events occur.
What I’ve presented here are some broad “brush strokes.” If you would like to learn more, contact Mike at email@example.com or (734) 778-8429.