To run a successful, sustainable and resilient business, it’s not enough to have a strong mission, vision and values statement (although that’s a good start), you also have to have an underlying business model supported by data that (1) makes financial sense; and (2) provides you with the financial data you need to make decisions quickly and in real time.
How do you know if your business model makes financial sense? While there is no one right business model, they all need to meet the following criteria:
- The business model at maturity will generate more revenue than expenses AND it can do this without an influx of outside capital or paying below market wages.
- Outside capital should only be needed to scale or bridge the bad times.
Sustainable businesses make projections based on real time, realistic financial data that accurately reflects their actual costs of doing business. Leaders who have their arms around these numbers also enjoy an added bonus. In start-ups or companies seeking to scale, decision-making can be rapid and exhausting. However, when leaders have key financial data at their fingertips, that data can drive decisions. It makes the process easier, objective and more transparent.
While there are entire textbooks and courses on the subject, I’ve tried to simplify it so that a company looking to scale can focus on the basics that indicate whether your business will be sustainable and resilient.
In Part 1 we cover the basic projection and tracking data plus related terminology. This may differ a little bit depending on whether you are a products or services company. In Part 2 we will look at more detailed breakdowns of costs associated with customer acquisition and retention.
Accrual v. Cash
Accrual is the preferred accounting method. It gives a more accurate statement of the health of the company as it includes accounts payables. However, accrual doesn’t work in a vacuum, and you should always keep an up to date cash flow statement. More on that below.
This is the most important number for growth. Not revenues. Without profits, your business will struggle to exist and have limited growth opportunities. There are several different types of profit: Gross, Operating and Net. Depending on the life stage, type of business/industry, one may be more valuable, but being able to account for all of them will help you look at the big picture.
Gross Profit = Net Sales (less any returns and discounts) — Cost of Goods Sold (COGS). COGS can include: raw materials, wages for those directly involved in production; packaging; and shipping costs.
Gross Profit Rate = (Gross Profit x 100) / Revenue (i.e. Net Sales)
Operating Profit = Gross Profit — (Operating Expenses, Sales and Administrative Expenses, Amortization, Depreciation).
Administrative expenses = salaries, payroll taxes, benefits, rent, utilities, office supplies, insurance, depreciation, etc.
Operating profit includes all expenses EXCEPT income taxes. Basically it is a good method for monitoring how well a company is managing supply and demand for a product or service.
Net Profit = (Operating Profit + Any Other Income) — (Additional Expenses) — (Taxes). Net profit is what is generally known as “the bottom line” and is also used to calculate Earnings Per Share (EPS). EPS is a number like EBITDA that is more relevant to mature companies looking for additional capital.
EBITDA = Net Income + Interest + Taxes + Depreciation + Amortization
or EBITDA = Operating Profit + Depreciation + Amortization
EBITDA Margin = EBITDA / Revenue.
EBITDA is used to find the profitability of a company irrespective of its capital structure. This is what investors use to compare companies which may have very different capital structures. However, EBITDA doesn’t take into account all aspects of the business and therefore could potentially overstate cash flow, so it is not a preferred day-to-day management tool.
Gross margins are your profit rate, i.e. a percentage of sales. This is an important number/ratio, because it’s how you can gauge the health of your company. It’s where you can look for savings in COGS, or understand if you need to increase pricing. You should also look at it per product, service and, potentially by client (if there are great variations of revenue generated by different clients.) Profit margins vary by industry, but generally 5% is considered low margin (in that case, you need to do more volume in order to be sustainable). 10% is average, and 20%+ is high margin. Gross margins also help you analyze your break even point and a return on assets/investments.
Fixed v. Variable Expenses
When it comes to making projections, it’s useful to distinguish between fixed and variable expenses. Fixed expenses include rent, salaries, long-term vendor contracts. Those can be quantified and projected as continuing obligations. However, some businesses may be seasonal and therefore those expenses fluctuate throughout the year. The best way to project those are by using previous years’ numbers. There also may be variable expenses that can be increased or decreased as needed, or as a reflection of increased or decreased sales. These can be projected using the ratios mentioned above.
Revenue is pretty straightforward, but projecting it needs to take variables into account. If you have a seasonal business, or make fewer but larger sales, you might want to adjust projections and rely on earlier years for guidelines, as outlined above. Another revenue breakdown is whether it’s one-time only revenue as opposed to recurring revenue. Recurring revenue is obviously easier to project, but also better for valuations of the company as a whole, especially if they are locked into a subscription model or a long-term contract.
Finally, there is cash flow. This is a crucial number to keep your eye on as it dictates how long you stay in business. Cash flow takes into account any cash that flows through operating, investment or financing systems of the company. With cash flow it’s important to track vendor payments (start/stop dates, payment due).
And, just like there are multiple categories of profit, there are also multiple types of cash flow tracking:
Free cash flow refers to the resources available for distribution among all the stakeholders in the company. In essence, free cash flow is cash that is not required to be reinvested in the company to pay bills.
- Free cash flow = Net income + Depreciation/Amortization — Change in working capital — Capital expenditure
Operating cash flow provides an at-a-glance view of the day-to-day cash flow within your business. This is really the cash on hand. Best to set a minimum alert rate for any bookkeepers, so that you can make necessary adjustments in advance of need.
- Operating cash flow = Depreciation + Operating income — Taxes + Change in working capital
Cash flow forecasts provide a future look at what your cash flow will look like in the coming month, quarter or even year.
- Cash flow forecast = Beginning cash + Projected inflows — Projected outflows = What is the price point for a profitable client
This is just a quick overview of key financial data that should be tracked from the outset of your company. But, it’s just part of the cost of doing business. In Part 2, we look at the cost of customer acquisition and retention, because without customers or clients, you definitely won’t have a sustainable business.