Why Understanding Finances Is The Secret Ingredient
I’m going to talk about finances.
Don’t delete the email or close the window! You really need to hear this, and I promise it won’t be boring!
OK, jokes aside, unless you are a finance specialist like an accountant or a bit of a numbers nerd, finances usually make a small business owners’ eyes go blank.
That’s understandable because if you are like most small business owners, you started your business as a subject-matter expert. You knew your stuff, that’s why you had the confidence to start your own business. You knew that at worst, you could back yourself on selling what you know. But you’re an intelligent person, so you realised that running your own business wasn’t like working for the man, where all you had to do was show up and do your stuff. That’s why, to your great credit, you end up reading websites or newsletter like this.
You knew you had to find out about business planning, you had to know about marketing, you had to find the sales prospects and work out the best and most efficient way to supply what you supply. You had to hire staff and then manage them.
And, you had to manage the finances.
Like most people who are not finance trained you probably bought software that was hopefully easy to use, and you copied the data at the end of the year and gave it to your accountant. As soon as you could afford it, you hired a bookkeeper and handed the operation of the accounting software to her.
I don’t like to tear you down, but that’s not good enough.
Firstly, you started this business because you had a dream – a vision that you would build a successful business that you enjoyed working in and that you could be proud of. You saw your business grow and be profitable – some of us dreamt we would be millionaires, others just that they earned a good living – but whichever, you saw the profits giving you an affordable and pleasant lifestyle where you enjoyed going to work and was still able to spend happy time with family and be able to look after your loved ones.
So, this means that one of the important outcomes of your vision must be profit and cash flow. I’ll tell you why I included “and cash flow” later below.
If this is true, then no matter how you define “sufficient” profit, you need to keep an eye on the financial result as an outcome you can control, not as an output of what you do. I mean that you cannot just do your thing and then wait until your accountant tells you how much you made, or lost. That makes you a puppet rather than a business owner who must control their own destiny. What you need to do as a business owner is to be in touch with your finances so that you know the result of your decisions, analyse what you can do to change the result, and put changes into place early, not once a year, several months after the end of the year.
Secondly, you are the business owner. You have invested a lot of money, time, and emotion into this business. You can legitimately delegate tasks, but you cannot abrogate your responsibility to yourself.
If you want to increase sales, you can hire a salesperson and delegate the task of calling customers to them. But you would never leave them alone, would you? You would manage them to see that they were calling customers, that they used the right approach, and that they were finding new customers. If you discover that they were not increasing sales and not keeping in touch with customers, you would do something about it, even if you, yourself were not an expert salesperson. So while you delegated the task of making sales to them, you never abrogated the responsibility to yourself that it worked.
So why should you not do the same thing with your bookkeeper or accountant? You can delegate the task of keeping the books to them, but why would you not manage the situation? You should be asking for regular reports, you should be analysing them with your bookkeeper or accountant, asking why profits were up or down and why things were costing more or earning less. Just because you are not financially expert does not mean that you can ignore the results of the delegation.
Third, you can do all the other things that you like – you can write and implement your business plan, you can create a great product, you can follow your focused marketing plan, you can make your work processes efficient, you can manage a functional team – but none of the other things tells you about what you should do or change in your business as much as your financial reports. Strategies in your business plan will have a financial effect, whether you increase expenses to implement them or they result in efficiency or expansion which increase profits. Innovative products have costs to develop and should return better sales. A marketing plan should get you more customers and show a better return on investment for your marketing dollar. Efficient processes save you money and increase profits, as well as make your business more valuable. Great functional teams produce better financial results. All of these things that you do have a financial effect – in fact, the purpose is to have a better financial result. So, how would you know that they do if you don’t receive, check and analyse their effects shown in your finances?
That’s why, after all your planning, marketing, and people leadership – all being things you need to do to work on your business improvement – understanding your finances is the secret ingredient of building your successful business.
OK, so those are the three reasons why understanding your finances is important. Now, you are not financially trained, so what should you be aware of?
You should know what reports are available from your system, what they mean, and what others you might need.
The basic reports that any system can produce are a Profit and Loss Statement and a Balance Sheet.
A Profit and Loss Statement (which sometimes might make more sense if it is called a Profit or Loss Statement) tells you what profit or loss you have made in a given period. It is a report covering a period of time, for example, your Profit and Loss Statement for the period 1st July 2019 to 30 September 2019, or a Profit and Loss Statement for the month of June 2019.
But it tells you much more than just whether you’ve made a profit or loss over that stated period.
If you buy and sell, or make and sell products, your Profit and Loss Statement can tell you what your gross profit is. Your gross profit is the profit you make after you deduct the costs to buy or to make your products. Your gross profit is what you make on your sales before you deduct overheads or running costs. Your gross profit percentage (gross profit as a percentage of total sales) should be constant whether you make one sale or a hundred because it should reflect the markup of your cost. For example, if you buy tools for $50 each and sell them for $100 each, your gross profit should always be 50% whether your sales is $100 or $100,000. This is powerful information to tell you things like: –
- Am I marking up by enough?
- What if I discounted my sale price – how would that affect my overall profitability?
- Can I get away with raising my prices – how would that affect my profitability?
- Should I find a cheaper supplier – how would that affect profitability?
- If I find a cheaper supplier but the quality fell, how many sales might I lose and is the saving a good trade-off?
- How many units do I need to sell to break even (after paying my overheads and running costs)?
Your Profit and Loss Statement also gives you information about the different categories of overheads and running costs like rents, power, stationery, office costs, salaries, and so on. Again, if you ask questions, this information changes from a static report into something you can change for better results. For example, rather than accepting that rents are something you pay, compare them to other premises. Can you save rental expenses while retaining what you need from premises? What about salaries? Can you make your people more efficient for the same cost?
Because your Profit and Loss Statement reports over a period, you can also make comparisons between periods. Why has the profit risen so dramatically this month from the last three months? Oh, I see, it looks like the result of my marketing campaign. Why are we buying more office supplies this quarter than last quarter? Hmmm, it seems that one of our older printers is really chewing up toner, I wonder if it would be cheaper to replace it?
Having explored questions like these, it is in your power to do more of something, less of something, or explore different alternatives.
Your Balance Sheet is a report on what your business is worth. It is a picture – at the end of one day – of the value of your assets, less the value of your liabilities.
Since it is a snapshot of your worth, it is a record of the last day of a period, for example, the Balance Sheet as at 30 June 2019. However, the difference of your net worth or net assets between one day of a period and another should reflect your profit or loss in that period. If you made a profit of $100,000 between July 2018 and June 2019, then the difference between the net assets shown on your Balance Sheets at 30 June 2018 and at 30 June 2019 should be $100,000. (Note: there are subtle differences, for example, if you took out some of the profit as a dividend, so you should ask your accountant to explain the differences.)
The most important information that a Balance Sheet tells you are: –
- What your net assets (or net liabilities) are – so what you are worth
- What you own
- What you owe
- Your solvency
Again, you should ask questions to see if you can make changes for a better result: –
- Why have my net assets fallen over the last two years, am I taking too much out? Are my assets depreciating in value because they are older?
- Why are my customers owing me so much? Is it because they are taking too long to pay or is it because we have been making more sales recently?
- Why are my liabilities increasing in the last 3 months, is it because I am buying more, or has cash flow been tight and I am taking longer to pay?
Your solvency is a critical financial factor, even for a business in a rapid growth phase.
Up above, I said “one of the important outcomes of your vision must be profit and cash flow” and I promised to explain why I included cash flow. Here it is – your profit is not the same as the increase in cash in the bank.
Let me say that again – because you made a $100,000 profit in the last month, it does not mean you have $100,000 more in the bank at the end of the month.
This is because, if you give your customers credit terms, some of that profit is sitting in your books as Accounts Receivable, not cash. On the other hand, you have probably not paid all your suppliers last month so you have more cash in your bank because of that, even though some of your cash in the bank is “spoken for”. As well, if you buy and sell a physical product, some of that profit is sitting on your shelves as physical stock, rather than in your bank. This means that in a period of rapid growth, you may unexpectedly find that you have severe cash flow problems. This is because, while you are selling your product like hot-cakes, you are paying out cash to stock your inventory shelves and to pay for running expenses faster than your customers are paying you. So, while your Profit and Loss Statement looks healthy, and your net assets look good (because you have plenty of stock and Accounts Receivable as assets), there’s not a lot in your bank.
These are just some of the things that can cause a difference between profit and the increase of cash in the bank. Ask your accountant to explain why your profit is not reflected in the bank (he can prepare and explain to you a report called the Statement of Cash Flow). Get to know the patterns that your business show. Then, you can ask the questions that might show you how you can improve, like: –
- What if I got rid of slow-moving stock?
- What if I gave my customers a cash discount?
- Should I increase my margins?
- Could I negotiate better terms from suppliers?
- Do I need to put in more capital or borrow long term?
From the discussion above, you can guess what other reports you might want to see.
Your accounting software should be capable of printing on-demand reports on Aged Receivables (who owes you, how much, and how old the debt is), Aged Payables (the same information but relating to what you owe others), and Aged Inventory (what’s on the shelves, what’s it worth, and how long it’s been there).
With more trouble, or by asking your accountant to prepare it, a cash flow report is also useful so that you can compare how your cash comes in and goes out in the same period as a Profit and Loss Statement showing how income is recognised and expenditure is incurred.
You should also be preparing, and comparing your actual results, to a budget. Comparing your Profit and Loss Statement for a period with the budget can give you invaluable information about assumptions that proved wrong (and therefore what you have to do) or circumstances that have changed (and how you need to react).
If all this discussion about understanding financial reports is stressing you out – relax!
I’m not suggesting you need to go and do a finance major or qualify as a CPA!
What I’m saying is that you need to understand the basic secret ingredient of understanding your finances, in order to make sure that the effects of working on your business produce financial results.
You can hire an accountant, but you cannot leave it to them. You must meet with them, get them to explain the reports to you, understand the meaning of those reports, and ask questions that you can work on to improve your business.
You must do this regularly and frequently so that you can make the changes early so that you improve early. Meet at least once a month. Maybe as you become more proficient, you can reduce that frequency and just analyse the computer reports yourself. But whatever you do, don’t leave it until the end of the year.
So there, you see – not boring at all, right? And all of it is within your capabilities – you can organise a meeting with your accountant, you can ask intelligent questions, you can make changes to try things out.
It’s your business – stay in control of your finances and don’t let your finances control you.
Use the secret ingredient!
Get over to Teik Oh Dot Com to see more (less boring) ideas, tools and resources that will grow your business into that successful one you dream of.
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