Editor’s note: This article was first published in January 2014, during Spain’s economic crisis; its references to how banks treated receivables “in the boom years” and to today’s “high default rates” reflect that context.
You can be a good businessperson and still be terrible at analysing the numbers in your business. Even so, a minimum of financial know-how will help you not only in your business but also to make the money you earn from your company work for you.
As your business grows, it is a very good idea to hire an outside accountant or advisory firm (depending on the budget you have available), but in the first few months or years your turnover may not allow for big outlays on these matters (even so, hiring an advisory firm is still recommended). There are plenty of numbers to look at in a business’s accounts, but there are a few figures that we really do need to give due importance to, and anyone can analyse them if they know where to look. So which numbers control the health of our company?
The first thing would be to forget the romantic poetry of business: “The customer is the most important thing, and our company bends over backwards for the customer…”. That sounds very nice in a company philosophy, and if one day you become a big businessperson, it will sound even better. The catch is that it isn’t entirely true. The most important thing is not the customer, but the profit your customer brings you and the overall profit from all your customers together. If after a while you are not making a profit, you will soon stop having customers and employees.
My old barber bent over backwards for his customers, but one afternoon, after crunching the numbers for rent, electricity, water, taxes and his self-employed contributions (the monthly social security payment self-employed workers make in Spain), he needed more customers to cover those costs than he could possibly see in 12 hours. In fact, when we went through his numbers, it turned out he had made a net profit of €15.47 the previous month. And that was a good month, because the month before he had lost money.
Some time ago we explained how much your business needs to grow each year for it to be worth keeping. We insist that, as far as possible, we should choose businesses that have real potential for growth with no fixed ceiling on that growth.
1. Profit
Clearly, the health of a company, whether we are talking about our small business or a listed company, is found in its profit. We are going to look at net profit (after deducting all variable and fixed costs, and ideally after tax). Now let’s see what studying our profit tells us, because it is a great indicator of where our business is heading.
If we look at the profit for each of the last 6 or 12 months, what numbers do we find: positive, negative, large, small?
Let’s analyse the trend: draw a chart (as if it were the chart of a stock). Is profit going up, going down or flat? It’s called a trend because, based on the past path of the line on the chart, it will in all likelihood carry on in the same direction in the future unless we do something urgently.
The most worrying trend may well be the flat line, since it could point to a ceiling, depending on the type of business. And ceilings (or permanent resistance levels) sooner or later lead to downtrends.
If your business is in a continuous downtrend, or isn’t profitable enough to pay you for the hours you are putting in, earning you less profit than the salary you would pay an employee, that business is not sustainable.
2. Expenses
Can you increase your sales and make less profit? It happens every day in many companies. We need to stay alert, because in the vast majority of businesses, if we draw two new lines on the previous chart, we could find sales going up and profit going down, simply because expenses have grown faster than income.
Expenses are a number you have to watch very closely, because in business the reverse rules work perfectly well, and “sometimes you earn more by selling less”.
Statistically, the probability of failure in small businesses rises just when they are making a leap in growth, because of new investments, new hires and new expenses in general.
Many companies are doing really well and fall when they try to make the leap. Going from small to medium-sized or large requires a strategy that has been very carefully thought through and worked out in advance.
So it is quite normal that, at some point in the life of your business, the chart will be temporarily thrown out of shape. The “secret” to pulling this off successfully is for it to be very temporary and for the situation not to last too long.
Watch out for taxes:
I don’t know how it works in other countries, but at least in Spain, a company can make much less profit and pay much more tax. Clearly, this situation can be avoided by resorting to expenses…
3. Accounts receivable
These days, the lower this number the better, because in the boom years even banks interpreted accounts receivable as future profit. Today they are called debts (which is what they really are), and with high default rates, a large percentage of those accounts could go unpaid.
It’s no secret that a healthy business collects at 30 days and pays at 60 days. If you do it the other way round, you’ll have problems.
Sometimes, when a business is just starting out, it is better not to sell at all than to sell on 90-day terms, depending on the type of business. For other types of business, with stock that has been tied up for 6 months with no way of shifting it, it may even suit us to sell it on 120-day terms. Even so, apart from a few exceptions, the fewer accounts receivable, the better.
4. Profit per customer
Few companies study this number, and so they don’t know how much their customers are worth. And we’re not talking about sentimental value, but economic value. Who are your best customers?
Obviously, the ones who generate the most profit for you. Not all customers are equal: some may even buy more from you but also generate higher costs, and therefore lower profits or even losses.
It is just as important to know how much each of our customers is worth on average as it is to know how much each individual customer is worth. When you analyse this number, you’ll probably save yourself the cost of sending a Christmas card to some customers.
This figure will give us ideas for sales strategies with our customers: offers for those who buy the least, more sales or bigger sales per customer for those who buy the most from us, and so on. (Read: How to sell more in a small business with 3 simple strategies)
5. Sales
As we explained in a previous article, as long as we have sales, everything else can be fixed. Sales are our raw material, from which we can shape expenses and investments, make everything as profitable as possible, and so on… This raw material also needs to keep rising over time to make sure our business stays healthy.
But if we have no sales, we have nothing. In fact, we don’t have a business, and we should forget everything else and focus solely on getting sales, because remember: the customer is the most important thing, and so is their money 🙂
Further reading
